How to solve the RBI problem

Indian Express, 21 August 2006

RBI's decision not to accept Naina Lal Kidwai as HSBC CEO because she was on the board of Nestle has once again brought attention to how RBI is out of touch with a modernising India. The conflict of interest arising from a bank CEO on a company board is certainly less than the conflicts of interest that are embedded in the very structure of RBI.

The RBI has multiple responsibilities, defined by the RBI Act of 1935. It is debt manager for the GOI, it is the banking regulator, it runs a bond exchange and it does monetary policy. Deeply mired in the mindset of the control raj, RBI is increasinly revealing its unsuitablity in developing and regulating modern market structures.

Worldwide, it has been observed that when a central bank is asked to perform multiple tasks, this comes at the price of performance on the core task: monetary policy. For example, in an economy that is facing inflationary pressure, when there is a need for raising interest rates, if the central bank is the public debt manager it has to worry about interest rates from the point of view of the borrower, i.e, the government. Raising rates would hurt the government, whose interest burden would increase.

If it is also responsible for banking regulation and the health of the banking sector, then higher interest rates would mean bond prices go down. This adversely impacts the balance sheets of banks. This concern would steer the central bank towards not raising rates.

If the booming economy encourages foreign capital to come into the country and this puts pressure on the currency to appreciate, a central bank that feels that exchange rate management is important will find it difficult to raise rates if it wishes to prevent further appreciation.

Conflicts of interest are half of the problem with RBI. An equally important problem is that RBI remains steeped in the mindset of the control and license raj. While, in the last 15 years, India has worked hard on reducing quantitative controls and bringing in systems of incentives to make markets work better, RBI continues to live in the physical controls paradigm. As an example of license-permit raj, domestic banks have to get permission from the RBI to open new branches. All foreign banks put together can only open a total of 20 new branches a year and for each branch they need the RBI's permission. The interest rate on savings deposits continues to be prescribed by the RBI. NRI deposit rates are fixed by the RBI. There are caps in terms of how much foreign exchange can move in or out of the country under various heads.

And when it comes to development of debt and currency markets, the RBI has lagged far behind India's equity market which, thankfully, was not in its domain. Modern finance works through better markets and not through imposing quantitative controls. The RBI approach consists of stifling the interest rate and currency market, to make it appear that prices do not move. This is a dangerous strategy, for the markets for interest rates and currency play vital functions in the market economy: they are messengers who carry news, and they are the economy's shock absorbers.

While the RBI might like to believe that India is helped by price controls, by disabling the shock absorbers, and by shooting the messenger, this increases the probability of a systemic crisis. The real task of monetary policy is to reduce the volatility of GDP growth. An RBI which uses controls to push down the volatility of the exchange rate and interest rates is perpetuating and accentuating the boom-and-bust pattern of Indian GDP growth.

One reason why RBI clings on to the control mentality is its size. The annual report of the RBI (2004-05) shows that the RBI has 22,727 employees.

How does size matter? Consider this. The largest department with 6,299 employees is the Department of Currency Management. In addition, 1,018 employees work in the Foreign Exchange Department. The staff union of the RBI was the only staff union in the country that opposed capital account convertibility. The move towards greater openness, easing of controls and working of markets would take away the private benefits of RBI employees.

How might RBI reform come about? As with India's experiences on steel or cement, when there are powerful vested interests at stake, reforms can only come from the outside. The old Ministry of Steel obviously never believed that steel prices needed to be determined by the market: this push had to come from outside it. It is perfectly normal for RBI to not believe in reform and subvert reform in all ways. A recent RBI report discussed the issue of multiple conflicting objectives and concluded that all is well with the status quo. It is unrealistic to expect it to say that it's Internal Debt Management team should be moved out of the RBI into an independent public debt office.

As with India's experience with capital markets, reforms will not come by imploring RBI to think in new ways or care about India's interests. What is required is more radical surgery: moves such as the closure of the CCI, the creation of SEBI, and the enactment of new legislation. The starting point of the discussion needs to be a repeal of the RBI Act of 1935.

The state of the art in monetary economics has very clear implications for institutional architecture. The best practice consists of a narrow central bank, which sets the short-term interest rate, and does nothing else. This task should be done by a new Indian Monetary Authority (IMA) with full transparency, full accountability in terms of a publicly stated inflation target, and full independence from the Ministry of Finance.

All the other finance and fiscal functions need to placed elsewhere - the task of selling bonds needs to be placed under the Ministry of Finance, the securities markets activities need to be divested or transferred to SEBI, and banking regulation needs to go into a new Banking Regulatory and Development Authority (BRDA). These steps would put Indian monetary policy on a sound foundation.

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