RBI’s Acharya Puts The Spotlight On Central Bank Independence

RBI’s Viral Acharya chose to send a not-so-subtle message about the perils of impinging on central bank independence

• The Reserve Bank of India wants to keep weak government banks under a corrective action programme. The government thinks the framework is too stringent and wants it relaxed.
• The RBI asked banks to follow a rule-based approach to bad loan resolution in a 12 February circular. The government pushed hard to get that diluted.
• The government wants a payments regulator, independent of the RBI. The RBI thinks it’s imprudent to take payment regulations away from the monetary authority.
• The government needs resources. It thinks the central bank is sitting on excess capital. The central bank says this capital only strengthens the position of the economy.

Those are at least four publicly known battles being currently fought between the RBI and the central government.

Against this backdrop, RBI Deputy Governor Viral Acharya chose to send a not-so-subtle message about the perils of impinging on central bank independence.

“I chose for today’s occasion the theme of the importance of independent regulatory institutions, and in particular, that of a central bank that is independent from an over-arching reach of the state. This theme is certainly one of great sensitivity but I contend it is of even greater importance to our economic prospects....” Acharya said while delivering the AD Shroff Memorial Lecture in Mumbai.

Acharya’s comments traversed experiences from Argentina to the US. He spoke of Martin Redrado, former governor of the Argentinian central bank, who stepped down after the government transferred central bank reserves to the national treasury. And of former Federal Reserve chair Paul Volcker, who had to fight the Raegan administration that wanted rates to be kept low.

Each of those incidents were used to highlight one theme – when central bank independence is compromised, the economy pays the price.

Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution; their wiser counterparts who invest in central bank independence will enjoy lower costs of borrowing, the love of international investors, and longer life spans.

Viral Acharya, Deputy Governor, RBI

Acharya noted that along with opposing rule-based policies pursued by the central bank, government’s can chip away at central bank independence in a number of ways. From appointing government-affiliated officials to key positions at the central, to eroding the statutory powers of a regulator, and setting up parallel agencies with weaker statutory powers.

RBI’s Victories & Battles

In India’s case, Acharya said that, over the years, significant progress has been made in securing the independence of the Reserve Bank.

Three areas where RBI’s independence has been strengthened include debt management, exchange-rate management and monetary policy. The last is the most recent. With the setting up of the monetary policy committee, independence of monetary policy has been strengthened, said Acharya.

While the jury will remain out for some time on the economic impact of the flexible inflation-targeting framework, it is incontrovertible that the MPC has given monetary policy an independent institutional foundation.

Viral Acharya, Deputy Governor, RBI 

At this juncture, though, the RBI’s battles for independence, rather than its victories, are front and centre.

Earlier this week, government officials on the RBI’s board pushed for a relaxation of the prompt corrective action framework being used to nurse weak banks back to health. This, despite the fact, the RBI has repeatedly explained the need for such a framework. Eleven government banks are under the framework. The pressure from the government to ease the framework prompted Acharya to reiterate the need for greater RBI control over PSU banks – a point highlighted by Governor Urjit Patel earlier this year.

“One important limitation is that the Reserve Bank is statutorily limited in undertaking the full scope of actions against public sector bank – such as asset divestiture, replacement of management and board, licence revocation, and resolution actions such as mergers or sales – all of which it can and does deploy effectively in case of private banks,” Acharya said in his speech.

Recently, the RBI has also publicly disclosed its dissent note on the government’s proposal to set up a Payment Regulatory Board, outside the RBI. Acharya cited this as another affront to the central bank’s standing.

“Payment systems are a subset of currency which is regulated by the RBI. The overarching impact of monetary policy on payment and settlement systems and vice versa provides support for regulation of payment systems to be with the monetary authority,” the RBI had said as part of that dissent note. The very fact that the usually reclusive regulator disclosed the note suggested that its defence was falling on deaf ears.

The now nearly three-year-old attempt to get reserves and capital out of the RBI’s balance sheet also found its way into Acharya’s speech. Former Chief Economic Adviser Arvind Subramanian had first suggested that some of RBI’s capital be transferred to the government. Then RBI Governor Raghuram Rajan opposed it. The option, however, continued to be mentioned in government conversations. In the last two years, the government has constantly sought higher dividends from the central bank to meet its fiscal targets. In April 2018, the RBI transferred a rare interim dividend for the year ending July 2018. In August, government officials suggested they may seek an interim dividend this year too.

Citing research from various academics and writings from former RBI Deputy Governor Rakesh Mohan, Acharya noted that having adequate reserves and capital is important for maintaining confidence in the central bank.

Having adequate reserves to bear any losses that arise from central bank operations and having appropriate rules to allocate profits (including rules that govern the accumulation of capital and reserves) is considered an important part of central bank’s independence from the government.

Viral Acharya, Deputy Governor, RBI

Beyond the battles that Acharya mentioned, concerns have also been raised on whether recent appointments to the RBI’s central board have a political hue to them. Meanwhile, the RBI governor and deputy governor’s attempts to bring in outside talent into the central bank have been resisted.

Acharya, in his strongly worded speech, tried to convince his audience – those present and those listening on the outside – that strengthening the central bank’s independence is important to India’s macro economic stability. It’s a matter of making the right choices, he said.

“Thankfully, it is only a matter of making the right choices, which I believe as a society we can with adequately thoughtful “what-if” analysis; I have sketched a scenario, which several parts of the world are presently witnessing, of great risk to nations from undermining the independence of their central banks.”

(This article was first published on BloombergQuint.)