Urjit Patel has taken over as governor at a time when the RBI has, for the first time, been given a clear legal mandate to target inflation. Governor Patel, lead author of the flexible inflation targeting framework, is undoubtedly the most suitable person to give credibility to the new mandate. His biggest challenge now lies in leading the reforms through which the RBI can actually influence inflation.
Raghuram Rajan’s key contribution was his firm commitment to inflation targeting as the objective of monetary policy. His term ended with the RBI being given the legal mandate for inflation targeting. Patel faces a much tougher task.
Why is Patel’s job much harder? Until now the RBI could talk about price stability and it could respond to the inflation rate by changing the policy rate, but it was not held responsible for the outcome. A rise in CPI inflation could be explained by blaming fiscal expansion, demand for protein, bad measures of inflation, inadequate transmission of monetary policy and so on. What has changed now is that the RBI can no longer merely “explain” high inflation. If CPI inflation is higher than the target, it has to not only provide reasons for its failure to meet the target, but also propose remedial actions.
While today it is a challenge for the RBI to even influence bank lending rates, let alone the CPI, the inflation targeting mandate requires the RBI to ensure that it is able to do so. The amendment to the RBI Act in the Finance Bill 2016 that redefined the objective of monetary policy might have shifted the decision of setting the policy rate from being the sole responsibility of the governor to a committee process, but the Monetary Policy Committee only has the mandate of setting the policy rate. The responsibility of ensuring that changes in the policy rate get transmitted to the financial sector remains with the governor. It is he who will lead the RBI in managing liquidity, undertaking repo transactions, buying and selling government bonds and foreign exchange and ensuring competition in the banking sector so that the MPC’s decisions get transmitted to markets.
Improving the transmission of monetary policy is no simple task. There are no easy recipes. For example, one necessary but not sufficient condition for obtaining financial markets that transmit changes made to the policy rate throughout the financial system is a deep and liquid bond market. The bond market in India is seriously limited by the lack of an independent public debt management office and restricted access to bond markets. This is an agenda that needs both legislative change and institution building. It needs cooperation between the RBI and government to make it work. Creating an independent public debt manager and the accompanying bond markets in which the debt office would sell government debt will be a crucial element in improving transmission of monetary policy.
In the next few weeks, a key element of Governor Patel’s strategy will have to be communication. Communication to show his commitment to the inflation targeting framework will give it credibility. Rajan’s legacy of regularly repeating the RBI’s commitment to inflation targeting was in sharp contrast to the flip-flops in the speeches of some of his predecessors. Patel has to continue Rajan’s legacy. While markets do assume that he supports the inflation targeting framework, speeches and statements emphasising his commitment to the framework will strengthen and consolidate it. This is particularly important in the present context when questions have been raised about elements of the framework.
Next, Governor Patel has to lay down, whether publicly or internally, a path of the financial market reforms he will undertake to improve the transmission of monetary policy. Some ground work has been done and recommendations are available in the form of the Percy Mistry, Rajan and FSLRC report. However, actual legislative and institutional reform is tricky and involves adept political manoeuvring. It involves negotiating both with the government and with RBI staff. Patel’s experience as deputy governor should come in useful in playing this complex role. The task of negotiating the path of reform will be an enormous challenge.
Wearing his academic hat, Patel is known to emphasise fiscal discipline. A profligate government can make the RBI’s job of inflation targeting much harder. While the bulk of the responsibility of fiscal discipline lies with the government, in India the RBI plays an important role. A necessary though not sufficient condition for the government to control its borrowing is the pain it should feel when the cost of borrowing goes up. This involves the goverment having to face markets that push up interest rates and punish governments for indiscipline. In India, the RBI, through the Statutory Liquidity Ratio (SLR), mandates that banks hold more than a fifth of their assets as government bonds. This provides the government with a captive market. Rajan laid down a path for reduction in the SLR. With Patel’s emphasis on fiscal discipline, he could exercise the option of accelerating this path. This would be the RBI’s contribution to pushing the government to show greater discipline.
Governor Patel’s second biggest challenge will be how to solve the stress in Indian banking. An alphabet soup of restructuring schemes like the CDR, SDR, S4A has not succeeded. The Bankruptcy Code will not yield results in the next couple of years. It is said that almost any negotiated settlement by banks runs into fear of the 3 Cs — the CAG, CVC and CBI. As a consequence, public sector bank officials are reluctant to sign off on haircuts.
There is no easy way out. Patel, no doubt, understands the enormity of the challenges he faces. As an insider, he would know not just the problems, but also the difficulties that any simple solution poses. This, in itself, is an advantage.