It was way back in 1988, when Dr C Rangarajan, the RBI governor (then a deputy governor of the RBI), advocated autonomy for the central bank for the first time. He emphasised this point at the annual presidential lecture delivered that year at the Indian Economic Association at Calcutta. And he has been emphasising the need for it since then.
Recently, the Bank of England, on which the RBI model is based, was relieved of its supervisory
functions, and given sole authority to decide on the monetary policy of the country. While these happenings have considerable relevance to the Indian situation, can the Indian system adapt itself to the extent of autonomy that the Bank of
England has obtained under the new Labour government? Also, how much autonomy, of what
kind, and in what direction, will be possible here?
In an exclusive interview with Abhijit Doshi of Business Standard, Dr. C Rangarajan, the RBI governor, answers a number of questions on the issue of the central banks autonomy.
What is your vision of the RBI autonomy? Can you spell it out in some detail? Have we already covered some ground in that direction?
Autonomy has many dimensions. To me, the most important dimension relates to the conduct of monetary policy. The central bank must have full operational freedom to achieve the objectives it has set for itself. Autonomy, however, should not be confused or misinterpreted to imply that the actions and the policies of the central bank are not accountable to anybody. The question of autonomy should be viewed from the perspective of the independence to choose the objectives of monetary policy and the freedom to pursue those objectives through a set of appropriate instruments.
In relation to the conduct of monetary policy, the Reserve Bank has, in the recent period, acquired greater freedom. The system of ad hoc treasury bills that has been in operation for almost four decades led to the automatic monetisation of the budget deficit. This constrained the freedom of the Reserve Bank of India in the conduct of monetary policy.
The replacement of the ad hoc treasury bill system by ways and means advances has completely altered this picture. The successive reduction in statutory liquidity ratio and the willingness of the government to borrow at more or less market-determined rates of interest have also created conditions in which open market operations can be used as an instrument of monetary policy. With the deregulation of interest rates, the Bank Rate is also emerging as a reference rate and a signal rate for the system.
The finance minister had recently mentioned that Bank of England could provide a model for the autonomy to the RBI. What has been happening at Bank of England in matter of autonomy and how far in your view will it be possible for India to adopt such measures?
After coming to power, the Labour Party in UK effected (on May 20, 1997) changes relating to the auto-nomy of Bank of England (BOE) and supervision over banks. The major changes included:
Granting independence to Bank of England in the conduct of monetary policy; and
Separation of bank supervisory powers from BOE and handing them over to an expanded Securities and Investment Board (SIB).
Granting of independence to Bank of England in the conduct of monetary policy and more particularly in relation to the determination of interest rate is in keeping with the trend that is noticed in all industrially advanced countries. In these countries, it has now come to be accepted that the major objective of monetary policy is to keep the inflation rate at a low level. Other objectives of economic policy are to be achieved by fiscal policy and other instruments. Given the dominant objective of inflation control, creation of autonomous central banks to pursue that objective is almost a natural corollary. It has become mandatory under the Maastricht Treaty for the countries which form part of the EU to grant autonomy to the central banks. UK has simply fallen in line with this thinking.
The supervisory system in UK has come in for a host of criticism after the collapse of the BCCI and the Baring episode. However, there is no unique pattern available in the world regarding an appropriate supervisory system. There are countries like Belgium, Canada and Germany where the central banks do not directly exercise supervisory powers. On the other hand, there are many other central banks where the supervisory powers over the banking system are part of the functions of the central bank. In the United States, there are multiple agencies
supervising the banking system.
There is no doubt that central banks must have autonomy if they are to be held responsible for the conduct of monetary policy. The central banks that are successful in containing inflation are those which have had a high degree of autonomy and which have set before themselves inflation control as the dominant objective. We have to learn from this experience.
If the supervision function is taken away from the RBI, do you think we have an alternative set up ready to take over this function? Or would you advocate another institutional mechanism for it?
As indicated earlier, there is no universally accepted system of bank supervision. More than the institutional arrangement, what is important is the quality of supervision. This depends upon the systems and procedures that are followed as well as the expertise of people who are entrusted with the responsibility of supervision.
In India, bank supervision has, all along, been a part of central banking function. However, the institutional arrangement underwent a change recently. The Board for Financial Supervision was set up with the governor as chairman and four deputy governors and four non-official members of the board of directors of the Bank as members. A separate Department of Supervision was created with an exclusive focus on supervision. The four members of the board of directors have been chosen in such a way that they have specialised knowledge in the areas of economics, accounting and management. The board format is superior to departmental processing because the inspection reports are discussed at the board meetings, providing opportunity for different views to emerge. The present arrangement has been done within the ambit of the Reserve Bank of India Act, as it stands today.
The present Board for Financial Supervision has sought to bring about a qualitative change in the supervision by placing greater emphasis on the analysis of banks performance in terms of capital adequacy, asset quality, management, earnings, liquidity, systems and procedures (CAMELS).
The periodicity of inspection has been brought down with every bank being inspected every year. A timeframe has also been fixed for correcting the specific defects or shortcomings pointed out in the inspection report.
The role of external auditors which had remained somewhat fuzzy earlier has been clarified. The auditors reports have to go beyond certifying that the accounts are true and fair.
The institutional mechanism that we have now evolved for bank supervision, in my opinion, adequately serves the purpose. However, one can keep an open mind on the subject.
How far do you think the system of mandated inflation, as suggested by the Tarapore Committee, is feasible? How would it work in practice?
