RBI is fighting inflation with its hands tied
Its difficulty in balancing its role in both inflation management and debt management is rooted in India’s monetary history
The emergency rate hike announced by the Reserve Bank of India (RBI) earlier this month was an implicit admission that it may have ignored inflation risks for far too long. As an earlier Simply Economics column (Inflation surge: Who gains, who loses, March 21) had warned, RBI risked losing its credibility as an inflation-fighting central bank if it did not act fast to anchor inflationary expectations.
It blew its chance to decisively shift gears in the April bi-monthly policy review meeting, maintaining that rate hikes would be gradual. Once it sensed that the inflationary surge was unlikely to be gradual, it called an emergency meet to push up interest rates, and suck out liquidity from the financial system.
RBI’s battle to win back credibility is not over yet. Its ability to take the right call on inflation will be hamstrung by the same factor that has constrained its ability to act earlier: The extraordinary burden of public debt it has to service. Raising interest rates makes borrowing dearer for the country’s biggest debtor, the government. Tolerating inflation helps the government by lowering the real value of its interest outgo (interest payments adjusted for inflation).
As the government’s debt manager, RBI has a strong incentive to tolerate inflation as long as possible, and keep yields on long-dated government securities as low as possible. RBI’s “operation twist”, involving the purchase of long-term debt and the sale of short-term securities was also motivated by the same impulse.
In prioritising its debt management role, the central bank ends up compromising its inflation fighting role. The conflict between the debt management and the inflation management role is not unique to India. Some countries have managed this conflict by carving out separate public debt management offices. Such proposals have been made in India too, but haven’t been carried through.
To understand why, we need to look at India’s monetary history. In the first few decades after Independence, RBI was largely a quasi-fiscal agency, helping meet development and financing targets set by the erstwhile Planning Commission and the Union finance ministry. Liberalisation brought an end to this era. Policymakers realised that an autonomous central bank that commanded the respect of market participants would help draw foreign investments.
The fact that a former RBI governor, Manmohan Singh, was in charge of the finance ministry at that point, and shared good relations with a reformist RBI governor, C Rangarajan, helped reset the RBI-finance ministry relationship. They established healthy precedents that their successors honoured.
Things began to change in the mid2000s during the euphoria of the boom years. The finance ministry wanted double-digit growth, and aimed to unleash big bang financial liberalisation measures. RBI disagreed, arguing for non-financial reforms first. So it came to be seen as a roadblock to the finance ministry’s grand plans. The Planning Commission shared the finance ministry’s views. So did the International Monetary Fund (IMF), which frowned upon RBI’s capital control measures. RBI saw the finance ministry’s proposals -- backed by “sound advice” from the IMF -- as a big risk to India’s financial stability.
The government set up several committees to frame its reform plan and to mobilise public opinion. The finance ministry set up the Percy Mistry committee in 2005, ostensibly to make Mumbai an international financial centre, but with the ultimate goal of removing what it perceived to be Mumbai’s excessive regulatory cholesterol. The Planning Commission followed suit in 2007 by setting up the Raghuram Rajan committee on financial sector reforms.
The reports of both these committees were washed out by the great financial tsunami of 2008. India’s (read RBI’s) position on capital flows and high risk financial “innovations” found more takers in the post-Lehman world. IMF admitted it may have been wrong about capital controls, and its position on this issue today is remarkably close to RBI’s.
Nonetheless, the finance ministry set up another committee in 2011 to pursue its unmet agenda. Like the two previous committees, the Financial Sector Legislative Reforms Commission (FSLRC) led by BN Srikrishna did not include any RBI official. As in the previous two cases, RBI’s exclusion from the committee rankled the central bank. RBI let it be known to financial journalists in Mumbai that its autonomy and turf were under attack for resisting Delhi’s diktats. The finance ministry let it be known to journalists in Delhi that RBI was being intransigent on financial sector reforms.
North Block and Mint Street recruited sympathetic economists to fight on their behalf, and the proxy war played out on the op-ed pages of financial dailies. RBI’s victim card eventually triumphed, and the FSLRC recommendations were dumped. This meant that even sensible recommendations such as the one on carving out the public debt office were buried. In a period of conflict, carving out the debt management office may have been perceived as cutting RBI down to size.
Given that RBI-finance ministry relations have improved considerably over the past few years, the time is perhaps ripe to revisit this proposal. RBI should view this step as a way to free itself from a heavy burden. Without having to worry about managing the government’s borrowing costs, RBI can focus better on its primary mandate of maintaining price and financial stability.