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Mainstream, VOL LIII No 34 August 15, 2015

RBI and Ministry of Finance: Shadow-boxing over RBI’s Role

Saturday 15 August 2015, by Arun Kumar


The RBI Governor and officials of the Ministry of Finance have often appeared to be at loggerheads in the last more than a year. He spoke on the economy in less than positive terms in his June policy pronouncement. There has been a controversy about the structure of the proposed Monetary Policy Committee (MPC). It appeared that this Committee was to be set up to end the veto of the RBI Governor over the setting of interest rates. A majority of the members of the Committee were to be appointed by the Ministry of Finance so that it could have its way in the setting of interest rates. Underlying this move was the resistance of the RBI Governor in the last one year to quickly lower the interest rates purportedly to boost growth in the economy.

Limited Autonomy of RBI

Has the RBI Governor been wrong in resisting the demand for cut in rates? The Ministry has been trying to create a positive sentiment in the economy and especially at a time when a drought is being forecast and also it has been under attack from the Opposition. However, if the RBI is supposed to be autonomous then it should have the right to differ from the views of the Ministry of Finance. The Governor need not be a cheer leader of the government even though he is appointed by the government.

The Governor has not bowed to the pressures from the Finance Ministry to sharply lower the interest rates because he believes in a gradual approach. His justification is the persisting consumer price inflation.

The RBI has also questioned the government’s claim of a higher rate of economic growth. On this issue, he is in the good company of the Chief Economic Advisor of the Ministry of Finance who in the Economic Survey in February questioned the higher estimate of growth rate. The moot point is: if the economy’s rate of growth is already high, is there a need for a rate cut? The government claims that India now has the highest rate of growth in the world. If so, why accelerate growth which may also accelerate inflation?

The Governor has also resisted the shifting of debt management to a Public Debt Management Agency (PDMA) as proposed in the Union Budget. The government conceded on the issue, perhaps hoping that this concession may allow it to have its way on the more critical issue of sharper reduction in interest rates. But the Governor has not obliged. All this indicates that the Governor is asserting the RBI’s autonomy from the Ministry of Finance. The result is confusion in the markets which adds to the already prevailing uncertainty.

It needs to be clarified that in India the autonomy of the RBI is limited by the way the institutions are structured. The Governor and Deputy Governors are appointed by the Ministry of Finance and they are usually beholden to the government for that. If they play ball with the government then in the future also they can get powerful positions. This is like the judges who are supposedly autonomous but usually look to the government for post-retirement favours. The Governor holds regular consultations with the Ministry in deciding on policy. Often the Governor has been a bureaucrat from the Ministry of Finance or Commerce and one who knows how to keep the politicians happy.

Given these institutional linkages between the RBI and government, what is going on is a shadow boxing between the two. That is why from time to time both come out with statements saying a consensus has been reached. Like, on ending the veto of the Governor in the MPC or on not shifting public debt management away from the RBI.

Is it possible that Raghuram Rajan has been an outsider to the system and hence less compliant? He does not depend on post-retirement largesse from the government and can easily get a job abroad. If that is the case, why has the RBI not more effectively used its limited autonomy and could it do more?

RBI and Inflation Control

The RBI has been arguing that its primary task is not to spur growth but keeping the rate of inflation within a band. The Union Budget 2015-16 states that a Monetary Policy Frame-work Agreement with the RBI has been concluded. It wants to bind the RBI to keeping inflation below six per cent. With a looming drought this is going to be tough and no wonder the RBI is treading carefully. But how will inflation be measured? Using the wholesale price index (WPI) or the consumer price index (CPI)? Recently, the WPI index has been declining while the CPI has been rising at about four-five per cent. Thus, the target may be easier to fulfil if the WPI is used but not if the CPI is used.

It needs to be made clear that in India the RBI has not been very successful in reigning in inflation however measured. The reason is that the phenomenon is not purely monetary. There are structural reasons that are not in the control of the Central bank. Shortages appear and speculation is rife making prices shoot up rapidly (as in the case of onions recently). Black liquidity is sloshing around waiting for such opportu-nities and it is not in the control of the RBI.

In a more open economy like present-day India compared to 1991, global influences are strong. The recent decline in the global commodity prices, especially of the petro goods prices, have helped the WPI inflation to come down sharply and it is now showing a declining trend. Such influences are not in the control of the RBI but are guided by global trends. In fact, there has been a threat of deflation in Japan and Euro zone in recent times. The decline in the WPI due to the global weakening of commodity prices signals a weak global economy and decline in India’s exports and consequently weak growth in India (as in China).

However, there is a deeper problem, namely, neither the WPI nor the CPI truly represent inflation in India. The services sector’s share in the economy is now more than 60 per cent and it is not represented in the WPI. It only has a small representation in the CPI. Thus, if school fees or health costs go up or capitation fees increase or the cost of eating out rises or cost of raising finance rises or payment of insurance charges rise, etc., none of them gets captured in the official inflation figures. In effect, the RBI is not really targeting inflation when it says it is doing so. The moot point is why has the RBI not used its autonomy to work towards creating better inflation indices which can help it better achieve its policy targets?

RBI and Growth Story

Similarly, there has been a controversy about the current rate of economic growth? The RBI needs this data to justify its stance on cutting interest rates slowly. As suggested above, if the rate of growth is already healthy why the tearing hurry to lower interest rates when the inflationary expectations are not yet tamed. International oil prices are fluctuating and have not stabilised. A bad monsoon coupled with a rise in energy prices can result in a rapid rise in the rate of inflation. If the US Fed raises interest rates, more trouble is in store.