The Report of the Committee on Capital Account Convertibility (chairman: S S Tarapore) had recommended: it is necessary to take early and effective measures to evolve a more specific commitment on the inflation rate...The Committee recommends that the mandated rate of inflation for three years period 1997-98 to 1999-2000 should be an average of 3-5 per cent.
In recent years a number of countries (New Zealand, Canada, UK, Sweden, Finland, Australia and Spain) have instituted explicit inflation targeting. An inflation targeting regime has several characteristics: (a) it is a quantitative inflation target - typically 2 per cent per year; (b) there is an explicit tolerance interval around the inflation target, typically plus or minus one percentage point and (c) there is no explicit intermediate target such as a money growth target or an exchange rate target.
Inflation targeting has some advantages and limitations. The general advantages include focusing monetary policy directly on achieving the goal of low and stable inflation. Within a specified quantitative target, it provides an ex-post measurement of monetary policy performance. It also provides a measurement of the credibility of monetary policy. But, inflation targeting can also lead to some potentially serious problems with regard to both implementation and monitoring.
Inflation targeting at times may be difficult to implement. Current inflation is to an extent predetermined by previous decisions; long and variable lags make decisions on current instrument setting inherently difficult. Inflation is also affected by factors other than money. In developing economies like India, supply shocks are greater than those in developed economies. Nevertheless, inflation cannot occur unless it is sustained by continuing increase in money supply. As such, control of money supply has to play an important role in any scheme to control inflation. In relation to inflation targeting, there is also a need to determine what the appropriate inflation threshold should be beyond which costs tend to exceed benefits.
In the system of mandated inflation, what freedom would the RBI require to manage the desired level of inflation?
In India, the Chakravarty Committee (1985) had suggested a target of 4 per cent as the acceptable rise in prices purported to reflect changes in the relative prices necessary to attract resources to growth sectors. No one in this country is advocating absolute price stability or even the order of price stability that is being sought as an objective in the industrially advanced countries. However, we need to have an appropriate fix on the acceptable level of inflation rate. In the 1970s, the average annual inflation rate in India was 9 per cent; it was 8 per cent in the 1980s and 10 per cent in the period between 1990 and 1995. In the prevailing situation, the objective of monetary policy should be to stabilise the inflation rate around 6 per cent, and then strive to bring it down progressively.
With the discontinuation of the automatic monetisation of Government deficit, the Reserve Bank has already taken a major step towards functional autonomy. However, there has to be a general consensus on the need to keep the inflation rate at a certain level. In the recent period, certain criticisms have been leveled against what some have described as the obsession of monetary policy to achieve a lower inflation rate.
If we have a system of mandated inflation, do you see some trade off between inflation and growth?
The emphasis on mandated inflation was never meant to belittle the importance of the growth objective. It is a well- recognised fact that sustained reduction in inflation will ultimately pave the way for attaining all the broad macro economic objectives, including higher economic growth, besides being a strong anti-poverty measure. Our efforts to achieve low inflation, mandated or otherwise, through appropriate monetary policy need not necessarily slow down the economic growth. As the recent experience shows, the low level of inflation has coincided with increased growth rates in many countries. Trade-off between inflation and growth is at best a short term phenomenon. This short term possibility should not be exploited in such a way that that it undermines the ability to keep the inflation rate at a low level over a longer period of time which is essential for sustained economic growth.
If the RBI is deprived of debt management and supervision, would it have adequate instruments to influence interest rates? How would the RBI manage this function?
Supervision has no direct implication as far as influencing interest rates is concerned. Debt management as such has a greater impact on the structure of interest rates rather than the level of interest rates. In managing the interest rate, the Bank Rate has to play an important role and we need to create conditions under which Bank Rate emerges as an appropriate signal and reference rate.
Under an autonomous system, what kind of fiscal and monetary policy interface do you foresee?
Even under an autonomous system, the inter-relationship between monetary and fiscal policies will continue to remain relevant. Both policies need to move in tandem with each other. For example, it has been the experience of many developed countries that a tight monetary policy alongwith loose fiscal policy results in the rise in interest rates with their attendant consequences. The stance of both monetary and fiscal policies has to be similar in order to produce the best impact on the system.
If the RBI stops participating in the primary issues of government debt, would it be open for it to undertake secondary market operations? How would it work?
Ideally, being a central bank, the Reserve Bank can manage the primary issues of government debt but need not participate in it. We are gradually moving to a stage wherein the Reserve Banks role in primary issuance will be minimal. In the secondary market, the Reserve Bank can play a useful role by conducting open market operations through the government securities market as a part of monetary management.
You have been advocating a ceiling on government debt. If debt management is taken away from the RBI, do you see this happening?
There is no relationship between the ceiling on government debt and the debt management function of the Reserve Bank. The debt management function can continue so long as the government has borrowing requirements. Parliament must take a view on the extent of borrowing the government does in the same way as it looks at the revenue and expenditure proposals.
There is a view that the RBI always had the necessary powers to take its own decisions, but it never used them. If that is so, would autonomy serve any purpose?
The conduct of monetary policy is guided by both legislation and tradition. The automatic monetisation of the budget deficit resulted from a very innocuous administrative arrangement under which the Reserve Bank issued ad hoc treasury bills in its favour whenever the cash balance fell below a particular level. So long as this particular system continued, the control over money supply became difficult. The central bank was for ever trying to neutralise the expansionary impact of the borrowing of the central government from the Reserve Bank.
Circumstances have changed and monetary policy is emerging as an independent policy instrument. However, there is need for clarity as to what the dominant objective of monetary policy is or should be. It is this clarity which will enable the Reserve Bank as a central bank to function more independently.
