The Changing Government- RBI Relations

A Look into the Recent Conflicts and the Subsequent Bonhomie

The Changing Government- RBI Relations
The Changing Government- RBI Relations

Economy is dependent on several factors for its growth. Certain critical functions like issue of notes, money supply, money maintenance, economic policy, monetary policy, regulation and controlling of banks play vital role in overall development of the economy. Initially, elected ministries were expected to bring about frequent changes in these factors and the public finances including control of currency. At the same time, credit in the country was expected to be in turmoil if left in the hands of elected ministries, as it would change with the changing political situation. In this backdrop to bring about stability and to give the control of public finances to an independent authority that would strive towards overall economic stability, the concept of central bank arose.

EXCERPT

RBI is the central bank of India established in 1934. The major roles of RBI include management of monetary policy, inflation targeting and supervising all other banks. The scope of work of RBI is such that it has certain level of effect on the fiscal and other policies of the government. It is important that the central bank is autonomous in order to function smoothly without political interference as political policies may be short sighted and may cause issue in the long run. In India, the RBI functions under the RBI Act. Even though provisions are present in the act regarding directions that government can issue to RBI but they have not been used and conflicts have been resolved by the government and the RBI by mutual understanding.

In India, the proposal to set up a central bank was first made by the Royal Commission on Indian currency and Finance in the year 1926. The legislation for setting up the Reserve Bank of India was introduced in 1927. It was enacted in 1934 under the RBI Act. Prior to the establishment of the RBI, the Imperial Bank of India performed the function of a quasi-central bank. The RBI commenced its operations from 1935. During its establishment, RBI was introduced as a privately owned and managed bank. However, after independence in 1948, RBI was nationalised under the Reserve Bank (Transfer to Public Ownership) Act. The government took over the RBI from private shareholders and the appointment of the Governor of RBI and the deputy Governors came under the Government’s hands. This nationalisation was in tune with the idea that a body regulating and controlling the monetary structure of a country and which has its direct effect on the general public cannot be left in private hands as it is a matter of national concern. The relation between RBI and the government has witnessed numerous changes from the very beginning. One of the major debated factors in the relation between RBI and the government is about the autonomy of RBI.

Role of Central Bank in an Economy and the Need for its Autonomy

The central bank has a variety of functions that it executes. In terms of macroeconomic objectives, it is responsible for price stability and inflation control and in terms of micro economic objectives it is responsible for payment systems, supervisory role etc. The primary functions of the RBI include management of the monetary policies by formulation of the monetary policy, management of public debt of the government and serving as a lender of the last resort for all other banks. Inflation rate control and maintaining the exchange rates occupy a significant position in the functioning of the RBI as they are major factors in deciding the monetary policy. RBI also performs the function of regulating and supervising all the other banks. RBI is the banker of the government that formulates policies for debt management as an agent of the government. The RBI also acts as the financer for development activities and other associated functions. RBI is responsible for the creation of money and for maintaining the price of money which in turn affects the domestic as well as external value of money. In the financial sector, the central bank also is responsible for directly or indirectly financing the government expenditure from its credits. RBI strives to maintain a sound and stable financial system with a stable price in the market including stability in the payment systems which are essential for achieving sustainable economic growth.

Role of RBI in the Indian economy Info 1
Role of RBI in the Indian economy

The primary reason for establishment of an independent authority to deal with the monetary policy was to avoid any form of instability that may arise due to the elected ministry members as their actions were expected to be guided by selfish needs to retain power. Government policies may be myopic to a certain extent and may fail to better utilise the new market condition and this is where the role of an autonomous central bank becomes important in avoiding the undue influence of political scenario on the financial sector. Further, it was thought necessary that the creator and spender of money should be different entities in order to avoid any form of conflict of interests. Autonomy of the central bank is needed for maintaining price and overall financial stability. Operational freedom is must for the central bank in order to achieve its targets. Inflation leads to redistribution of wealth from poor to the rich section like the land-owning wealthy people, real estate or stockholders etc. Government may be tempted to utilise the inflation tax for solving the short-term issues like lags in tax collection, but this measure hampers the sustainable real economic growth as it overlooks the underlying structural challenges. Autonomy is essential in another sector also concerning the credit to the government. Without autonomy, the government may use the central bank to make up for the short-term credit deficits of the government by use of central bank reserves. This step will have disastrous long-term effects on the overall economy.

Conflict Between RBI and the Government, Recent Issues and the Bonhomie Between the Two

After its nationalisation in 1948, the RBI had a cordial relationship with the government. Discord between government and RBI started to erupt during the second 5-year plan and it was marked by the resignation of the then Governor Rama Rau in 1957. Subsequently in late 1950s financing of cooperatives and the pattern of organisation of the lending agencies cropped up as another area of conflict between RBI and the government. Further during 1960s interest rate policy, deficit financing, cooperative credit policies and management of substandard banks became the issue of conflict between the two. Another crucial area of conflict was the creation of ad hoc Treasury bills during mid-1950s. Ad hoc Treasury bills were to be in favour of the RBI that would replenish government’s cash balances The ad hoc Treasury bills were to be temporary in nature but later they became an attractive source of financing for the government expenditures and hence became an issue in the autonomous functioning of RBI. In 1969, the nationalisation of major banks also served as a conflict area between RBI and the government. The effect of government ownership of banks and the high fiscal deficits posed serious problem to the monetary policies and RBI took necessary steps to stabilise the economic condition by neutralising the price level and effect of monetisation. During 1990-91, India experienced a severe balance of payments crisis. The post reform period gave a new shape to the relation between the RBI and the government with developmental steps like elimination of ad hoc treasury bills that used to automatically monetise the government deficits. The opening up of the economy and improvement in the domestic financial market brought about a degree of moderation in the relation between RBI and the government. During the early 2000s the Fiscal Responsibility and Budget Management Act and review of the RBI Act as well as the Banking regulation Act have had significant developmental effect on the monetary policy of India.

