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:
“PREAMBLE
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!
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(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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