Tag Archives | Central Bank Independence

The Need for Clarity in the Revised IFC

Six new financial agencies with no clear mandates – the draft Indian Financial Code has to be redrafted to reduce the number of conflicting agencies and give clearer mandates to any new agency it will create.

The draft Indian Financial Code has been in the limelight since the time the Finance Ministry put it online and welcomed comments. The main criticism against the code is that it substantially weakens the Reserve Bank of India, by taking away many of its existing powers. More specifically, the substantial part of the criticism is directed against the Monetary Policy Committee (MPC), the composition of its members and what it would imply for the conducting of monetary policy in India. The MPC, according to the draft IFC, will contain seven members, of which four will be selected by the Central Government and three from the RBI. This obviously fosters fear of transferring monetary policy powers from the RBI to the government, because of the majority in MPC held by the latter.

While the brouhaha over the MPC is justified, it is preventing adequate attention to be given to other aspects of the draft IFC that deserves it. One of the principal, yet flawed recommendations of the IFC is the creation of a seven-agency structure for the financial sector — the Reserve Bank of India (RBI), Unified Financial Agency (UFA), Financial Sector Appellate Tribunal (FSAT), Resolution Corporation (RC), Financial Redressal Agency (FRA), Financial Stability and Development Council (FSDC) and Public Debt Management Agency (PDMA).

The RBI currently manages the functions that are designated to these agencies, namely monetary policy, financial stability, banking regulation, regulation of non-banking financial institutions, forex management, deposit insurance and credit guarantee and payment and settlement systems. However, after the creation of the six other agencies, the RBI will be partially in charge of monetary policy (via the MPC), banking regulation and only systematically important payment and settlement systems.

The creation of the Redressal and Resolution agencies, which are independent, have some merit, as their mandate is to protect consumers. However, other agencies and their functions are contentious as there is very little clarity over their exact mandates.

The six new financial agencies and the RBI with conflicting mandates will be fighting for control over the steering wheel. Illustration by C.R Sasikumar. Source: http://indianexpress.com/article/opinion/columns/a-code-too-soon/

The six new financial agencies and the RBI with conflicting mandates will be fighting for control over the steering wheel.

Banking regulation has been, fortunately, left with the RBI. However, the Unified Financial Agency has been given the regulatory power over all non-banking financial institutions (NBFCs) and payment systems. This could include segments of the markets such as securities, commodities, NBFCs, Micro Finance Institutions, insurance, etc. Separating banking regulation (with RBI) from that of other, non-bank credit institutions (with UFA) will create many possibilities of regulatory arbitrage, and could lead to financial instability.

Looking at the Public Debt Management Agency (PDMA), the mandate is to make the market for government securities liquid and to keep the costs of borrowing down. It is clear then that the PDMA will strive to keep the rates down through participation in the G-Sec markets. This will severely hamper RBI’s operations in the secondary markets through its Open Market Operations (OMO). The PDMA will have seven members, of which four will be chosen by an expert selection committee (who chooses these members?), and one each from the RBI, central government and the state governments in turn.  Envisage a situation where the government has accumulated large amounts of public debt, which has increased the cost of borrowing and the rate of inflation. The two main instruments of the RBI to fight this scenario are through control over the policy rate and through open market operations. However, in the new system, the MPC may not allow an increase in the policy rate and any RBI OMO operations will be dominated by actions of the PDMA.

The Financial Stability and Development Council has the mandate to evaluate and manage the systemic risks in the financial system. This functioning is closely linked and inalienable to the function of regulation of the banking system, which lies with the RBI. How does the IFC imagine the FSDC to manage and mitigate systemic risks without having the power to regulate the banking sector?

Each of these agencies will have different mandates and views, which might conflict with the other agencies. Further, each agency will have members belonging to the government, RBI, or independent experts, who will try to pursue their own agenda. It should also be remembered that there already exists a host of other regulatory bodies in the financial space: SEBI, FMC, IRDA, PFRDA, NABARD, etc. How will the actions of all of these financial agencies be coordinated to pursue a higher agenda of financial stability, price stability and long term sustainable growth?

