Demonetization Episode Shows why Reserve Bank of India cannot be Independent

Demonetization Episode Shows why Reserve Bank of India cannot be Independent of National Economic Policy Makers

Ramgopal Agarwala 16 January 2017

In the wake of demonetization, a debate has emerged on independence of Reserve Bank of India (RBI). Several former Governors of RBI are calling for greater independence of RBI citing the case of demonetization as an example of erosion of RBI’s independence. We would suggest an opposite line. Demonetization shows why RBI cannot be fully independent in matters of currency. Suppose RBI decided to demonetize along the lines of what has happened. This would be a case of bunch of unelected officials (babus) to decide on a matter of vital importance for the public without any recourse to the public to punish the decision- makers. In what has happened, the public will have an opportunity to dislodge the decision makers in next election if they so wish which is what democracy is about.

While talking of monetary policy, it is relevant to compare it with defence policy. Issues of defence are, if anything, even more technical that the issues of monetary policy. Yet defence policy is decided by elected civilian authorities with of course full consultation with the defence personnel. In some cases, defence officials may disagree with the decisions of civilian authorities or the other way round. In such cases, the buck stops with the civilian authorities and the technical experts even in such a complex field as defence may either resign or be fired. The same rules should apply to monetary affairs. This of course does not preclude intensive consultations between the civilian authorities and technical experts. If such consultations have been inadequate in the current episode of demonetization, that is the right issue to discuss. Not who the boss is.

Our obsession with independence of central bank is a colonial hangover where we are trying to copy the Anglo-American world, where the case for such independence was developed in very different circumstances. In our case, the more relevant experience is that of East Asia where monetary policy has been seen as part of the overall economic management of the country with the political leaders in charge with full consultation with technical experts. These are the countries that have shown how to move from a low income country to a developed country within a generation or so with reasonable price stability. Our Look East/ Act East policy is relevant in this area as in many others. For the benefit of readers we reproduce below our reflections on independence of the central bank as published in our web page of 16 September , 2015.

Look East for Wisdom on Our Monetary Policy Framework: Monetary Policy is Too Serious a Business to be Left to Monetary Authorities and Inflation is too Big a Job to be Left to Monetary Policy

On monetary policy as in many other areas, we tend to ape the latest in the West without considering the differences of circumstances. On the issues of independence of Reserve Bank of India(RBI), its mandate on controlling inflation, its instrument for controlling inflation, we have been we have been trying to replicate the US/UK strategy and the results have been suboptimal. In this blog we argue that we have more to learn from our neighbors in East Asia in particular China who has achieved an economic transformation similar to what we want.

On the issue of independence of the Reserve Bank of India, we suffer from schizophrenia. The de jure position is clear. As per the Reserve Bank of India Act (1934),

“The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.”

However, in an attempt to appear following the fashion in the Western world on independence of the central bank, we pretend that de facto RBI is independent. We thus have the spectacle of Minister of Finance pleading in public that the Governor of RBI should take note of declining inflation and lower the interest rate. This is pathetic. Either the Central Government should exercise its legal prerogative and ask the RBI to lower the interest rate or keep quiet and let RBI do its job.

The idea that RBI’s professional independence should not be compromised by politicians seeking easy money is disingenuous. Inflation is a serious issue in elections and a political leader is as much interested in controlling inflation as any bureaucrat. In fact it is the Governor of RBI that suffers no consequences for failing in controlling inflation. Thus giving the Governor independent power of controlling inflation is a case of power without responsibility.

Secondly, following the current fashion, we seem to accept that RBI’s primary mandate is to control inflation. This is too narrow a definition of a central bank’s job. It should include at least three other objectives: maintaining an appropriate stability in external value of the rupee, promoting growth and employment and maintaining financial stability and probity.

Thirdly, it is absurd to think that RBI can be a lead agent for controlling inflation, particularly in Indian conditions where the price index has a high weightage of agricultural products whose prices are dependent on non-monetary factors and of administered prices and wages outside the jurisdiction of RBI. The pathetic performance of RBI’s anti-inflation policy since 2011 is ample enough proof of the limited powers of RBI in controlling inflation.

Fourthly, the imported idea that inflation targeting by RBI will influence inflationary expectations is out of touch with reality. In its latest review of monetary policy, (April 2015) RBI refers to learned articles from US and UK about the power of central bank’s target on inflation in influencing price expectations and the power of price expectations on actual inflation. To quote:

“The experience of inflation targeting countries suggests that a credible monetary policy framework with clarity about the objective function of the central bank helps in anchoring inflation expectations. In the UK for example, just the announcement of instrument independence for the Bank of England in May 1997 led to an immediate fall in inflation expectations by 50 basis points along the entire term structure (Haldane, 2000). In this context, the Monetary Policy Framework Agreement in India should be able to reinforce the disinflationary forces currently at work and anchor inflation expectations around the medium-term inflation target.”

The data on inflationary expectations in India over the last few years published by RBI itself however clearly show that these price expectations are not responsive to RBI inflation targets. Nor does actual inflation show much link with inflationary expectations.

