By Anjan Roy
The Reserve Bank of India has plunged headlong into a battle with the government over its independence. Last week, the RBI had a meeting of its board of directors where the government and nominee directors have reportedly strongly criticised the central bank’s handling of the liquidity squeeze following the denouement at IL&FS.
The heavy-handed interventions would surely have further soured the strained interface between the government and the RBI. A mildly adversarial relation between government of the day and the central bank is normal and not surprising. Open wars are seldom fought.
But the tensions must have been running really high that RBI’s deputy governor Viral Acharya took is first opportunity at hand —a public lecture in Bombay— to hector all concerned (including the government) about the importance of an independent central bank. Delivering the A.D. Shroff Memorial Lecture, Dr Acharya stated at the outset that the topic chosen was at the suggestion of his boss, the governor.
From a high academic pedestal the RBI functionary underlined the importance of social institutions (including, as it happens, a central bank) as an essential part of a liberal order. Dr Acharya is every inch an academic and his lecture was steeped in the literature on the subject.
He cited the plights of countries which dared violate that cardinal principle of central bank’s independence, including the experience of Argentina in 2010. Following the departure of its central bank governor over differences with his government on impounding a part of the bank’s reserves, Argentina had faced a sliding market and depreciating currency. But that was only the end result of its general economic mismanagement not just emasculating its central bank.
At any rate, it is difficult to find fault with this line of argument. A plurality of social institutions was essential and desirable. The government of the day should not have the last say on every matter and checks and balances were the safety valves. But that does not mean that the individual institutions cannot be criticised at any point of time and criticism is a violation of the independence of the institution.
In some instances, Dr Acharya himself admits this and even suggests some mechanism for sorting out differences between the central bank and the government. There are certainly very valid grievances about the way the RBI has been taking care of its charge.
The proximate trigger for the current fracas appears to be the different perceptions about credit flow after the disastrous defaults of IL&FS. A large swathe of industries — particularly small businesses — have been complaining of almost credit freeze for them. The entire network of non-banking financial companies, which ordinarily provided funds for smaller businesses, had clammed up following the IL&FS defaults.
RBI had been caught totally off guard on this whole affair. Large lenders to IL&FS did not get back their money in time and as a result they went off the market. Similar was the fate of mutual funds. In such a situation, the central bank should have thought of alternative measures to meet the requirements of those who needed the funds. The bank did not think much of this need.
Shortage of funds and creeping credit freeze could seriously derail the entire process and the government was underlining the need for fresh infusion of liquidity. This may not be viewed as intrusion on independence.
Earlier, the public sector banks were accumulating bad debts and they were ever agreeing their non-performing assets to present decked up and misleading balance sheets. Until Raghuram Rajan flagged the issue, RBI did precious little to stem the rot. Aren’t these justifiable criticisms? RBI, of course, will point out that it did not have much powers until recently. However, cautioning adequately was its responsibility.
The truth of the matter is that RBI has mostly been found to be behind the curve. Its supervisory role has been found to be somewhat dissatisfying and the markets had got the better of it. What were the qualities of its inspections when major faults were discovered only when things had gone out of control.
Indeed, central banks all over the world are currently going through a fundamental re-think. If anything, rather than being intimidated by the governments of the day, there are instances when the central banks are threatening governments with consequences if they do not fall in line.
The European Central Bank (ECB) regularly pointed fingers at government to follow its diktats, failing which it promised actions which could shut out defaulting countries from say its bond purchase programmes. US president is now bemoaning the appointment of the incumbent chair of the Federal Reserve system.
Milton Friedman, the high priest of monetarism, had publicly decried the US Federal Reserve as an ineffective and blundering institution and urged it to be scrapped. He had blamed the Federal Reserve for blundering into the Great Depression of 1931 and the subsequent prolonged recession. In his Monetary History of the United States he had pointed out the exact policy faults of the central bank, which he felt had harmed the US economy and failed to correct emerging distortions.
A recent issue of The Economist magazine had noted the reverse of the central bank ability to control inflation — a central theme of Viral Acharya’s argument for independence. It cited a 1993 paper by Alberto Alisina and Larry Summers, which found a “tight inverse correlation between an index of central bank independence and average inflation”.
That strikes at the very root of the cause for central bank independence, so to say. Let no one take that too seriously and rally behind paring RBI’s powers. Giving the powers of printing money to politicians could be too dangerous, seeing the efficiency with which they function.
But it is also true the central bank should not be too jittery about any criticisms of its handling of its responsibility. The real test of independence lies in the Reserve Bank’s ability to robustly face criticism and opposition to its viewpoints and yet drive with its objectives.
It is not as if the RBI has not demonstrated its virility earlier. In its open thrusts and cuts with the then finance minister P. Chidambaram, governor P.V. Subbarao did not mince words and matched the finance minister word for word. Get along with a good fight. (IPA Service)
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