Monetary Policy: The Global ANALYST, January 2016

The Global ANALYST, January 2016
Monetary Policy:
 Don’t Underestimate It*
M G Warrier
I am writing this article soon after TGA Managing Editor N Janardhan Rao mentioned to me about a media report(December 2015) which quoted a view that monetary policy is losing its sting with every incremental rise in money supply generating less growth each passing year. The report was padded further with observations like, “In FY15, every incremental rupee of money supply generated just Rs 1.2 of incremental gross domestic product (GDP). The ratio was 1.6x in early 2000s and 2.2x on the eve of economic reforms in 1991 according to data from the Reserve Bank of India (RBI).” As I have not done much research on the impact of monetary policy per se on GDP, adjusted for inflation over time, this article is not getting involved in a discussion on this media report. But the report, which gives an impression that the function of central banks hovers around making adjustments in their own ‘base rates’,  is ‘food for thought’, strong enough to make one get disturbed about the perception even among the well-informed people about monetary policy and the role of central bank in the economic growth of the country. At the risk of repetition, we may have to dwell in some detail about the evolution of the role of Reserve Bank of India as an institution responsible for not only the core functions of a central bank, but as a proactive partner with Government of India in regulating and preserving a financial system which has been playing an effective role in the country’s economic development.

At this stage, we need to go back in time. The Indian legislatures, during the two decades each that preceded and succeeded independence, functioned smoothly and gave shape to several statutes including the Indian Constitution and the Reserve Bank of India Act, 1934 which every Indian can be proud of. There were informed and intelligent debates in legislatures and the Constituent Assembly before finalising every clause of the documents which later became statutes. The credit goes to the then political leadership, which did not have an opposition which thought its only role was to ‘oppose’, and the Indian National Congress which respected and allowed ‘informed dissent’ from within and shared views with and took into confidence on all important issues, an opposition which had great leaders, but was not very strong, going by numbers. We will leave this here, but the reminder was necessary to explain the context in which we are going back to the preamble of the Reserve Bank of India Act, 1934 for initiating a discussion on Monetary Policy. The PREAMBLE reads:
 An Act to constitute a Reserve Bank of India.
Whereas it is expedient to constitute a Reserve Bank for India to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency any credit system of the country to its advantage;
And whereas in the present disorganisation of the monetary systems of the world it is not possible to determine what will be suitable as a permanent basis for the Indian monetary system;
But whereas it is expedient to make temporary provision on the basis of the existing monetary system,
and to leave the question of the monetary standard best suited to India to be considered when the international monetary position has become sufficiently clear and stable to make it possible to frame permanent measures; It is hereby enacted as follows:”

Although, it would be illogical to presume that ‘the international monetary position’ did not ‘become sufficiently clear and stable to make it possible to permanent measures’ during the 8 decades that followed the establishment of RBI, fact remains that no comprehensive review of the provisions of RBI Act was ever taken up and this defies common sense. Please do not remind me about the (Draft) Indian Financial Code (IFC) prepared by the Financial Sector Legislative Reforms Commission (FSLRC). The FSLRC lacked the expertise and time to undertake the huge task of reviewing the entire legislative set up in the Indian financial sector. The (Draft) IFC it put together is an avial( reference is to a South Indian mixed vegetable dish, which was originally prepared from the left-over vegetables after use for the main course menu for a feast!) cooked in a hurry by an amateur cook who did not have any idea about the final product or the fate of those who are destined to taste it. Suffice to conclude that the review envisaged in the original statute which constituted India’s central bank is yet to happen. I am not contesting the use of FSLRC report as a basis for further deliberations on the issues that have been covered in the report.

By traditional definition, “Monetary Policy is a regulatory policy by which the central bank or monetary authority of a country controls the supply of money, availability of bank credit and cost of money, that is, the rate of Interest.” Monetary management, therefore, is regarded as an important tool of economic management in India. RBI controls the supply of money and bank credit. The Central bank is duty-bound to see that legitimate credit requirements are met and at the same credit is not used for unproductive and speculative purposes. Reserve Bank of India is aware of this responsibility and rightly calls its credit policy as one of controlled expansion, with focus on economic development and financial inclusion. The constraints in evolving an ideal monetary policy emanates from the fact that the central bank is owned by Government of India which has huge stakes in public sector commercial banks which have a share of 75 per cent in the country’s banking business and, sometimes, exercise their ‘ownership rights’ indirectly to manipulate the decisions of RBI and banks, which should normally be taken by the respective institutions, applying mind, consistent with the statutory mandate vested in these institutions.

The main objective of Monetary Policy in India is ‘growth with stability’. This is sought to be achieved by regulating availability, cost and use of credit. Reserve Bank of India has also been playing a significant role in institution building in the financial sector. Even the recent approach of RBI to licensing a couple of new private sector banks and introducing payment banks and small banks which essentially meant bringing some of the existing institutions like post offices and microfinance institutions into mainstream banking business with concomitant obligation to conform to regulatory norms applicable to banks, should be seen in this perspective.

Financial stability means the ability of the economy to absorb shocks and maintain confidence in financial system. Threats to financial stability can come from internal and external shocks. Such shocks can destabilize the country’s financial system. Thus, RBI adopts an apparently conservative policy approach  seeking to maintain confidence in financial system through proper regulation and controls, without sacrificing the objective of growth. To be successful in its objectives, RBI needs functional independence within the contours of law and a strong balance sheet with adequate ‘reserves’ to meet any eventuality arising from its market-related operations in Indian and foreign currencies. RBI should also be in a position to manage its personnel by hiring competent staff and retaining them by providing competitive compensation and career development opportunities. Governor Dr Raghuram Rajan has flagged some HR-related issues in RBI Annual Report 2014-15 which should receive the attention of GOI.