In the recent times, conflicts between RBI and the government have been raging on several sectors. Disagreements between the two on matters like the demonetisation (RBI governor wanted to reform taxation to curb future generation of black money whereas the government went ahead with demonetisation to curb the existing black money), action of RBI against the NPAs (RBI had directed banks to publicise the bad loans and curb the NPA issue but it was not done effectively), high interest rates so as to maintain the deposit base of banks etc were the areas of conflict during the tenure of RBI governor Rajan. After Raghuram refused a second term as a governor, Urjit Patel assumed charge as the governor of RBI. During his tenure in 2018, several issues cropped up between the RBI and the government. RBI had been increasing the interest rates for inflation targeting despite the government’s wishes to curb the rates to increase the liquidity in the market. Further RBI’s corrective action against the NPAs and for stressed banks were seen as a measure too harsh by the government. RBI also refused to provide relief by improving liquidity in favour of the Non-banking finance companies that were witnessing a cash crunch after the failure of IL&FS to repay loans. Another issue was that the government had wanted that RBI provide more credit to Micro, Small and Medium enterprises that were worst hit due to the policies of demonetisation and GST. The RBI was hit by the government for failing to stop the Nirav Modi scam. Lastly, the sharing of surplus of RBI between RBI and the government became a cause of concern as the government wanted to use the surplus to make up for the fiscal deficits and the RBI was reluctant due to future issues that may arise from such action. The issues gained prominence after it was thought that section 7 of the RBI act would be invoked by the government to issue directions to the RBI. Due to these differences on the issues of RBI’s capital framework and governance, RBI governor Urjit Patel resigned and Shaktikanta Das took charge as the 25th governor of RBI at a time when the relation between RBI and the government has been going through a sour phase.

After the appointment of Shaktikanta Das as the governor, the turbulent relation between the RBI and the government has calmed down. The approach of the new governor has been different from his predecessor. During Mr. Das’s tenure, a committee was appointed to look into the issue of economic capital. Besides this, Mr. Das went ahead with extensive consultation exercise involving all the necessary stakeholders like the banks, non-banks and industry houses and took into account divergent viewpoints before policy formulation. The RBI also reduced the interest rates by a total of 135 basis points. Even though RBI had to do away with rate cuts due to the increasing retail inflation, it stated that further rate cuts were not off the table. RBI has adopted certain adjustments and has provided support for securitisation of the NBFCs. Due to the RBI’s steps like lowering of interest rates, surplus banking liquidity, and higher surplus transfers to the government, the raging conflict between the RBI and the government has been calmed down considerably.

Global Examples

Globally, a trend has been seen where the governments have been taking steps in order to exercise more control over the central banks. An increase in the government interference in the policies of the central banks has become a common phenomenon. In case of USA, the increase in rates several times between 2015 and 2018 was heavily criticised by the government. The government has been openly criticising the actions of the central bank and at the same time the central bank has been reluctant to bend to the political pressure. But in the case of USA, the Federal Reserve enjoys a significant level of independence as each of the member of the reserve are appointed by the President for a fixed period of 14 years and one of them is appointed as the chairman for a fixed period of 4 years thereby ensuring that they are free to a certain extent from political meddling. The European central bank members are appointed for a fixed period of 8 years by its governing council in consultation with the Parliament. The policy of the central bank cannot be tinkered by the bureaucrats or the politicians.

 In New Zealand, the central bank has a dual mandate of employment as well as price stability. This allows the finance ministry to exercise greater control over the bank thereby undermining its independence. Brazil has granted a greater extent of autonomy to its central bank. The central bank of Brazil enjoyed autonomy to decide on interest rates and recently there has been a move by the government to grant formal autonomy to the institution in order to provide it with necessary freedom in executing its goals.

Conclusion

The concept of central bank arose out of the need to separate the creator and spender of money and in order to establish an independent authority to deal with the monetary policy exclusively. The central bank serves as a lender of last resort for all other banks and it functions as the government’s banker. In India, RBI was established in 1934 under the RBI act. However, since its establishment, RBI and the government have been at loggerheads at numerous instances where they differed in their approach and opinion. The government has been reluctant to grant greater extent of autonomy to the RBI in the view that RBI deals with the monetary policy which has national significance and hence needs to be closely monitored and controlled for the betterment of the overall economy. Numbers of issues like the sharing of surplus, decreasing the interest rates, lending support to the non-banking bodies etc have cropped up in the recent times that led to conflict. However, after the appointment of Shaktikanta Das as the governor of RBI, the relation between RBI and the government has witnessed a relative calmness. RBI needs to be given autonomy so that it can function without political meddling however a certain limit must be set, and accountability measures need to be set up for smooth functioning of RBI. In order to ensure the sustainable growth of economy it is essential that the government and RBI work in tune respecting the rights and authority of each other and none should try to transgress upon the working space unnecessarily.

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