The RBI is not the finance ministry’s back office, even if the law makes it seem so
The public row between the ministry of finance and the Reserve Bank of India has been making news. The media have reported statements, and unearthed similar rows that occurred earlier. They have also pointed out that the Reserve Bank of India Act gives the finance ministry unlimited power to bend the RBI to its will. If that is so, what both sides say does not matter: if push comes to shove, the finance minister can dismiss the dissenting governor and deputy governor and put his own yes-men in their place. In that case, the merits of the contretemps are irrelevant; the finance minister will win — unless he realizes his error or sees that display of muscle would do his image no good. He is not known for backing down or changing his mind, so the likely outcome seems boringly clear.
What is not clear is why, in light of the law, the RBI is necessary. If it is a slave in law, all that it does could be done by a junior clerk in the finance ministry; the finance minister could get whatever he wanted by calling a minion and telling him to do it. The fancy building of the RBI overlooking the Mumbai harbour, the posh residences of its senior officials, its numerous offices in and outside India — they are all a sheer waste of money, which the finance minister ought to end forthwith.
It is striking, however, that the central bank of no major country is a back office of its finance ministry; all countries that India would like to compare itself with have separate central banks and give them autonomy. And this did not happen yesterday. The Bank of England was created 324 years ago, much before any of the other features of the modern form of government — universal franchise, judicial independence, professional bureaucracy — were invented. Many a president or chancellor would like to exercise unbridled power; why have all respectable countries bridled them when it comes to monetary policy?
The answer goes back to a time before presidents and chancellors — when there were kings who could lock anyone up in the Tower of London at the drop of a hat. They fought wars, for which they needed soldiers, swords, clothes, shoes, horses, gauntlets, helmets and what not. All these had to be paid for. The kings could get the wherewithal from the rents of their peasants or taxes on traders and landlords; but often they needed money immediately, in the middle of a war for instance, and had to borrow it. Those who had money to lend could not be sure that their king would win the war, and if he did, that he would repay his loans. To reassure them, William III, who was fighting an expensive war against France, got his rich and respectable subjects to create a bank which took over his accounts; in other words, he ransomed his kingdom. Conversely, the moneybags financed him to protect themselves from the French. The conclave of plutocrats called itself Bank of England. It managed the king’s finances to protect England’s international standing.
That is the prime duty of central banks all over the world to this day. It is in this context that RBI deputy governor Viral Acharya said, “A government’s horizon of decision-making is rendered short, like the duration of a T20 match (to use a cricketing analogy), by several considerations. There are always upcoming elections of some sort — national, state, mid-term, etc. As elections approach, delivering on proclaimed manifestos of the past acquires urgency; where manifestos cannot be delivered upon, populist alternatives need to be arranged with immediacy. Less important in the present scenario, but only recently so, wars had to be waged, financed and won at all costs. This myopia or short-termism of governments is best summarized in history by Louis XV when he proclaimed, ‘Après moi, le déluge! (After me, the flood!).’ In contrast, a central bank plays a Test match, trying to win each session but importantly also survive it so as to have a chance to win the next session, and so on.”
He did not mention, because it would have been impolite, that India has had many finance ministers who left a deluge behind them. Inflation was endemic before the reforms of 1991-93; and there was a payments crisis at least once every decade, despite crippling controls intended to prevent them. Arun Jaitley criticized the RBI for the bad debts created by banks in 2008-14; but it was not the RBI that allowed banks to lend to dodgy borrowers — it was the government, their owner. The RBI did not “[look] the other way”: it kept watching, but it had no power to stop government banks from giving injudicious loans. Jaitley has not been as disastrous as some of his predecessors; but that is less due to him than to his luck. After Raghuram Rajan’s asset quality review of 2015, banks stopped lending out of fear that they would be blamed for consequent bad debts; and foreign exchange reserves are so high that it would take a bigger genius than Jaitley to take India into a payments crisis.
It would also take a less self-satisfied finance minister to improve the relationship between him and the central bank. But his British counterpart has just done it. Her Majesty’s Treasury signed a memorandum of understanding with the Bank of England in June. The government had got British Parliament to pass the Bank of England Act in 1998 which gave the Treasury power to direct the Bank of England, much on the lines of Section 7 of our Reserve Bank of India Act. The memorandum of understanding converts the master-slave relationship defined by the 1998 Act into a more consensual one. The 1998 Act defined the functions of the Bank of England (financial stability, monetary policy and prudential regulation), gave it powers to carry them out, specified subsidiary institutions that would implement them (financial stability committee, financial policy committee and monetary policy committee), created two supervisory institutions (financial stability authority and prudential regulatory authority) and made the Treasury responsible to Parliament for Bank of England. The memorandum of understanding lays down rules about the financing of the Bank of England — ensuring its capital adequacy, laying down how it would pay dividends to the Treasury which is its owner, authorizing the cash ratio deposits it collects from banks, as well as the bond purchases it may do as part of financial regulation. Other countries do it in other ways. In the United States of America, the Federal Reserve is owned by 12 state reserve banks. Germany follows a different model; its Bundesanstalt für Finanzdienstleistungsaufsicht is financed by fees levied on financial institutions.
Indian legislation on central banking is archaic: it empowers the finance minister to do anything he likes without knowing anything. But it would be a mistake if he does so. Financial regulation requires specialist knowledge, good judgment and timely action; it is best left to an independent professional institution. If it is professional enough, there is much that a finance minister can learn from it. But that requires a finance minister willing to learn; in the absence of one, we have the best possible arrangement we deserve.