The RBI is supposed to maintain ‘price stability’ and ‘monetary stability’. The problem is that only one of those terms is properly defined.
The RBI’s Central Board is set to meet on Monday, November 19. The agenda includes a range of issues that have cropped up between the Government and the RBI. While there have always been differences between the two (and different viewpoints are not always bad), the relationship between the RBI and the Government has not been this bad in recent years.
At a broad level, the issues can be divided into two categories: One, policies of the RBI, ranging from level of interest rate to the current liquidity situation to credit flow to the economy; Two, the adequacy of the reserves on RBI’s balance sheet, and the way to deal with excess reserves. Before we get into these two issues, it is worth reflecting on why the RBI exists. The preamble to the Reserve Bank of India Act, 1934 which governs the functioning of the RBI sets this out as follows:
An Act to Constitute a Reserve Bank of India
whereas it is expedient to constitute a Reserve Bank for India to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage;
AND WHEREAS it is essential to have a modern monetary policy framework to meet the challenge of an increasingly complex economy;
AND WHEREAS the primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth;
AND WHEREAS the monetary policy framework in India shall be operated by the Reserve Bank of India;]
It is hereby enacted as follows…
Essentially, the RBI is expected to perform two functions: maintain monetary and price stability. Other variables such as economic growth are subservient to these goals. (Generally, monetary stability and price stability have the same meaning, but given that these two terms are mentioned separately, I think monetary stability is to be construed to imply overall macroeconomic stability or financial stability – basically to prevent internal shocks to the economy.) This RBI Act is where the genesis of the current difference of opinion between the government and the RBI can be traced to.
When it comes to price stability, the law now explicitly provides for what the RBI must achieve, and the consequences in case the RBI fails to achieve its mandate. The inflation target is explicit, and if the target is breached for three consecutive quarters, this constitutes a failure on the part of the RBI. In such a case, the RBI has to, on its own, write to the central government explaining why the inflation target has not been met, what the RBI is proposing to do about it and within what time frame the RBI will get inflation back to target.
It is worth noting that once the RBI has been given a mandate, it is up to the RBI to choose which tools to deploy to achieve its mandate – be it interest rates or liquidity or exchange rate or something else. The job of the government is restricted to setting an inflation target for the RBI. That is a political decision. But once having decided the inflation target, the government does not get into the ‘how’ of the mandate — or at least it is not supposed to. The demarcation between the Government’s turf and that of the RBI is clear.
But What is ‘Monetary Stability’?
The problem when it comes to the RBI’s mandate of ‘monetary stability’ (interpreted as macro stability or financial stability as discussed above) is that it is not clear what exactly the RBI is supposed to achieve. The law does not define monetary stability or offer any guidance on what it is supposed to mean. This raises important questions. Does the fact that many banks are sitting on 15-20% of their assets as NPAs constitute a failure to ensure monetary stability? Or the fact that despite banks sitting on such large NPAs, there is no panic in the financial system, the economy is still growing at 7%, people still have faith in the banks (there has been no run on any bank either from retail depositors or institutional depositors) and credit is still flowing relatively smoothly, a sign of RBI having succeeded in maintaining monetary stability despite the challenges? Is the default of IL&FS, a large RBI-regulated entity, and the consequent dislocation of short-term money markets a sign of RBI having not succeeded in maintaining monetary stability? Is the double-digit fall in the value of rupee against the US Dollar a sign of monetary instability?
The point is since there is no clear definition of what ‘monetary stability’ means, it is hard to judge whether the RBI has achieved its mandate of maintaining monetary stability. And because there is no way to evaluate whether the RBI has fulfilled its mandate, there is no way to hold the RBI accountable on this mandate. And this is where our problems begin.
To be fair, unlike price stability, it is hard to define monetary stability with any great precision. One can perceive whether there is monetary stability or not, but it is hard to pin this down to numbers. And unlike the inflation target, monetary stability is not binary, but a continuum. The opposite of monetary stability is not monetary instability or vice-versa.
Having some sort of working definition of what constitutes monetary stability is necessary, for this sets out what to expect from the RBI. This could be based on a number of ‘markers’ of monetary stability such as level of system-wide NPAs, debt levels, leverage, credit spreads and asset prices, or a periodic subjective assessment by an independent body based on some objective markers. This is not perfect, but having RBI’s performance being judged, subjectively, by either the RBI itself or by the Government, whose objectives are often not aligned with those of the central bank, is worse. This is also important because while high inflation and monetary instability generally go together, low inflation, while a necessary condition for monetary stability, is not enough. Thus, the price stability and monetary stability objectives of the RBI may not always be in sync.
And this is where we link back to the current situation. The difference of opinion between the RBI and the Government is over which tools the RBI should be deploying. (For example, as per media reports, the Government wants the RBI to open a line of credit for NBFCs or make capital adequacy standards less stringent or reduce the restrictions on lending on some PSU Banks.) But like with the other mandate of the RBI of maintaining price stability, once a working definition of what constitutes monetary stability is adopted, by both the RBI and the Government, the choice of tools that should be deployed to achieve that automatically falls into RBI’s domain. We get a clear demarcation between the role of the Government and that of the RBI. The Government lays down the mandate and the RBI decides how best to achieve it.
