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Reuters/Shailesh Andrade
Not seeing eye to eye.
THE END OF THE WORLD AS WE KNOW IT

Resentful politicians must stop meddling with India’s central bank, or risk disaster

By Commentary

India’s political and bureaucratic authorities are moving slowly but surely towards reducing the role and importance of the Reserve Bank of India (RBI) in the country’s financial sector.

In pushing for change, the government is armed with the report of the Financial Sector Legislative Reforms Commission (FSLRC), which came out in March 2013, and the Committee on Financial Sector Reforms (CFSR)—headed by RBI governor Raghuram Rajan—which came out in September 2008. Many of the proposed moves have also been backed by other committees earlier.

Any attempt to rush through the moves is, however, fraught with risk.

These are the principal areas of contention between the government and the RBI at the moment.

The Monetary Policy Committee

In his budget speech in February, finance minister Arun Jaitley announced that the government and the RBI had concluded an agreement under which India’s central bank would have to keep the inflation rate below 6%.

He said the government would amend the RBI Act to set up a Monetary Policy Committee (MPC), which would activate this agreement.

The big question is whether the MPC can function independently of the government—and that obviously depends on how the MPC is constituted.

On this, the government and the RBI don’t see eye to eye with each other.

Whether the Monetary Policy Committee can function independently of the government will depend on how it is constituted.

In Janury 2014, an RBI committee headed by deputy governor Urjit Patel had proposed that the MPC have five members: Three members from the RBI (including the governor) and two external members. These two external members would be chosen by the RBI governor and one of his deputies.

The government, however, is reluctant to give the RBI governor such influence.

That is because, so far, monetary policy has been entirely the prerogative of the governor and the intention in creating an MPC clearly is to have other inputs in the making of monetary policy.

The FSLRC, on the other hand, had proposed a seven-member committee with two members from the RBI (including the governor, who would chair it) and five external members appointed by the central government, of which two would be appointed in consultation with the governor.

This tilts the composition in favour of the government—and to this, the RBI is resistant. The FSLRC, however, was willing to allow the RBI governor to “override the MPC in exceptional circumstances.” Some reports suggest that if the committee is set up as suggested by the FSLRC, the RBI would like the governor to have veto powers in all situations.

It may well be that the composition of the MPC will be put on the back burner for now, and the RBI allowed to get on with its job of meeting the inflation target. It’s doing well on that account for now.

Yet, if the RBI falters in keeping inflation under controls, the governor will immediately come under pressure to heed the preferences of the government on the MPC’s composition.

An independent agency for public debt management

The government also wants to create an independent agency for managing its debt.

The FSLRC and the CFSR had both mooted this idea.

Since the government managed its own foreign debt, with domestic debt handled by the RBI, the FSLRC argued that an independent agency could take care of both.

A second—and more important—argument was that the RBI’s management of the debt puts the onus on the central bank to raise funds for the government at low interest rates.

The RBI does this by prescribing a statutory liquidity ratio (SLR) for banks, whereby a certain proportion of their liabilities (21.5% currently) has to be parked in government securities. This ensures that the government gets the funds it needs—and cheaply. However, this is also said to prevent the development of the market for both government and corporate bonds. Who would want to invest in these given the low yields?

Moreover, critics of the RBI say that the central bank’s management of government debt creates conflicts of interest. The RBI’s keeping the interest rate low for government may come in the way of its inflation targeting mandate. And the RBI has its own stock of government debt, so in managing borrowings for the government, it’s something of an insider trader.

In managing borrowings for the government, the RBI is something of an insider trader.

However, moving debt management to an independent agency carries its own risks.

The RBI cannot prescribe any SLR for an “independent” agency. If SLR is abolished, can the government meet its borrowing requirements at an affordable rate?

Second, who would raise funds for the states? Will they be willing to entrust any central government agency with the management of their debt?

Third, if the agency is not completely independent, will it be able to withstand pressures to meet the government’s needs for funds by raising short-term funds or funds from abroad? Both these measures, the financial crisis of 2007 showed, carry serious risks.

Rajan has said recently that he’s not averse to a truly independent agency for managing debt. Maybe he knows that such an independent agency is not easily created.

Again, this may be an idea that is unlikely to fructify in the next 18 months or so, by which time Rajan’s three-year term would be over.

Regulation of the government bond market

Meanwhile, the government has proposed to move regulation of the government bond market to India’s market regulator, Securities and Exchange Board of India (SEBI).

Rajan, as chairman of the CFSR, had thrown his weight behind the idea, looking to consolidate India’s fragmented and “suboptimal” bond market.

The regulation of financial trading in India is divided among three agencies: the RBI (government bonds and currencies), SEBI (equities and corporate bonds) and the Forward Markets Commission (commodities and futures).

The CFSR argued that housing regulation of all markets under one roof would help one regulator achieve economies of scale, impart greater liquidity to trading and bring about greater competition among financial entities such as exchanges and depositories, each of which was now confined to one of the three silos.

As the RBI governor, however, Rajan has a different perspective.

“My personal view is that moving the regulation of bond trading at this time would severely hamper the development of the government bond market, including the process of making bonds more liquid across the spectrum, a process which the RBI is engaged in,” he said in June 2014. It may well be that Rajan has changed his views because, sitting inside the RBI, he has a better appreciation of the ground realities.

But moving regulation of the government bond market out of the RBI would again mean that the the central bank does not specify an SLR for banks. And the government will be on its own for meeting its requirement of funds.

Statutory power to the FSDC

India currently has a Financial Stability and Development Council (FSDC) that is presided over by the finance minister.

It came into being after the CFSR under Rajan proposed its creation to ensure coordination among the different regulators. The FSLRC went further: It wanted the FSDC to be made into a statutory body with added responsibility for monitoring risk in the financial system as a whole.

The creation of the FSDC would not only deprive the RBI of its special status among regulators, but also runs the risk of the government encroaching on the turf of the regulator.

Rajan had lashed out against this recommendation and called it “schizophrenic.”

In June 2014, Rajan had lashed out against this recommendation of the FSLRC calling it “schizophrenic.”

“On the one hand, it (the FSLRC) emphasises synergies in bringing together some regulators into one entity,” he said. “But in the process it suggests breaking up other regulators, with attendant loss of synergies.”

Devil is in the detail

All the proposals, except the one on FSDC, have their merits. However, the issue is one of timing, sequencing and detail.

India can have an independent MPC if it is held accountable for the inflation target and the RBI governor enjoys security of tenure. (At present, the governor can be removed from office without assigning any reasons).

An independent agency for public debt and moving regulation of government securities out of the RBI can wait until the fiscal situation is under better control and the debt market becomes more liquid.

And it is not as if the development of India’s financial sector—or the economy—is held up by poor regulation. If anything, India has done much better on financial regulation than many other emerging as well as advanced economies.

The hurdles to growth today lie in the real economy and in under-capitalised banks.

The rush to remake the financial sector seems to have more to do with resentful politicians and bureaucrats attempting to cut the RBI down to size. That could turn to be a costly mistake for Asia’s third largest economy.

We welcome your ideas at ideas.india@qz.com.