In the light of these deplorable experiences on monetary management, there is clearly a need for a new code of conduct and the draft Indian Finance Code (IFC) is a step in the right direction. Unfortunately, the present draft does not pay enough attention to the lessons to be learnt from our own experience or to those of our neighbors such as South Korea, Japan and China who have shown an impressive record on achieving rapid growth with price stability. During the post-war period, 1945-1990 when Japan achieved remarkable growth with reasonable price stability, monetary policy was not in a silo but was fully integrated with macro-management policy of the Government working through the Ministry of Finance. South Korea which achieved rapid growth during 1962-2000 had an initial period of high inflation until 1980 but an impressive record on price stability with high growth during the subsequent period. For most of this period, the monetary policy worked closely in coordination with fiscal policy and price/wage policy with co-ordination provided by the Economic Planning Board. Even more impressive is the performance of China in achieving sustained high growth with moderate inflation. It will be worth our while to study how China handled the issue of monetary policy and what lessons we can learn from that.

China’s Law on Monetary Management

China’s current law on monetary management was enacted in 1995. It so happens that I was in Beijing at that time as chief of economic unit of the World Bank’s Resident Mission in China. The World Bank was not officially engaged in conversation with the Government of the issue of monetary management law. But informally, I was often engaged in such conversation. The western advisers were mostly pushing for independence of the central bank (People’s Bank of China) but I was happy to note that the Chinese position was basically that monetary policy is too serious a business to be left to monetary authorities.

The law as it came out is worth studying closely by the Indian authorities particularly in view of the impressive performance of the Chinese authorities in reconciling price stability with high growth in the period that followed.Some of provisions of the Chinese law are worth quoting.

“The People’s Bank of China shall, under the leadership of the State Council, formulate and implement monetary policies, guard against and eliminate financial risks, and maintain financial stability.”

Article 3. “The aim of monetary policies shall be to maintain the stability of the value of the currency and thereby promote economic growth.”

Article 5. “The People’s Bank of China shall report its decisions to the State Council for approval concerning the annual money supply, interest rate, foreign exchange rates and other important matters specified by the State Council before they are implemented.”

Article 7. “The People’s Bank of China shall, under the leadership of the State Council, implement monetary policies, perform its functions and carry out its business operations independently according to law and be free from intervention by local governments, government departments at various levels, public organizations or individuals.”

It is interesting to note that PBOC is clearly placed under the State Council as an instrument for national economic management.

Draft IFC and Questions Raised in the Light of East Asian Experience:

1.IFC states: “The objectives of the Reserve Bank under this Part are to formulate and implement monetary policy.”

Can RBI “formulate” monetary policy independently of “fiscal policy” and other supply side policies managed by the Government? Shouldn’t there be a place in the government that will formulate the overall macro-policies in all their dimensions?

2.IFC states: “The objective of monetary policy is to achieve price stability while striking a balance with the objective of the Central Government to achieve growth”.

Aren’t there other objectives such as financial stability which are parts of objectives of monetary policy? What about external value of Rupee and financial stability of the economy? Will RBI be the sole judge of whether a right balance is being struck between price stability and growth? Isn’t price stability also the objective of the Government?

3.IFC states: “price stability” means meeting the inflation target.

1.“inflation” means the year-on-year change expressed in percentage terms in the monthly Consumer Price Index”

2.“Policy Rate” means a rate at which banks borrow from the Reserve Bank and which is approved by the Monetary Policy Committee as the Policy Rate”

3.“Inflation target for each financial year will be determined in terms of the Consumer Price Index by the Central Government in consultation with the Reserve Bank every three years.”

4.“The Reserve Bank must constitute a Monetary Policy Committee to determine. by majority vote the Policy Rate required to achieve the inflation target.”

Is Consumer Price index the only indicator of inflation? What about producer price or asset price? Is policy rate the only instrument for achieving inflation target? Other issues such as money supply, fiscal policy, administered prices are also important. Who will integrate these aspects? As mentioned in the title of this blog, monetary policy can have serious consequences for investment, exports, growth, employment and stability of the economy and it cannot be left to unelected officials. Equally, inflation rate particularly in Indian context is not just a monetary phenomenon. It is very much influenced by fiscal policy, administered prices of food and fuel and public service wages. Monetary policy cannot by itself control inflation and monetary authorities cannot be held responsible for breaching the inflation targets.

Concluding Remarks

East Asian experience shows clearly that an independent central bank is not necessary to achieve price stability with rapid growth. In the cases of Japan, South Korea and China, there was no separate silo for monetary policy. Monetary policy, fiscal policy and other issues of macro-economic management were considered as a package in a central agency which could be Ministry of Finance, or Planning Board or Cabinet.

In the current Indian conditions, it is advisable to learn from East Asian experience and take RBI out of its silo of conservative monetary policy and make it a part of overall development policy-making body in the Government. If India is to provide decent employment to its rapidly growing labor force and meet other development priorities such as providing housing, education, health and social security for all in the next ten years, it will need to achieve double digit GDP growth. Given the deflationary atmosphere in the world economy, India can achieve such acceleration in growth mainly through internal demand stimulus and without much inflationary pressures as was done by China in the eighties. However, that would be possible only if there is a central agency co-coordinating different dimensions of macro-management rather than working in separate silos for monetary, fiscal and supply side-policies.

Dr.Ramgopal Agarwala is Chairman, Pahle India Foundation

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