While RBI should have lowered rates, it held its own brief despite government pressure.

The economic news of the last few weeks has not brought any cause for cheer. First, India’s annual growth rate forecasts have dropped to 5.5 per cent. Consistent double-digit growth prospects seem hallucinatory. Inflation is at a plateau, though it is between 8 and 9 per cent per annum in general, and at over 12 per cent for food items.

Reserve Bank (RBI) of India Governor D. Subbarao has kept interest rates unchanged, at a high level, thereby asserting a central bank’s independence in taking the decisions it is charged to take. This has not stopped the Finance Ministry boss, P. Chidambaram, from expressing a view that an interest rate reduction could have supported the Government in its task of promoting growth.

One is disappointed that interest rates are unchanged. Yet, one applauds Subbarao for not bending to Government suasion and upholding the RBI’s independence.

The late author, John Mortimer, of the Rumpole of the Bailey series, remarked that in a free speech trial a barrister’s duty was to defend the client’s right to say what she liked, in spite of the barrister completely disagreeing with the content of any such statement.

Thus, Subbarao has every right to assert RBI’s independence to take a decision. The decision may not be palatable. But that is not the only issue at hand.

Central Bank autonomy

Chidambaram could have a point. China, faced with slowing growth, has lowered interest rates twice in the past few months. Obviously, there is a connection between lowering interest rates and supplying fuel to a sputtering growth engine.

That the decision should have been different, however, because Finance Minister said so, strikes at the root of RBI independence. Nevertheless, RBI and Subbarao have to consider inflation and growth issues simultaneously.

The Finance Minister would have to keep in mind that unbridled spending and growth can overheat the economy and drive inflation upwards. The relationship between Finance Minister and RBI is symbiotic but uneasy. Managing the relationship is tricky.

Should the RBI be independent and free to decide as it chooses? In 1967, on his arrival as RBI Governor, the late L. K. Jha had asserted that the RBI was bound to finance the budgetary deficit of the Government. As reported in the RBI’s 1951 to 1967 history, he had stated that: “what needs emphasising is not the independence of the Reserve Bank but that monetary and fiscal policies work in harmony and pull in the same direction.”

L. K. Jha rightfully pointed out the need for harmony. What he did not state was that FM intervention in RBI-related issues would invite disaster. In Indian economic history, there is the tale of such a disaster. The lessons from it are salutary.

Precursor to friction

T. T. Krishnamachari (TTK) succeeded the late C. D. Deshmukh as the Finance Minister in mid-1956. Within weeks, TTK began making public his differences with the then RBI Governor, Benegal Rama Rau over busy season credit policy. TTK even went to the extent of articulating in BRR’s presence a preferred monetary policy stance that varied with RBI’s position.

Matters came to a head over stamp duty on the sale of treasury bills. Stamp duty is a tax, and a fiscal policy instrument. Decision on rates are taken by Central and State governments. Central revenues from such a source are re-allocated to States for spending. Hence, constitutional issues also arise.

Till late 1956, the stamp duty on treasury-bill sales was 0.0125 per cent ad-valorem. The Finance Minister increased this 40 times, to 0.5 per cent, ad-valorem, initially. Subsequently, the stamp duty was to be 1 per cent of treasury-bill value. There were RBI and FM differences arose over the increase in stamp duty. Initially, it was an increase of 40 times. Subsequently, it would result in an 80-times duty increase. The RBI and the Finance Ministry having earlier agreed that there would be no increase in the bank rate, the stamp duty increase was an effective rate hike carried out insidiously by the Finance Minister.

At that time, the bank rate was 3.5 per cent. The effective bank rate would be 4 per cent, but that rate had been decided by the Finance Minister and not the RBI. The Finance Minister had broached the RBI’s independence.

The Prime Minister, Jawaharlal Nehru, not known for his grasp on economics, refused to intervene, though Rama Rau and he had been students at Cambridge simultaneously. Rama Rau resigned as RBI Governor in early 1957. A hike of stamp duty to 0.5 per cent was an effective 14.3 per cent tax on interest payments paid by banks to FM, which could then redistribute the sums to the States. TTK declared in Parliament that the proposed hike was a fiscal measure with monetary intent, and in the process created a huge constitutional issue.

TTK justification for the stamp duty hike was the need for an indirect credit control measure different from an increase in the bank rate. A bank rate increase would have sent wrong signal to entrepreneurs. An indirect method would allow FM to obtain interest taxes so that resources could be mobilised to finance the Second Five-Year Plan.

The stamp duty hike went against the need to liberalise credit. Indian industrialisation was just beginning to take off, and industrialisation was the thrust of the Second Plan. Industry clamoured for cheaper interest rates. There were large protests at the measure and rapid decline in borrowings.

Till then, inflation had been trivial. Between 1957-58 and 1958-59, inflation shot up to near double-digits. A cycle of high inflation and falling growth was set in motion that would take India years to recover from.

Moral of the Story

The story has two lessons: The Finance Minister should not meddle with the RBI, and TTK’s back-door rate hike crippled India.

The RBI independence is critical and crucial. It has to be fiercely guarded. But, that does not mean that in shaping monetary policy, the RBI should not consider the fiscal consequences of monetary policies.

Subbarao should not let the insidious influences of date-expired monetarists, hanging around New Delhi, impact the RBI’s reasoning. Instead, as an ex-administrator, he should let grassroots considerations prevail on policy prescriptions that make citizens’ lives tolerable because more goods are available.

Hence, to flog a dead horse, real interest rates are a determinant of investment and growth. The lowering of real interest rates can reduce the cost of capital of entrepreneurs, provide incentives, generate output and lead to enhancements in direct tax collections which then reduce the fiscal deficit. Surely, the compelling logic of a well-established empirical regularity would persuade the RBI to lower real interest rates the next time it has the opportunity.

(The author is Professor of Technology Strategy, University of Texas.)

(This article was published on November 5, 2012)
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