BOOK EXTRACT. Dealing with FM was a tightrope walk

How does the finance minister interact with the governor? The answer is, it depends. Monetary policy is the core function assigned to the RBI. The issue of autonomy and accountability of the RBI becomes critical here. The RBI is a lender of last resort to the financial system as a whole, and is therefore, responsible for the financial stability of the system also. While the RBI is the first line of defence in times of stress, the sovereign assumes the big risks in times of crisis. The RBI act also specifies that the RBI is the banker to the government and its debt manager.

The Banking Regulation Act that came later, assigned functions of regulation to the RBI. In the Indian context, public sector banks account for a majority of the banking system and the government is the majority owner of the public sector banks. Even more interestingly, the government is also the owner of the RBI itself. This means that the government — as the RBI owner — regulates itself — as the owner of public sector banks. In a convoluted maze of ownership, accountability and autonomy, the RBI must regulate the entity that is owned by the government, and is accountable to the owner of the regulated entity.

If that were not complex enough, the Foreign Exchange Management Act is a separate act that empowers the RBI to manage the external sector, while the forex reserves are on the balance sheet of the RBI. But since the interactions are with the external world, it is impossible for the RBI to work without the close cooperation of the government.

In many developing countries, the central bank is a repository of expertise related to money and finance. India is no exception. Governments tend to draw heavily from this expertise; making the RBI an advisor to the government. RBI’s responsibilities include the payment and settlement system, distribution of coins and management of currency. It functions as a banker, debt manager, and advisor to State governments. For these reasons, the relationship between the RBI and the government is multifaceted, dizzyingly complex, and sometimes circular.

Also, personalities of the governor and finance minister matter. In the case of Chidambaram and I, both were known to go into excruciating detail (sometimes excruciating to each other) and we had a reputation (entirely well-earned) of being stubborn. In this spicy mix, we also had a PM who was both a former RBI governor and a former finance minister and knew the tricks of the trade of both sides. I sometimes wondered if the PM would have a quiet chuckle to himself while observing the back and forth between Chidambaram and me.

The monetary policy deals, essentially, with managing the supply of money, credit allocation, interest rates, and exchange rate, to achieve defined objectives such as inflation and growth. In India, the monetary policy is announced annually (usually in April/May) and mid-term (October/November). During my tenure, we introduced quarterly reviews also. Normally, monetary measures are taken as part of the policy statement.

Technically, monetary policy is decided by the RBI. But it is customary to have consultations with the minister. During these consultations, the first step is to reach an agreement on the direction in which the monetary policy should move. We take into consideration domestic and global factors. We take a view on both present circumstances as well as the future path (as these measures impact the economy with a time lag). Then we take a view on which instruments to use: whether to tweak interest rates or change the supply of money.

Reforms and measures in monetary, financial, external, and fiscal sectors have to be mutually consistent. Every decision impacts different interests (for example, importers vs. exporters, savers vs. borrowers) differently. Therefore, Chidambaram and I had a lot to discuss as we debated the implications of each decision.

I had to contend with a further complication. Even as we were having consultations on monetary policy, there were occasions in which Chidambaram would express his opinions in public. This meant, first, if I were to announce measures that were contradictory to the minister’s public statements, it would send confusing signals. Second, it would mean that, by the time my policy was announced, his statements had already influenced expectations — and therefore my policy then became less effective. That was not all. After every important policy statement, Chidambaram would convene a meeting with the chief executives of public sector banks and give guidance to them on all aspects of policy. Invariably, given the timing, the guidance included follow-up actions on the monetary and regulatory policy and developmental measures announced in the statement. The transmission of my policy – which was mainly through public sector banks — was diluted with the minister’s guidance.

Early on, I raised this issue. I urged Chidambaram to be circumspect about expressing his opinions before the monetary policy statement. ‘I agree,’ he said. ‘I sympathise with your point of view.’ But, he pointed out, in a democracy, it is legitimate for the finance minister to express his opinions on important economic policies, including those having monetary implications.

I had no choice but to leave things at that. However, though he continued to express his views, perhaps there was some moderation in the light of my concerns. Therefore, while designing the monetary policy, I had to take into consideration possible statements that Chidambaram would likely issue.

In the early part of my tenure, there were occasional disagreements, but I would not consider any of them to be serious. They were part of the usual differences of views and philosophies between the RBI and the government. The first sign of serious difference surfaced with the tightening of policy on 24 January 2006, due to global imbalances, oil price scenario, booming levels of credit and asset market activity in India. The perceptions on growth prospects and pressures on prices differed significantly.

In the Mid-Term Review of policy on 31 October 2006, I mentioned that there were signs of overheating. I raised the repo rate and said that it is only a signal that borrowing from the central bank would be expensive. I added that we had complaints about fairness and transparency in regard to the housing sector. On 1 November, Chidambaram said that there were no signs of overheating, though he justified the Reserve Bank’s decision to hike repo rate by 25 basis points as ‘well intended’. He added, ‘And if they had not taken action, I think some sectors have shown some signs of overheating.’

To be fair to Chidambaram, in public, he was muted in his unhappiness about my using the word ‘overheating’. His reaction in private was strong. He said, ‘What are you doing? For decades since independence, we have been dreaming of double-digit growth. Now that we are almost there, you want to spoil everything. Where is the evidence that there is overheating? What is overheating for that matter?’

After this conversation, I decided not to use the word ‘overheating’ but continued with policies to moderate asset bubbles and excessive credit growth. I was merely responding to Chidambaram’s guarded criticism of my approach. Chidambaram’s reaction in private was strong in another instance, namely, on self-imposed inflation target that I had proposed in April 2007. I said, ‘For the medium term also, the RBI has lowered its inflation target to 4 to 4.5 per cent from 5 per cent earlier.’

Chidambaram promptly called me over the telephone and said, ‘What is this target? It is too ambitious a target. I don’t agree.’

Edited extracts. With permission from HarperCollins India

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