RBI's many roles hinder core monetary policy mandate, resolution is crucial

Columnists like me are offering advice to the new governor of the Reserve Bank of India (RBI) on the important questions that he faces. However, a remarkable feature of the present situation is that, for the governor to succeed, the onus is on the Government of India (GoI).

 

Most central banks (CB) are narrowly focused on monetary policy. The RBI has a sprawling mandate. The trouble is these roles contain many inherent conflicts. The bulk of the RBI’s difficulties arise from these conflicts. What are these roles?

 

1. RBI is the monetary authority, with its functions now controlled by the Monetary Policy Committee (MPC), where the governor and the RBI have a decisive, though not complete, say.

 

2. It is the regulator for banks and non-banking financial companies (NBFCs). It is also the owner of the deposit insurance entity, whose functions kick in when banks fail (which is partly caused by failures of banking regulation).

 

3. It is the regulator for payment settlements. It also has indirect control of a monopoly player (National Payments Corporation of India) in this space.

 

4. It is the financial stability regulator, whose function is formally shared with the GoI and other financial sector statutory regulatory authorities, but led by the RBI.

 

5. It is the government’s treasury and debt manager, as well as the regulator of the government debt market. It is the biggest player in the government debt market and operates and owns the bulk of the market infrastructure institutions (MIIs).

 

6. It is the regulator of foreign currency flows and the biggest player in the foreign exchange market.

 

7. It is the frontline regulator and issuer of currency, even running its own currency press, while parliamentary legislation assigns most of the formal regulatory role of currency to the GoI.

 

8. It regulates the money market and all derivatives not regulated by the Securities and Exchange Board of India (Sebi).

 

9. It runs a technology services company with a team of over 800 employees and is seriously considering the creation of a cloud services company.

 

If you, gentle reader, are left breathless by this range of tasks, you are not alone. There is no other central bank in the world that performs this “serpent guarding a hundred eggs” act. The problem is many of these roles are in conflict with each other.

 

The RBI in its role as the public debt manager of the GoI hankers after lower rates, which conflicts with its mandate to deliver on the inflation target. Similarly, its extra-legal pursuit of a strong or stable exchange rate conflicts with the legal mandate to control inflation. The Banking Regulation Act and the special role that it carves out for the GoI vis-a-vis public sector banks (PSBs) puts the RBI in direct conflict with the GoI in banking regulation; and sound economics in payments regulation runs into conflicts with the NPCI and UPI government monopolies.

 

People new to central banking tend to be dismissive of theoretical ideas like the Mundell-Fleming “Impossible Trinity,” Tinbergen’s “Assignment Principle,” Kydland/Prescott’s rules vs discretion, separation of powers, and other related principles of economic and regulatory design. Practical people, however, understand that these theoretical ideas matter.

 

Let us briefly examine and explain the episodes of turbulence during the tenures of recent RBI governors:

 

1. Y V Reddy vs Finance Minister was about managing the irreconcilable conflict between huge and burgeoning capital inflows and exchange rate stability. The consequential domestic liquidity boom led to a lending boom, the inflation crisis of the United Progressive Alliance years, and the banking crisis thereafter.

 

2. D Subbarao versus Finance Minister was about controlling inflation while there was fiscal indiscipline, and about preserving a market-determined currency in the face of calls to peg the exchange rate.

 

3. Raghuram Rajan versus the GoI was about demonetisation and the conflicting roles of the RBI and GoI. The role of the regulator of currency is important in a cash-dominated economy, which we still are, even as this dependence is waning. In this context, recall that the RBI Board proved to be no great counter-majoritarian force when it was consulted on the demonetisation exercise. These facts are now in the SC judgment on the subject.

 

4. Urjit Patel’s term was about conflicts in the regulation of PSBs.

 

5. The last few months of public expressions of dissatisfaction by various senior GoI functionaries with Shaktikanta Das was again about controlling inflation and maintaining exchange rate stability along with reasonable free capital flows.

 

The new governor inherits the headache of large speculative positions built up in the derivatives market, with questions being raised about losses to the exchequer that may result from a possible rupee depreciation. Why have all the RBI governors faced these difficulties? Each of them is an outstanding individual bringing enormous intellectual power, maturity, and personal judgement. With due apologies to Shakespeare, “The fault, my dear Brutus, is in our stars and not in us.”

 

The very mandate, the foundation of RBI, and its sprawling role, represent a poisoned chalice that trips up one governor after another. The solution lies not in better execution of the RBI’s mandate. It lies with the GoI (and, through the GoI, with Parliament), which must apply itself to resolving these conflicts, as it did when it legislated the inflation target.

 

All the financial sector regulatory agencies are created by Parliament on the advice of the executive. The Ministry of Finance shapes the laws that define the role, powers, governance, processes, and accountability mechanisms of all these agencies. The next Budget should revisit 2016, when the legislative changes to mandate inflation targeting was made, and plan to complete the cleanup of the RBI’s mandate over the next few years. All the ideas and draft legislation are available in expert committee reports, most notably the Financial Sector Legislative Reforms Commission.

 

In the meanwhile, governor, wish you good luck.

 

The author is an honorary senior fellow at the Isaac Centre for Public Policy, and a former civil servant