Vote for continuity

RBI should focus more on inflation management

The Union government has done well to give Reserve Bank of India (RBI) Governor Shaktikanta Das a three-year extension. This shows that the relationship between the central bank and the Union government has improved markedly over the past three years. Better coordination between the RBI and the government is critical for a country like India, particularly in times of crisis. Perhaps the vast experience of working in the government, including in the Ministry of Finance, helped Mr Das. Continuity in central bank leadership will be useful in the present circumstances. Mr Das has steered the RBI’s interventions to contain the disruption caused by the pandemic, and it makes sense that he also leads the process of normalisation. Besides, a three-year extension would ensure there is stability at the central bank till well after the next general election.

Mr Das’ term, to be sure, would be judged by the central bank’s response to the pandemic, which is bound to go down as one of the most defining periods in modern history. The RBI did most of the heavy lifting in the initial phase of the pandemic. It reduced interest rates and flooded the system with liquidity to avoid any friction in financial markets. It introduced targeted repo operations to make sure liquidity reached where it was needed. In this context, unlike several other large central banks, it did well to not directly intervene in the corporate debt market. Further, aside from ensuring the proper functioning of financial markets, it also extended forbearance at a critical time. It appears that asset quality in the banking system has not deteriorated to the extent many had feared, though it may be too early to pass any judgment.
 

The RBI has also done well to absorb the excess flow of foreign currency to build reserves. India’s reserves have gone up by over $160 billion since April 2020. The RBI’s intervention is necessary to avoid undue appreciation in the rupee, which can not only affect India’s external competitiveness but also create financial stability risks. Interestingly, the latest India report of the International Monetary Fund suggests that a further accumulation of reserves is less warranted and intervention should be limited to addressing disorderly conditions. Mr Das and his team will be well advised to not change their position on foreign exchange management. Lower than desired intervention in the aftermath of the global financial crisis, for instance, led to a near currency crisis in 2013. However, the RBI will now have to be more vigilant as it unwinds excessive policy accommodation. It will need to manage liquidity more actively, depending on foreign flows. This will also require coordination between the RBI and the government because of potential fiscal costs.

One area where the RBI has faced problems during the pandemic period is inflation management. Since the RBI is an inflation-targeting central bank, it will have a large weight in the final evaluation of Mr Das’ governorship. The RBI has been underestimating inflation for quite some time. The average inflation rate in the last fiscal year was above the tolerance band and risks continue to persist. Thus, while the central bank did well in terms of responding to the crisis, the challenge for Mr Das now would be to ensure timely and non-disruptive unwinding of excessive policy accommodation along with bringing the inflation rate close to the 4 per cent target on a durable basis.