Finally, a surprising omission from the draft IFC is the control over exchange rates. As it is well known, the exchange rate of the Indian rupee is not entirely determined by the market forces. The RBI intervenes from time to time to either reduce volatility (stated mandate) or to maintain the exchange rate at ‘comfortable levels’ (unstated). An exchange rate policy cannot be independent of monetary policy and forex management. Then, will the MPC be in charge of exchange rate management as well? If so, it can create all sorts of distortions in the economy. The government may try to have a ‘strong’ currency out of a misplaced sense of pride.

The Financial code will have to be redrafted to reduce the number of conflicting agencies and give clearer mandates to any new agency it will create. Finally, it will need to look at the justification behind its attempt to fix a system that is not broken and not tinker with the well functioning aspects of the financial system.

Image Source: http://indianexpress.com/article/opinion/columns/a-code-too-soon/       Illustration by C.R Sasikumar.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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A Fiscal Lesson for Monetary Policy

Is it wise to entrust monetary policy to the central government, when it has consistently failed to achieve its fiscal and revenue deficit targets?

The Finance Ministry has put up the revised draft of the Indian Financial Code (IFC) on its website and has invited comments from the general public. Its many drastic proposals have invited much outrage from economists with the main target being the structure of the monetary policy committee. Earlier this year, the Reserve Bank of India and the Finance Mininistry came to an agreement to form a monetary policy committee (MPC) and also agreed on adopting inflation targeting. The draft IFC goes on to expound the structure and functions of the MPC:

Part XI “Reserve Bank”, Chapter 64 – Objectives and Functions of the Reserve Bank; Clause 256:

  1. The Reserve Bank must constitute a Monetary Policy Committee to determine by majority vote the Policy Rate required to achieve the inflation target.
  2. The Monetary Policy Committee will comprise –
    • (a) the Reserve Bank Chairperson as its chairperson;
    • (b) one executive member of the Reserve Bank Board nominated by the Reserve Bank Board;
    • (c) one employee of the Reserve Bank nominated by the Reserve Bank Chairperson; and
    • (d) four persons appointed by the Central Government.

Thus, the MPC will consist of seven people, the majority of which (four) will be from the central government. Since it is stipulated that the interest rate will be set by the MPC on the basis of a majority vote, the government will get a greater say in the determining of monetary policy than the RBI. Further, the chairperson of the MPC (the RBI chairperson) does not get a veto vote. This is essentially the heart of the heated debate on the transfer of control of monetary policy from the RBI to the central government.

Why is this a bad thing?   

The issue boils down to whether the government can be trusted to keep the long term interests of the economy in mind while making monetary policy decisions. The trends in fiscal policy can point towards the answer. As Anantha Nageshwaran points out, “the Indian economy is inflation prone and fiscal populism, is its biggest contributor. From loan waivers to corporate give-aways, fiscal policy primes the pump needlessly on many occasions for non-economic considerations.”

It is difficult to trust a central government (irrespective of which party in power) which has failed to adhere to its own rules regarding fiscal policy. The government passed the Fiscal Responsibility and Budget Management Act (FRBMA) in 2003 with the intention of reining in the ballooning fiscal and revenue deficits. It planned to reduce fiscal deficit to 3% of GDP and eliminate revenue deficits by 2008, though this deadline was later extended to 2009 without any opposition. However, by 2009 the revenue and fiscal deficits were as high as 4.7 and 6.2 per cent of GDP respectively.  From 2009 to 2012, the FRBMA targets were never met as can be seen in Figure 1.

The events after 2012 are even more disturbing. The budget speech of 2012-13 contained amendments to the FRBMA which diluted targets and extended deadlines. The amendments extended the deadline to reduce the fiscal deficit to 3% to 2017 and increased the targeted revenue deficit to 2% instead of 0% (to be achieved by 2015). May, 2013 witnessed further dilutions and extensions of the targets.

Figure 1: The central government has consistently failed to meet its targets for containing fiscal and revenue deficits.

Figure 1: The central government has consistently failed to meet its targets for containing fiscal and revenue deficits.

There are multiple reasons for the central government’s failure to adhere to its own targets. However, the essential problem lies with the inherent short term growth bias of the central government as these posts have elaborated. Political considerations like re-election make the central government more than willing to consistently spend more than it earns despite the risks of higher future inflation and increased interest rates.