It is widely suspected that the rate of growth is not what is suggested by the government’s statistical agency. Index of Industrial Production (IIP) data, slow growth in the core sector, slow rise in bank credit, decline in exports recently, slowdown in services and agriculture are all indicators of a sputtering, rather than a roaring, economy. Why is the RBI not giving alternative credible estimates?

The government claims that the rate of growth has gone up due to the new method of calculation it has adopted. Especially for the contribution of the industrial sector to the economy’s growth. First, this sector’s coverage has been made more extensive and secondly, the calculation is based not on the value of production but the value added in production. But, neither of these would automatically lead to a faster rate of growth of this sector or of the economy.

The smaller companies that were not earlier covered under the IIP are not necessarily growing faster, so why would a larger coverage lead to a higher rate of growth? Further, value addition is made up of profits and wages. Neither of these two are rising rapidly. That is why the government’s collection of direct taxes has been less than what was targeted. Most of the big companies that dominate the total profits of all companies find their profits either shrinking or stagnating. If input costs are falling but the price charged is not, then the profits should have risen sharply which is not the case. The other component, the real wages, have also not risen much because in a period when the industry’s growth is sluggish it is unlikely to concede a big wage increase. The rising NPAs of the banks also suggest that the industry is struggling.

Impact of the Black Economy

But there is an even bigger lacuna in the growth data. India has a big black economy; so a lot of value addition is not counted. The actual rate of economic growth is the average of the black and white rates of growth. The implication is that the official rate of growth of the economy has a big error. Why has the RBI not worked on this and corrected the rate of growth to get more robust policy-prescriptions?

The black economy requires for its circulation additional liquidity and, therefore, affects the money supply and the money multiplier—the crucial inputs into the equations used by the RBI to determine policy. Activities associated with the black economy like, hawala, misinvoicing and smuggling of gold, gems etc. have a direct bearing on capital flows and therefore on money supply. The RBI does not factor in any of these into its policies while it should.

The IMF, OECD, ADB, RBI, Ministry of Finance and private analysts are all giving marginally different rates—a few decimal points here and there. But, these differences are inconsequential given the large error and uncertainty in the actual rate of growth due to the factors mentioned above. The RBI could help resolve this confusion.

Role of Monetary Authority

The RBI is a rich organisation with huge resources and can help research to resolve the various economic controversies plaguing the Indian economy. It has a large research wing which is researching these areas. It also gets studies conducted on many of these areas. Yet, it is reluctant to help clarify matters lest it goes against the views of the government of the day. That is why its autonomy is limited.

The RBI’s role is to regulate the financial system in the country which has become increasingly complex. Even the well-established Central banks, like the FED of the US or BOE of the UK, are unable to effectively regulate the financial systems of their countries. The global economic crash beginning 2007 demonstrated this. The global banker, the IMF, did not see the recession coming till a year later when the world economy had already entered a recession. As the analysts then said, the experts were ‘behind the curve’. Alan Greenspan had to admit in Senate hearings in 2008 that he was wrong in believing that the markets are ‘self-regulating’. What a huge mistake to make for a Central banker? A large number of people all over the world are still paying the price for the mistakes of the financial system and the failure of the Central banks.

The role of banking in any economy is to be the intermediary between the savers and investors. The RBI’s task is to see that this is efficiently carried out. The task of control of inflation and stepping up growth is primarily that of the Ministry of Finance. In a situation where the profitability of the industry is hit due to the lack of demand, a reduction of even a few per cent in interest rates can only have a marginal impact. It could even lead to expectations of a further cut in rates and if interest rate was the reason for the slowdown in investments, then investors could wait for a further cut. At the heart of all this confusion is the controversy between the Keynesian and Monetarist understanding of the economy and the role of money.

To efficiently regulate the financial system in India, the RBI needs to curb the rampant malpractices in the system. The stock markets suffer from insider trading, the commodity markets have also been hit by speculation, there is a large hawala market that moves funds within India and also abroad, there is flight of capital and round-tripping of black funds and so on. The FII and PN are used to bring back black funds and since they are hot money they tend to destabilise the stock markets.The banks have a large portfolio of non-performing assets because of manipulation by big and small businesses in connivance with the political class and these are hitting at their profitability and efficiency. In the name of servicing the High Net Worth Individuals (HNI), the private banks are functioning as hawala operators.


The current problems of the economy are deeper than what the RBI can resolve. The Ministry of Finance is also not able to tackle these problems because of a flawed policy framework. What is being witnessed is a shadow-boxing between the two. The domination of the world of finance is at the root of the problems globally and in India. But this has given the Central banks (including the RBI) a certain influence over economic policies.

The limited autonomy that this gives the RBI could have been used to better regulate the financial markets and also throw more light on some of the critical issues, like the impact of the black economy on money supply, and what are the true rates of inflation and growth and so on. But, the RBI has failed in this and that dents its credibility. The confusion is that the RBI is a part of the establishment and yet it appears to be rocking the boat in small ways. But, as argued above, the differences are a mere shadow-boxing between the Ministry and RBI. The RBI would have been more credible if it had asserted its limited autonomy to help sort out the above mentioned issues. So, is the RBI putting the cart before the horse?

[This article is partly based on the one by the author, entitled‘Central Confusion’, The Indian Express, July 23, 2015.]

The author, a well-known economist, was the Sukhamoy Chakravarty Chair Professor, Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi. He has just retired from service. He is the author of Indian Economy since Independence: Persisting Colonial Disruption.

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