The Hindu Wife

RBI established in 1935 has an interesting anecdote related to its initials days. A journalist asked the, then governor of Bank of England, what should be the role of RBI vis-a-vis GoI. His response was "It should behave like a Hindu wife advising from the background without imposing itself too much". Although derogatory, the remark is amusing as almost 80 years after it was made, there were several criticisms regarding role of RBI during demonetization. Even before this, the previous RBI governor faced pressure from several quarters regrading his monetary policy stance. For, those interested in this conundrum, it leads to several questions. What should be the role of central bank in an emerging market economy like India. Should it be similar to Federal Reserve of US or EU bank? Is there a need for RBI to be an independent entity like Election Commission? What should be the relation between RBI governor & finance minister? Although there are no simplistic answers to these questions and a book can be written on each, lets attempt to understand some of the underlying principles. 

The RBI act defines its role as to ensure the price stability and assist in financial policies in line with the economic goals of the country. With time, RBI has assumed many roles ranging from monetary policy, financial regulation to payment systems regulation. Not long ago, the monetary policy included the balancing act between different parameters like inflation, exchange rate & public debt etc. This inadvertently put immense external pressure on RBI governor before any policy announcement. The govt. & industry wanted cheap credit to boost growth while the pensioners looked for high return of deposits. With the formulation of MPC the goal has been narrowed down to inflation targeting. Moreover rates will be decided by a committe of six with two govt. representatives. This will help bring consistency in monetary policy regime and diffuse pressure over RBI governor. Some detractors has seen MPC as a tool by govt, to curb RBI's autonomy. RBI is considered as a banker to the govt. Should the principal borrower which in this case is the govt. have a say in the rate of interest? Does this not amount to conflict of interest? Should Vijay Mallya be allowed to sit in the board meeting of SBI? Similar criticisms were hurled during the 3 months of demonetization including those from previous RBI governors. The joke that went around was "Silent PM with Vocal governor is replaced by Vocal PM with Mute governor"

The answers to these criticisms & questions can be understood through two pronged approach. One, what is the amount of legal autonomy bestowed upon RBI under different acts. The other issue deals with whether laws in their current form require modification in congruence with the best global practices. RBI was nationalized in 1949 and since then the debate on its independence is settled. The RBI is subservient to the sovereign. The governor is appointed directly by the govt. and it has right to advise the governor. Hence in case of difference of opinion, the only option a governor has is to resign or toe the government's line. This brings us to the second question of whether independent central bank is desirable. The global financial crisis of 2008 provides a useful insight. Inadequate regulation, easy credit, inappropriate financial supervision led to the crisis in developed world. In India, there was risk of shrinking liquidity in capital markets with outflow of foreign funds. The industry faced crisis with the lackluster global demands.To save economy from external shock a coherent economic & financial policy was required. Fiscal stimulus driven domestic demand needed the support of monetary stimulus driven liquidity. With direct correlation between fiscal & monetary policy can they be decided by two independent organizations. Since, there is a considerable trade-off between the two, the risk for difference in opinion is very high. In a developing country like India, which still does not have matured institutions compared to west, absolute autonomy of a central banks seems unfeasible. The arguments can be extended to financial sector regulations, exchange rate management, public debt & so on. 

The sole purpose for existence of central bank is to save governments from bankruptcy by printing currency if the need arises. Hence, the comparison of public debt with corporate debt seems frivolous. To quote Voltaire "If Gods did not exist, we would have to invent them". Similar quote can be used to define the relationship between central bank & govt. Apart from monetary policy there are other issues like NPAs in financial sector & increasing security threat to payment systems in digital age that need coherence of policy between govt. & RBI. The role & functioning of RBI will increase & become more complex as the economy matures. When we develop different institutions to take care of different strands of economy, some sovereign power can be pooled into those institutions. "The Hindu wife will take some more time to turn British".