The road ahead for Rajan

Financial Express, 5th September 2013

Reserve Bank of India has a new governor, Raghuram Rajan. While Rajan's immediate job would be to determine the stance of monetary policy, and hand out banking licences, as RBI Governor for the next five years, his main task must be to transform RBI into a modern central bank.

The task of transforming RBI into a modern central bank consists of redefining the mandate of the central bank and its functions, clearly defining the objective of monetary policy and institutions related to conduct of monetary policy, and redesigning the role of RBI as a banking regulator.

These issues have been raised by a number of official committees, including the one headed by Rajan himself. Most recently, the Financial Sector Legislative Reforms Commission (FSLRC) made its recommendations. It has three major implications for RBI. First, the central bank should be a regulator only of banking and payments and the monetary authority. Second, the regulatory governance for regulation has to be significantly improved. Third, the objective of monetary policy should be clearly defined.

According to the FSLRC, RBI should have independence and accountability. It should set up a statutory monetary policy committee with powers to take decisions on monetary policy, unlike the present one that is advisory and where decisions are taken by the Governor, who is open to pressure from the ministry of finance. In addition, it recommended that RBI should give up some of its present functions such as those of the government's debt manager, the regulator of markets for securities such as government bonds, currencies and interest rate derivatives, of capital controls and of non-bank financial intermediaries.

Decisions about issues of regulatory architecture and governance would be made by the government. It involves decisions not just about RBI but other regulators as well. The most important task for Rajan will be to help define the objective and functioning of monetary policy.

The fall of the rupee has highlighted India's high inflation. In the last five years, under Governor D Subbarao the rupee was largely allowed to float. However, though policy shifted away from a pegged exchange rate to a floating exchange rate, monetary policy was left unanchored. There was no clear and well defined nominal anchor that could guide price expectations. Though the floating exchange rate gave RBI the opportunity to have an independent monetary policy, by failing to define the objective of monetary policy, and given RBI's multiple other objectives, the rupee was left unanchored. Worse, on a number of occasions, the central bank argued that inflation control was not the main objective of monetary policy.

RBI's commitment to inflation control has been episodic. Some governors like C Rangarajan believed that it was the main job of monetary policy, others like YV Reddy focussed on the exchange rate as the nominal anchor. Even though in the last 5 years there seemed to be some effort at price control, India has now witnessed years of consumer price inflation between 8-10%. In recent surveys, inflationary expectations of households have risen above 10%. The rising demand for gold is another indication of higher inflationary expectations.

The FSLRC has suggested that the RBI Act of 1934 be repealed and a new law more suitable for a modern central bank replace it. In most advanced economies, especially those with recent monetary policy laws, the objectives of monetary policy are contained in the law. The Commission has left it to the government to define what the objective should be. The law is proposed to only say that it will be a measurable nominal objective for which RBI will be held accountable. So, it could be an inflation rate, a price level, nominal GDP or even the level of the rupee.

In the consultations on the proposed Indian Financial Code, Rajan's role is to discuss whether FSLRC's proposal is a suitable proposition or whether the objective of the policy should be written down in the law. The present formulation in IFC is a non-standard one. The new Governor's job is to help the ministry of finance choose the best nominal anchor and, preferably, write it in the law.

His second task would be the constitution of the monetary policy committee (MPC), where again the IFC has a non-standard formulation. One plausible alternative composition, somewhat similar to the Bank of England, might be to have four members, from inside the central bank, including the governor, and three independent experts from outside who bring in diverse views. These members would then vote to choose whether the repo rate should be raised or lowered. Their individual voting stance would have to be justified and made public to prevent them from either being quiet yes-men or from being unnecessarily contrarian. Rajan will have to work hard on building a well functioning MPC.

Coming to the here-and-now, the stance of monetary policy is no doubt going to involve difficult decisions. The economy is faced with a stagflation. It would have been much simpler for him if it was either high growth and high inflation, or low growth and low inflation. Standard rules of monetary policy could have been easily used. To make matters worse for inflation the rupee is under acute pressure and monetary easing would increase the pressure.

The trade-offs are difficult. Ultimately, the only instrument in RBI's hands is the interest rate. While RBI may sometimes try changes to the CRR, sometimes foreign exchange intervention or sale and purchase of government bonds, or changes to some specific interest rates, ultimately it is bank interest rate that will be impacted and affect firms and households. As demonstrated in the last few weeks, trying to address these multiple objectives with a single instrument is impossible. Rajan will have to find the right balance between his emphasis on growth, inflation and the rupee, and choose whether to raise rates or lower them. There are no simple answers.

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