The RBI cannot perform its role of keeping inflation in check, if the government violates fiscal discipline.

The Euro Zone crisis brought home the need for an independent monetary authority. The responsibility for monetary policy transmission, supervision of banks and supply of credit to the economy lies with the central bank (in our case, the Reserve Bank.)

The RBI not only provides money to banks, but also has to supervise them on the issue of distribution of liquidity in the economy. It consolidated its credentials with its competent handling of the 2008-11 financial crisis.

A crucial issue which Reserve Bank needs to tackle is reconciling the need to hold prices and financing the deficit of the Centre.

Both these actions are the mandatory functions of the RBI.

While every step of Government to finance the deficit by borrowing from the RBI generates additional money supply resulting in inflationary pressures, every step of the RBI is directed towards mitigating the inflation rate.


If we look at the deficit figures, it is clear that the Government has, time and again, breached their acceptable limit.

This is a violation of the policy discipline of the RBI. The fiscal deficit of the Government is, in fact, a glaring intervention in the process of keeping inflation under control.

The cap on Government borrowing, enforced by the RBI, has been violated by the Government from time to time. This limit was fixed as a mandatory cap. Today, inflation in India has become a function of Government deficit. Under the RBI Act, 1948, “the Central Government may from time to time give such direction to the bank as it may, after consultation with the Governor of the Reserve Bank, consider necessary in the public ‘interest’ ” but it is not mandatory for RBI to provide credit to Government.

In the past, Government did intervene or disrupt the functioning of RBI policy, without regard to the RBI.

However, now the frequency of circulars issued by the Government to public sector banks has shown that intervention in the working of the RBI has become more frequent. For instance, the direction by the Government for conversion of banks’ bulk deposits to retail deposit was done to increase liquidity and ease the interest rate.

When the proportion of bulk deposits increases in the total deposits of banks, it reduces the purchasing power of the people and results in lower demand for goods and services, and consequently brings about a reduction in the inflation rate.

Bulk deposits account for 35 per cent of the total deposits of PSU banks, and earn a higher interest rate.


This expansion of monetary liquidity can nullify the anti-inflationary efforts of the RBI.

On July 31, the central bank did cut the statutory liquidity ratio (SLR) from 24 per cent to 23 per cent, which would surely add to money supply and inflation rate.

Moreover, banks have been directed to liberalise bank loans. These sops have been given by the RBI under Government pressure.

Such directives can expose PSU banks to high risk. The Government should appreciate that its policies may undermine the central bank’s independence and authority on the financial liabilities and assets of the banking system.

The Reserve Bank is responsible for performing the duty of lender of last resort.

Supervision of the banking sector helps the Reserve Bank assess not only the financial strength and performance of banks but also liquidity, maintenance of monetary ratios and capital ratios such as CRR, SLR, equity ratio and capital adequacy ratio. In such a scenario, how can the government consider changing the assets and liabilities structure of banks?

The conversion of bulk deposits into retail deposits will hurt the profitability of the banks and perhaps disturb the net worth position of the financial system.

This is because if the level of profit declines, banks will not be in position to allocate adequate amount to their reserves which is an important component of their net worth.

Such interference in the asset structure of banks runs counter to the general advancement towards full liberalisation of the financial system.


The Secretary concerned to the Government should have sought the RBI’s consent before issuing such a directive to banks.

Changes or reforms that the Government considers should be sent to the RBI Governor for his consideration.

There are certain activities that work as a roadblock in discharging central bank responsibilities.

For instance, Government intervention to lower the interest rate has been an obstacle to controlling the inflation rate.

Moreover, subsidies of the Government also result in more supply of money as well as depreciation of rupee, which also generates inflation.

Employment-generation schemes should be implemented along with additional supply of foodgrains and other food items so that Government expenditure does not result in price increases.

It may be noted that prior to reduction of SLR ratio from 24 per cent to 23 per cent, there was pressure on the RBI to cut interest rate.

The RBI Governor wisely substituted the interest cut advice with lower SLR to add to liquidity. The continuance of high interest rate will keep undesirable demand for credit in check. Clearly, the Reserve Bank is trying to control the inflation, but Government policies and pressures are working the other way.

Experts believe that the obligation of a central bank to provide monetary financing limits its ability to control monetary expansion, whether this obligation is to the central Government, State, local Government or public sector enterprises.

In such cases, the Central Bank resists the increase of money but it is on the losing side.

Its independence is undermined. On the one hand, the central bank in every country is responsible for financial stability, while on the other hand, it has to provide unlimited deficit finance to Government.

At times, the RBI has to work as a lender of last resort, while it also needs to implement restrictive monetary policy measures. In such a conflicting environment, the Reserve Bank is unable to function as a supervisor and monetary authority.

In order to empower the RBI to cap Government borrowing, this provision should be backed by Parliamentary approval. Stringent conditionalities should be attached to acceding to such demands.

(The author is former Economic Advisor, SEBI)

(This article was published on August 10, 2012)
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