For historic reasons RBI has been involved also in ensuring adequate credit flow to priority sector which includes agriculture, export and small scale enterprises and weaker section of population. RBI guides banks to provide timely and adequate credit at affordable cost to weaker sections and low income groups.

Monetary policy helps in employment generation by influencing the rate of investment and allocation of investment among various economic activities of different labour Intensities.

Interest rates

This is a time when the whole world is worrying about a possible 25 basis points(one basis point is one percent of one per cent) rise in Fed Reserve’s benchmark rate. RBI had during 2015-16, so far, reduced its base rate by 125 basis points. During the Monetary policy review on December 1, 2015, RBI Governor Dr Rajan mentioned that reduction in benchmark rates by banks consequent to this has so far been to the extent 0.6 percentage points. The delay in percolation of the impact of RBI’s rate cuts has made RBI think in terms of guiding banks to introduce ‘marginal cost pricing’, details of which are expected to be announced any time now. In this context, Dr Rajan referred to LIBOR(London Interbank Offered Rate) which, banks in UK charge each other for short term loans. The new concept of marginal cost pricing may require banks to pass on the benefits of deposit/resources cost reduction to their new borrowers immediately.

FSLRC and Monetary Policy Committee

The deliberations that preceded the constitution of the Monetary Policy Committee and the final recognition that as regards monetary policy management, the buck stops at RBI Governor’s desk gave an impression that relationship issues between finance ministry and RBI should be sorted out first. In this context, let me recall S S Tarapore’s article ‘A Plot to Destroy RBI’(The Hindu Business Line, May 3, 2013) which concluded with the following observations:
Devil in the detail
The Commission recommends the setting up of a statutory Monetary Policy Committee (MPC) to take executive decisions on monetary policy with each member having a vote and the Chairperson having a veto, which must be explained with a public statement. The devil is in the detail.
There would be only two RBI members and five external members appointed by the Government. The Ministry of Finance nominee would be a non-voting member on the MPC but would articulate the Government viewpoint.
With Big Brother watching over their shoulder, brave would be the external member who would deviate from the Government line. The RBI would be better off with the present arrangement.
The leitmotif of the FSLRC is to charge the gate of the temple of money with iconoclastic fervour. One prays that in this internecine battle, the RBI’s Pretorian Guards fight off the charge of the Commissioners.
One must remember that countries that destroy their central banks destroy themselves.”
 Fortunately, times have changed and the change of guard at North Block(Finance Ministry) and Mint Road(RBI) has made mutual consultations between the central bank and GOI more frequent and meaningful. For those who have been following the position taken by some of the members of FSLRC and by the RBI top management, this gives great relief. The relief comes also from the confidence that Dr Rajan’s strong leadership in the financial sector can defend the right postures consistently taken by the central bank.

Not much research is needed to conclude that finance ministry and FSLRC, in a hurry to resolve certain minor issues, ignored the evolution of the role of RBI and the care with which RBI has nurtured the financial sector. There are eminent analysts and economists who compare the role of RBI with that of Fed Reserve. The two central banks have two different histories and they function in two different worlds. To say that time is not right for dismantling or truncating the RBI which is doing creditably well as has been admitted in several international forums, would be telling the obvious. 

The dissenting notes recorded by 4 out of 7 members who signed the final report are well-argued documents, which inter alia plead the case for maintaining the basic features of RBI and assert the need for allowing the central bank to carry on with its present mandates. One wonders what motivated the FSLRC Chairman to finalize the report ignoring the difference of views expressed especially by K J Udeshi, P J Nayak and Y H Malegam. 

It would appear that FSLRC was not adequately briefed about the relationship between the RBI and GOI. The regulatory apparatus plus legislations in financial sector in India are in working condition. It has to be admitted that till Dr Rajan’s emergence as an acceptable leader of the Indian financial sector, the FSLRC’s effort to re-invent the institutional structure of regulatory bodies had pushed the regulators and supervisors with the exception of RBI to a confused state, making the possibility of an intelligent debate on the issue remote. 

The idea of creating a Unified Financial Agency for all financial regulators except RBI, truncating RBI by separating Public debt Management and keeping the agency doing that work (presumably with the same work force) in RBI premises, later UFA subsuming even RBI, all give a feeling that the FSLRC was not allowed to ‘apply its intelligent mind’ and in the eagerness to satisfy all, and so fast, it had forgotten its own original brief. Perhaps, the purpose would be served better, if RBI is allowed to function with its present mandate, a coordination committee sorts out issues among the remaining regulators. If GOI aim is to reduce the number of regulators, after necessary groundwork, merger of the regulatory agencies outside RBI one by one, as work stabilizes could be thought of. The twin goals of one Unified Financial Agency and managing the man-power-related issues that may arise with merger here could be better handled this way.

I wish all readers a happy and prosperous 2016!

(M G Warrier, Ex-GM, RBI, Mumbai is author of the 2014 book “Banking, reforms & Corruption: Development Issues in 21st Century India”)
*Submitted version. The article published in January 2016 issue of The Global ANALYST.



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