Next is the discussion over the RBI being over-capitalised. As per law, the RBI must pay out its entire surplus to the Government. And the RBI has been compliant with this. Where the suggestion of RBI being over-capitalised comes in is from an accounting policy that the RBI has been consistently following, which is to not recognise any unrealised gains on its assets due to changes in market values of those assets as profit. And since the rupee has consistently depreciated against most other currencies, most notably the US Dollar, the RBI is sitting on a large unrealised gain on its assets.
For all practical purposes, there is little difference between realised and unrealised gains on mark-to-market of financial assets. So, in a sense, through an accounting quirk, the RBI has managed to keep profits for itself, which, but for this accounting policy, it would have had to pay out to the government.
The real question should not be whether the Government should now demand all or a part of those back, but about how much reserves the RBI should have in the first place. The problem is that unlike commercial banks, which have a globally accepted framework for determining the appropriate level of capital, there is no such framework for central banks, or specifically for the RBI. But it is almost trivial that any entity that takes risks should have some sort of framework that tells it the appropriate level of capital/reserves commensurate with the risk inherent in its operations.
So, at a conceptual level, the Government is right to be raising this question. Unfortunately, when these questions are raised in an election year with a tight fiscal situation, there will be questions over the government’s motive, especially when the questions seem to have been raised in a confrontational manner. The solution is to make this assessment without coercion, when the government faces no fiscal pressures, so that there is no scope for the perception to creep in that fiscal considerations influenced the determination of central bank’s capital framework. There is scope for involving an international institution of repute such as the BIS to increase the credibility of such a determination.
Plan For Stress
The important thing to note here is that this determination of the adequacy of reserves should be made based on stress scenarios. It is the RBI’s balance sheet that comes to our rescue during times of stress. In 2013, for instance, the RBI allowed banks to float foreign-currency-denominated NRI bonds, or borrow money from overseas markets, with the RBI taking the currency risk. Those borrowings bolstered our foreign exchange reserves and helped India to tide over the crisis. This was possible only because even deep inside a crisis, the RBI’s balance sheet was perceived to be rock solid — as indeed it was.
Similarly, the RBI has swap lines with other central banks which can be activated during periods of stress. Effectively, other central banks lend to the RBI (and vice-versa) if there is a need. This can only happen if other central banks have full faith in the ability of the RBI to come good on its obligations.
The stress need not always be external. If the RBI has to raise interest rates by 200-300bps to deal with runaway inflation, the value of government securities it holds will fall, eroding its reserves. Thus, the evaluation of the adequacy of RBI’s reserves should be based on a stress scenario. RBI needs to have adequate reserves during periods of stress, and by implication, this means that RBI will have excess reserves during normal periods. Thus, excess reserves today do not ipso facto suggest that the RBI is fundamentally over-capitalised. Excess reserves with RBI during normal times (and as a corollary, lower income for the government) is the premium we pay for the insurance cover the RBI provides during periods of stress.
The question of whether the Government should demand back the excess reserves comes after a determination of adequate level of reserves has been made. And it is not clear what the outcome of this process will be. In any case, as the former RBI governor Raghuram Rajan has pointed out, a one-time large dividend from accumulated reserves is unlikely to help the economy. Rajan argues:
[T]he Government can use the special dividend to spend, reducing its public borrowing by that amount. But the RBI will have to sell bonds of exactly that amount to the public in order to stick to its target for money creation. The overall net sale of Government bonds by the Government and the RBI combined to the public (that is, the effective public sector borrowing requirement) will not change. But the entire objective of financing Government spending with a special RBI dividend is to reduce overall Government bond sales to the public. That objective is not achieved!
One final point is regarding the composition of the central board of the RBI which meets on Monday. Of the 18 members on the RBI’s central board, five are from the RBI (the Governor and the four Deputy Governors) and two are current bureaucrats from the Ministry of Finance. Unfortunately, of the remaining 11, most are either retired bureaucrats or corporate leaders/businessmen. All of them are people of repute of course. But many are probably not competent to have an informed and independent view on the complex topics likely to be discussed. That’s a problem.
The RBI’s board needs to have members who can engage with the RBI Governor and Deputy Governors, push back at their views and disagree vehemently if needed. The board seat should not be a post-retirement job for bureaucrats, nor a reward for people favourably inclined to the incumbent government. We need people with much more intellectual heft on the topics the RBI board must deal with.
The bottom line is that the current conflict between the RBI and the Government raises legitimate questions. The short-term solution is for both parties to give and take, but the real solution lies in changing the law which governs the RBI. There is a need to lay down in clearer terms what is expected out of the RBI. Once this is done, the government needs to leave it to the RBI to decide what tools it ought to use.
There is a legitimate need to decide the appropriateness of the RBI’s capital. But all these changes need to be done in a less confrontational way, so that the RBI’s independence is not affected. With the shift of monetary policy to an explicit inflation targeting framework, we fixed a part of what the RBI is expected to do. The government’s ability to influence interest rates is now significantly curtailed as a consequence. It is about time we fix the other issues. We need to safeguard the independence of the RBI, and make it easier to evaluate its performance. We also need to reduce the scope for Government-RBI conflict.