A top Reserve Bank of India (RBI) official on Friday warned that “governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution”.
RBI Deputy Governor Viral Acharya said the market can discipline the government not to erode central bank independence, and it can also make the government pay for its transgressions. “Interestingly, the market also forces central banks to remain accountable and independent when it is under government pressure,” he said.
Delivering the A D Shroff Memorial Lecture in Mumbai Friday, Acharya listed three “important pockets of persistent weakness” in maintaining the independence of the RBI. One, its inability to undertake the full scope of actions against public sector banks vis-à-vis private banks; two, the discretion to retain reserves without having to transfer surpluses to the government; and, three, protecting its regulatory scope, a case in point being a recommendation to have a separate payment regulator bypassing RBI’s powers.
“I chose for today’s occasion the theme of the importance of independent regulatory institutions, and in particular, that of a central bank that is independent from an over-arching reach of the state,” Acharya said. “This theme is certainly one of great sensitivity but I contend it is of even greater importance to our economic prospects.”
In a footnote, he acknowledged that it was Governor Urjit Patel’s “suggestion” that he “explore this theme.”
According to Acharya, good progress in earning RBI’s independence has been made in the monetary policy framework, which has been recognized by Moody’s while upgrading India’s sovereign rating last November. “To secure greater financial and macroeconomic stability, these efforts need to be extended to effective independence for the Reserve Bank in its regulatory and supervisory powers over public sector banks, its balance sheets strength and its regulatory scope,” he said.
Besides the three issues which Acharya flagged, the RBI is also under pressure from some quarters in the government to relax the prompt recovery action (PCA) framework on 11 public sector banks with restrictions on lending and expansion.
Previous RBI Governors, including YV Reddy, D Subbarao and Raghuram Rajan had conflicts with the finance ministry and the government on various issues relating to the RBI’s independence during their tenures.
In a strong reminder to the government, Acharya said the world over, the central bank is set up as an institution separate from the government. “Put another way, it is not a department of the executive function of the government; its powers are enshrined as being separate through relevant legislation,” Acharya said.
As many parts of the world today await greater government respect for central bank independence, independent central bankers will remain undeterred, he said. “Their wiser counterparts who invest in central bank independence will enjoy lower costs of borrowing, the love of international investors, and longer life spans,” Acharya said.
Alluding to pressure points in government-RBI relations, he cautioned about excess money supply, which while facilitating ease of financial transactions, including the financing of government deficits, can cause the economy to over-heat in due course and trigger (hyper-) inflationary pressures or even a full-blown crisis that eventually require sharper monetary contractions.
He warned that excessive lowering of interest rates and/or relaxation in bank capital and liquidity requirements can lead to greater credit creation, asset-price inflation, and semblance of strong economic growth in the short term. But excessive credit growth is usually accompanied by lending down the quality curve which triggers mal-investment, asset-price crashes, and financial crises in the long term, he said.
Acharya said allowing foreign capital flows to flood into the economy can temporarily ease the financing pressures for an expanding government balance-sheet and the crowded-out private sector, but a “sudden stop” or exodus of these flows in future can trigger a collapse of the exchange rate with adverse economy-wide spillovers.
He said sweeping bank-loan losses under the rug by compromising supervisory and regulatory standards can create a facade of financial stability in the short run, but inevitably cause the “fragile deck of cards to fall in a heap” at some point in future, likely with a greater taxpayer bill and loss of potential output.
Acharya said a government’s horizon of decision-making is rendered short, like the duration of a T20 cricket match, by several considerations. “There are always upcoming elections of some sort – national, state, mid-term, etc. As elections approach, delivering on proclaimed manifestos of the past acquires urgency; where manifestos cannot be delivered upon, populist alternatives need to be arranged with immediacy,” he said. Less important in the present scenario, but only recently so, wars had to be waged, financed and won at all costs. This myopia or short-termism of governments is best summarized in history by Louis XV when he proclaimed “Apres moi, le deluge!” (After me, the flood!).
In contrast, Acharya said, a central bank plays a Test match, trying to win each session but importantly also survive it so as to have a chance to win the next session, and so on. “In particular, the central bank is not directly subject to political time pressures and the induced neglect of the future; by virtue of being nominated rather than elected, central bankers have horizons of decision-making that tend to be longer than that of governments, spanning election cycles or war periods.