This begs the question as to how the central government can be entrusted with conducting monetary policy when such a task requires a long term perspective. “There is thus plenty of reason in the Indian context for the central bank to remain in a perpetual vigilant and adversarial mode. It provides the vital check and balance”, as Anantha Nageswaran elaborates. Thus, if the IFC is insistent on setting up an MPC, it should revisit the composition of members and should tilt the balance away from the political central government and towards the RBI.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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The Macroeconomic Case for Central Bank Independence – II

Independence of the Central Bank results in low average inflation rates with minimal variance, which provides a conducive environment for high and sustainable growth.

Part I explored the inherent growth bias in an elected government and the reason why the government would be willing to tradeoff higher growth rates for a slightly increased inflation rate. The short run Phillips curve explains this phenomenon, while the Long Run Phillips Curve or the Expectations Augmented Phillips Curve shows that there is no long run tradeoff between the two variables in the long run and further, that any policy that tries to take advantage of the short run Phillips curve will end up with lower growth rate and a higher inflation rate. While fiscal policy still falls trap to the short run Phillips curve in many countries today, subjecting monetary policy to this line of thought will result in a stagnated economy with high inflation, which has very real economic costs to the population.

Milton Friedman, in all his wisdom, demonstrates the effects of monetary policy conducted with short term visions:

When the alcoholic starts drinking, the good effects come first; the bad effects come only the next morning, when he wakes up with a bad hangover – and often cannot resist easing the hangover by taking the ‘hair of the dog that bit him’.

The parallel with inflation is exact. When a country starts on an inflationary episode, the initial effects seem good. The increased quantity of money enables whoever has access to it – nowadays, primarily government – to spend more without anybody having to spend less. Jobs become more plentiful; business is brisk, almost everybody is happy at first. Those are the good effects.

But then the increased spending starts to raise prices. Workers find that their wages, even if higher in dollars, will buy less; businessmen find that their costs have risen, so that the higher sales are not as profitable as had been anticipated unless prices can be raised even faster. The bad effects are emerging: higher prices, less buoyant demand, inflation combined with stagnation.

As with the alcoholic, the temptation is to increase quantity of money still faster.. In both cases, it takes a larger and larger amount of alcohol or money, to give the alcoholic or the economy, the same ‘kick’.

— Milton Friedman in Money and Mischief: The Cause and Cure of Inflation.

This is the theoretical case for Central Bank independence which has a long term vision.

Empirically, economic literature on this subject is not definitely in favour of central bank independence, though the dominant thinking is for independence. Grilli, Masciandaro, and Tabellini in 1991 developed an index for measuring central bank independence. The index mainly tried to measure two factors: political independence and economic independence. These factors comprise the following sub-factors:

Figure 1: Showing the various factors that comprise political and economic independence of Central Banks.

Figure 1: Showing the various factors that comprise political and economic independence of Central Banks.

Mainly, central bank independence has to be thought of in two main areas. Firstly, does the central bank have goal independence? Many central banks are given the mandate of price stability or the dual mandate of growth and price stability by the government. Secondly, does the central bank have operational/instrumental independence? In this kind of independence, the central bank can choose its instruments for achieving its policy goals and the timing of its use.

The strongest evidence for central bank independence is given by a simple regression plotting level of inflation and measures of central bank independence. The figure below shows inflation and central bank independence for industrialized economies using data from 1955 to 1988.

Figure 2: Showing the relationship between inflation rates and central bank independence for the period 1955-1988. Source: Alesina and Summers (1993)

Figure 2: Showing the relationship between inflation rates and central bank independence for the period 1955-1988. Source: Alesina and Summers (1993)

More modern studies have also been able to replicate this particular relationship.

Figure 3: Showing the relationship between inflation and central bank independence for 1995-2005.

Figure 3: Showing the relationship between inflation and central bank independence for 1995-2005.

Finally, studies have also shown that central bank independence is strongly correlated with lower variance in inflation. The Alesina and Summers paper show this graphically for the same period.

Figure 4: Showing the relationship between Central Bank independence and variance in inflation.

Figure 4: Showing the relationship between Central Bank independence and variance in inflation.

Thus, central bank independence results, more often than not, in low and stable inflation rates. Low and stable inflation rates, as economic theory has repeatedly proved, provides a conducive environment for GDP growth.

Thus, to achieve high growth rates, the central bank must be independent and must strive to achieve low and stable inflation.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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