Can RBI, finmin turn a new leaf?


The stock market has given a warm welcome to P. Chidambaram’s return to the finance ministry. In his first address to the media, Chidambaram announced a review of the retrospective amendment to the Income Tax Act to bring back investor confidence. He also said adjustments would be made both on revenue as well as expenditure fronts to rein in the fiscal deficit and hinted at some monetary easing by India’s central bank. Incidentally, Reserve Bank of India (RBI) governor D. Subbarao met Chidambaram on that day. We don’t know what transpired at the meeting but everybody wants to keep a close tab on such meetings as the relationship between the finance ministry and RBI is rather complex.
RBI is answerable to Parliament and, hence, no governor can afford not to consult the finance minister on critical policy decisions. Besides, the government also employs another way of controlling the central bank—the Trojan horse strategy. It’s no coincidence that a majority of RBI governors have been former finance secretaries, including Subbarao. The five-year term of Subbarao’s predecessor Y.V. Reddy that ended in September 2008 is particularly well known for what Reddy himself dubbed as “creative tension”. Reddy’s book, India and the Global Financial Crisis: Managing Money and Finance, a compilation of 23 speeches delivered at various forums in India and abroad offers glimpses of the serious differences between the finance ministry and the central bank on many critical issues.
The introduction has a reference to RBI’s reservations about the creation of sovereign wealth funds and use of foreign exchange reserves for infrastructure development. It was possibly the toughest fight RBI waged against the ministry, opposing the use of foreign reserves for any other purpose than what the existing law permits.
Chidambaram’s reaction to Reddy’s seemingly academic discussion on foreign money flow is also fresh in many people’s memories. While releasing the India Development Report 2004-05 of the Indira Gandhi Institute of Development Research in January 2005, Reddy said a view needed to be taken on capping foreign institutional investors’ (FII) inflows into the markets, suggested monitoring the “quality and quantity” of FII flows, and asked authorities to examine the efficacy of “price-based measures such as taxes (on FII flows)”. The minister quickly appeared on TV channels to clarify that there was no proposal to cap portfolio inflows or tax them.
Subbarao has been fighting with the finance ministry openly for preserving RBI’s autonomy. In 2010, when the government decided to end the turf war between market regulator Securities and Exchange Board of India and the Insurance Regulatory and Development Authority on unit-linked insurance plans through an ordinance and proposed setting up a joint panel to resolve disputes among financial sector regulators, Subbarao wrote to the then finance minister Pranab Mukherjee, saying that “the appearance of autonomy is as important as the actual autonomy itself” and “the very existence of a joint committee will sow seeds of doubt in public mind about the independence of regulators”.
In the past, justifying a half a percentage point interest rate hike, Subbarao had said it was done to “maintain the credibility of the commitment of monetary policy to controlling inflation” and the objective was to “reinforce the point that in the absence of complementary policy responses on both demand and supply sides, stronger monetary policy actions are required”. More recently, in July, he left the policy rate unchanged and squarely blamed the government for its inaction on fiscal corrections. Things get complicated when the finance ministry openly talks about market-sensitive issues such as interest rates and liquidity. Reddy’s tenure was fraught with such instances with then finance minister Chidambaram and Prime Minister Manmohan Singh talking about interest rates more often than RBI. Of course, both Chidambaram and Singh always qualified their statements by saying RBI is the best judge about taking the final decision on interest rates.
Typically, RBI and the finance ministry have divergent views on interest rates, with the central bank focusing on price stability and the finance ministry on growth. The sustained battle of wits between former finance secretary Vijay Kelkar and former RBI governor Bimal Jalan on which way the interest rates should move in 1998 could be still fresh in public memory. On his part, Jalan had perfected the art of hearing but not listening. Under former RBI governor C. Rangarajan, the central bank gained substantial freedom to conduct monetary policy primarily by getting the government to agree to pay market rates of interest for its borrowings and also by reducing its right to monetize deficits at will. The discontinuation of the automatic monetization of central government deficits was a big step towards fiscal correction as well as giving RBI functional autonomy in the conduct of monetary policy. Jalan got the finance ministry to see the lack of alignment in the overall interest rate architecture and managed to convince the government to cut administered interest rates in politically-sensitive areas such as small savings and public provident fund. Subbarao couldn’t prevent the ministry from creating the Finance Stability and Development Council, but has been vocal about the government’s failure in managing the fisc. He is also not happy with the way the banking division of the ministry has been directing public sector banks on operational issues. Indeed, the ministry has the right to do so as the government is the majority owner of the banks; but doing such things through its representatives on the board would be a better way than directives from the ministry. Similarly, RBI needs to put its house in order. It’s difficult to fathom why RBI takes years to formulate norms for new bank ownership or foreign bank subsidiaries. A progressive ministry and a proactive RBI are the best solutions. One hopes Chidambaram and Subbarao turn over a new leaf.

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