Leave the RBI alone

The turf war between the government and the RBI seems to be intensifying. The government is readying its arguments for serious modifications in the recommendations of the Urjit Patel committee; this is with respect to the composition of the monetary policy committee (MPC) which sets policy rates. It seems to have reservations on RBI appointing the two external members — out of the proposed five-member team — to the MPC.

The MPC is to include the RBI governor as chairman, the deputy governor as vice-chairman and three additional members, one of whom would be an RBI Executive Director.

The government’s argument is that there should be more external members in the MPC and they should be nominated by the Centre. It also says the inflation target for the rule-based monetary policy should be set by the government and not the RBI.

This missive highlights the discord between the Finance Ministry and RBI. Implicit in the government’s bid is the assumption that current decision-making powers vested in the RBI governor will be strengthened if the governor decides on MPC members as well. If the government appoints external members to the MPC, it is assumed to provide for a more balanced decision-making process — a euphemism for a more compliant RBI.

In contrast, the Urjit Patel committee seeks to broaden the decision-making process. This is the practice with inflation-targeting central banks around the world. The Patel committee says that in nearly half the central banks in the world, the government does not have representation in MPC. In some cases (Israel, Serbia, South Africa), MPC members are decided by the central banks and in others, they are appointed by the government (UK, Poland, Mexico, Indonesia).

No government, please The government’s inherent lack of faith in the RBI’s ability to select the right candidate for its MPC and manage financial stability and inflation isn’t justified. The boot, in fact, is on the other foot.

For one, the persistence of high inflation is attributable to large fiscal expansion and pro-inflation food policies.

We had a similar policy slant from March 1996 to April 1999 when food inflation averaged 9.3 per cent. RBI governors have expressed their concern over the fact that profligate fiscal policies have eroded the Central bank’s ability to attain price stability.

Second, there is a serious risk to financial stability arising from the persistent rise in impaired assets of public sector banks and the resulting erosion of banking capital. Our firm’s 2012 estimates placed the recapitalisation requirement of PSBs at $30 billion or close to 2 per cent of GDP. The IMF’s recent study estimate is even higher, at 2.1-5 per cent of FY13 GDP. It is clear that government’s responsibility in recapitalising PSBs, which contribute 80 per cent of banking business in India, and restoring country’s financial stability, is far greater than RBI’s. Hence, the issue of conflict of interest is evident.

Undermining role Third, the government’s role in the banking sector in general and PSBs in particular has subordinated the interest of minority shareholders; the banks have emerged as big value destroyers for investors. For example, the banks are burdened with the objective of growing agri-lending at more than 25-30 per cent despite rising indebtedness and the sector growing at a meagre 3 per cent, resulting in a moral hazard problem. The postponement of government subsidy payments funded by PSBs is another burden. Further, these banks have had to absorb the impaired credit of government utilities.

Four, the banks’ statutory liquidity ratio (SLR) requirement, which currently stands at 23 per cent of deposits, has long served as a captive investor base for funding fiscal profligacy. It will be a glaring case of conflict of interest if government insists on appointing the MPC members.

The RBI Act gives specific powers to the RBI to determine the reserve ratios (Section 42) and also deal exclusively in repo, and reverse repo transactions (Section 12AB). In light of these provisions it is difficult to understand how an external body can have the right to appoint members to a decision-making body and not just an advisory body.

If the government agrees that price stability is the RBI’s central objective, it should leave it to the Central bank to decide how it will attain that objective. The Urjit Patel committee has laid out the monitoring mechanism. It will be better if the government concentrates on establishing its credibility in fiscal management.

It is high time policymakers realise that growth isn’t going to return if RBI cuts interest rates. Macro cyclical and structural adjustments are necessary for rates to start declining.

( The writer is head of institutional research and an economist at Emkay Global Financial Services. The views are personal)

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