How independent is RBI ?

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RBI.jpg
RBI.jpg

The one regulator in India that dominated the news in 2016 was the Reserve Bank of India (RBI). First there was controversy about whether or not Raghuram Rajan would receive an extension for his tenure, which ended with Rajan announcing that he would not be seeking another term. Then Rajan’s predecessor D. Subbarao came out with a book where he has listed details of his disagreements with the government over various issues, and how he had to pay a price for it. The biggest of them all, however, was reserved for the end. With Narendra Modi government’s note-ban decision, questions about RBI’s independence and credibility seem to have become the running refrain.

In addition to the public debate on the issue, even RBI’s employee union wrote a letter to the governor expressing its concern over infringement on the central bank’s autonomy.

Are such obituaries to the RBI’s autonomy justified? How autonomous is India’s central bank in comparison to its international peers?

A 2014 paper by N. Nergiz Dincer and Barry Eichengreen from TED University, Ankara, and University of California Berkeley, which was published in the International Journal of Central Banking, might surprise many in India. Dincer and Eichengreen find the RBI to be the least independent among 89 central banks they have looked at in their study.

Roughly speaking, the paper takes into account four factors to decide on how independent a central bank is: government intervention in appointing the central bank’s head, government intervention in making policy decisions, price stability being the sole or primary goal of monetary policy, and limits on ability of the government to borrow from the central bank. The authors have given four highly correlated rankings of central bank independence in their paper.

The one regulator in India that dominated the news in 2016 was the Reserve Bank of India (RBI). First there was controversy about whether or not Raghuram Rajan would receive an extension for his tenure, which ended with Rajan announcing that he would not be seeking another term. Then Rajan’s predecessor D. Subbarao came out with a book where he has listed details of his disagreements with the government over various issues, and how he had to pay a price for it. The biggest of them all, however, was reserved for the end. With Narendra Modi government’s note-ban decision, questions about RBI’s independence and credibility seem to have become the running refrain.

In addition to the public debate on the issue, even RBI’s employee union wrote a letter to the governor expressing its concern over infringement on the central bank’s autonomy.

Are such obituaries to the RBI’s autonomy justified? How autonomous is India’s central bank in comparison to its international peers?

A 2014 paper by N. Nergiz Dincer and Barry Eichengreen from TED University, Ankara, and University of California Berkeley, which was published in the International Journal of Central Banking, might surprise many in India. Dincer and Eichengreen find the RBI to be the least independent among 89 central banks they have looked at in their study.

Roughly speaking, the paper takes into account four factors to decide on how independent a central bank is: government intervention in appointing the central bank’s head, government intervention in making policy decisions, price stability being the sole or primary goal of monetary policy, and limits on ability of the government to borrow from the central bank. The authors have given four highly correlated rankings of central bank independence in their paper.

So, on the face of it, India never had a very independent central bank. However, such studies need to be looked at with a certain degree of caution. According to the paper, Kyrgyz Republic and Latvia had the two most independent central banks in 2010. While India has the lowest rank, even countries like the US and Japan are placed towards the bottom. It is extremely unlikely that this would make the Kyrgyz central bank more credible than US Federal Reserve or even the RBI. To be sure, there would also have been some improvement in the RBI’s independence ranking after adoption of the inflation targeting framework in March 2015, and the creation of the monetary policy committee since October 2016.

Also, evolving economic wisdom in the post-crisis world also cautions us against placing too much faith in mechanical measures of what should be the ideal central banking framework. For example, in an op-ed published at Brookings website, economists Eswar Prasad, Raghuram Rajan and Barry Eichengreen (who has come up with these rankings) argued that it was desirable for a central bank to sometimes sacrifice inflation targeting in the interest of restoring overall financial stability. It is likely that such policies could lower a central bank’s independence score in the rankings discussed above.

Interestingly, the ongoing debate about the RBI’s conduct during the entire note-ban exercise is something which is not entirely unexpected in an emerging economy. An earlier Plain Facts column had shown that friction between central bank and the legislature was more common in emerging economies than industrial economies.

So is the current debate about RBI’s autonomy an irrelevant one? To say so would be a complete travesty. There exists some evidence to show that RBI’s current state might be preventing it from discharging its functions in a proper manner. The Modi government has been lackadaisical in appointing non-official directors to the RBI board, which has led to many vacancies in the RBI’s board.

Given such vacancies, it is unlikely that the RBI’s deliberations on demonetisation would have received a rigorous examination before they were sent to the government, as was pointed out in an opinion piece published in the Mint.

In fact, there have been attempts to curtail RBI’s autonomy since the days of the UPA government, when a committee to examine financial sector reforms, the Financial Sector Legislative Reforms Commission (FSLRC) laid out several suggestions to clip RBI’s wings. As was pointed out in this blog post by the economist Amol Agrawal, the draft FSLRC report suggested reducing the strength of RBI’s board from 21 to 12, and doing away with any role for local board members who bring important wisdom from RBI’s regional offices with them. It also recommended that a majority of monetary policy committee members be appointed by the government, a proposal that was roundly criticized when the FSLRC published its report.

Unfortunately these points have not received the same attention as the more newsy talk about RBI’s role in the note-ban episode. Those who are interested in safeguarding the autonomy of India’s central bank would do well to dwell on such issues in greater detail.

So, on the face of it, India never had a very independent central bank. However, such studies need to be looked at with a certain degree of caution. According to the paper, Kyrgyz Republic and Latvia had the two most independent central banks in 2010. While India has the lowest rank, even countries like the US and Japan are placed towards the bottom. It is extremely unlikely that this would make the Kyrgyz central bank more credible than US Federal Reserve or even the RBI. To be sure, there would also have been some improvement in the RBI’s independence ranking after adoption of the inflation targeting framework in March 2015, and the creation of the monetary policy committee since October 2016.

Also, evolving economic wisdom in the post-crisis world also cautions us against placing too much faith in mechanical measures of what should be the ideal central banking framework. For example, in an op-ed published at Brookings website, economists Eswar Prasad, Raghuram Rajan and Barry Eichengreen (who has come up with these rankings) argued that it was desirable for a central bank to sometimes sacrifice inflation targeting in the interest of restoring overall financial stability. It is likely that such policies could lower a central bank’s independence score in the rankings discussed above.

Interestingly, the ongoing debate about the RBI’s conduct during the entire note-ban exercise is something which is not entirely unexpected in an emerging economy. An earlier Plain Facts column had shown that friction between central bank and the legislature was more common in emerging economies than industrial economies.