Today's Editorial

12 January 2017

Playing second fiddle



Source: By Anup Sinha: The Telegraph



One of the most powerful and important institutions in any modern economy is its central bank or the monetary authority (as it is often referred to). In India, the central bank is the Reserve Bank of India. The central bank of an economy creates liabilities in the form of money, which the rest of the economy holds as assets.


It controls the supply of money, and regulates a large part of the financial sector, particularly the commercial banks. Amongst its many functions the two most important ones are price stability, and influencing the cost of funds. It does this through what is called monetary policy. It attempts to control the rate of inflation and interest rates. In doing so it obviously affects macroeconomic variables like the level of prices, aggregate investmentsgross domestic product growthforeign exchange rates and the flow of international capital. In its functioning, the central bank is not accountable to the polity of the nation.


For instance, the RBI can announce monetary policy measures without getting approval of Parliament. All things that are to do with the supply of money in the economy are the exclusive domain of the RBI. This is quite unlike the fiscal policy of the government, where taxes and expenditures need the approval of Parliament. Indeed, this is one area of economic policy that is delinked from the political process. It is important that the central bank retains its independence from the political agenda of any government.


In India, the RBI has been one of the most respected institutions that have carried out their tasks with competence and generally a fair degree of success over the years. However, over the past two or three years, the RBI has been under pressure to reduce interest rates and stimulate the economy even when inflation rates were reasonably high.


The RBI, in asserting its independence, made it clear that controlling inflation in the current context of the economy's health was more important than rate cuts. The finance ministry on the other hand, had been suggesting that since the management of the fiscal deficit was important, there was no room for expansion of government expenditures, which is often the alternative way of stimulating demand and growth in the economy.


Therefore, an expectation was being built up that it was the duty of the RBI to stimulate the economy. The RBI had held on to its independence quite firmly. Perhaps not happy with this situation, the government made changes in the making of monetary policy where a committee would take the decision and people appointed by the finance ministry would occupy three positions in a group of six. The RBI governor would have the casting vote if it came to a tie. With this change, and a new governor at the helm, a rate cut came immediately. Then the big shock of demonetization of 500 and 1,000 rupee notes arrived.


Since this would directly affect the money supply, the announcement ought to have come from the RBI. It could have been later backed up by the government, justifying the decision. In November, the announcement came from the prime minister himself in an open address to the nation. This, in less than a minute, devalued the position of the RBI as an independent institution. The RBI officials did go through the motions of a press meet a little later, but it appeared that the officials were not very confident of what was happening and what the economic implications would be. The bulk of the talking was done by a senior civil servant, who was not an RBI official.


It may be noted that the first time when the prime minister announced that the two types of currency notes would cease to be legal tender from midnight of November 8, 2016, he mentioned three reasons for the action — unearthing of black moneystopping fake notes from being printed, and snapping the link between the first two kinds of money and terrorism. The control of none of these three objectives is the duty of the RBI. There are specialized institutions and policy mechanisms that can control the problems. It was a failure of governance if these had been unsuccessful in the past. Overnight, the RBI and the commercial banks became crime- control machines made to work on the assumption that every citizen was guilty until proven innocent.


To make matters worse, the benchmark of innocence kept changing every few days as announced by the government. It even came down for a day to the level of having Rs 5,000 in old currency notes. The complete subservience to the government and the continuous but random changes in the procedures of replacing old notes have made the RBI a virtual department of the government, where RBI senior officials behave like mid- level minions in the civil service whose vocabulary seemed to have become limited to exactly three words: Yes, prime minister. This erosion of the independence of the RBI will have longterm effects on the economy; especially how the rest of the world perceives policymaking in India.


Confidence in the financial sector and in how it is regulated has taken a serious beating. The economic literature on public policymaking has contributed to the emergence of a conventional wisdom that claims discretionary policies are unambiguously worse than those based on transparent rules known to all. What one is witnessing today is discretionary randomness at its worst being touted as responsive governance.


There is another technical aspect of the sanctity of the monetary liabilities created by the RBI. If even 100 rupees of the older notes do not come back to the banking system, then the monetary liabilities of the RBI would go down to that extent. Adjustments would have to be made on the asset side of the balance sheet. Hence, there was speculation that these ' extra' assets could be used to recapitalize banks, or given to government for budgetary use.


The RBI governor, in one of his very infrequent statements, claimed that he would not change the balance sheet after the swapping timewindow closed. Currency notes that did not come back to the banking system would continue to be the liability of the RBI. Hence, as far as one can understand, it would have to stick to the promise made on the note "I promise to pay the bearer the sum of ...". Yet the notes have ceased to be legal tender. This means that one cannot settle debts with such notes, but the RBI retains its promise to give one the sum of 500 rupees or 1,000 rupees as the case may be.


The narrative of demonetization has shifted far away from black wealth and terror. It changed to ushering in a cashless India with electronic payments only. Now it is about a less cash India, going by the advertisements being recently put up. We are far away from coming even close to a developed market economy in terms of IT infrastructure.


Forcing the issue would undermine not only confidence but create major disruptions in production and demand. Who knows what the next shift in the prime minister's narrative might be? It is, however, evident that the RBI in playing second fiddle to the government has for the first time in its illustrious career actually hurt the economy by its policies.


It is often being heard that the prime minister may have had long- term political objectives in mind, which he himself has more than once indicated. Pains are therefore an essential part of this transition to the long term. Very few Indians understand the importance of the central bank and the role it is supposed to play. Most have not even heard of the RBI. Hence any political gamble can safely rely on this assumption and give the signal that all disruptions are for the greatest common good for the greatest number.


The prime minister might be correct in his gamble. The poor may not be affected much. After all, how much more can one hurt a person living below the poverty line. The point, however, is that even if many have not heard of the RBI or do not understand its important functions, the fact will remain that one more important institution succumbed to the pressures of government and surrendered its independence.

It is about reinforcing big government and poor governance, contrary to the electoral promise of the prime minister. Above all, it signifies the arrival of big government and even bigger whimsy conducted by one individual with a large and growing fan following.