RBI’s role needs to change: Draft Indian Financial Code prises open the black box of monetary policy making

August 10, 2015

Financial sector regulation in India has developed in an ad hoc manner in response to evolving requirements. Consequently, it suffers from substantial prudential weaknesses and regulatory arbitrage that makes for heightened risks for both investors and financial consumers. By putting together a modern law for governing the complex financial sector, the draft Indian Financial Code (IFC) represents a quantum jump forward.

When enacted, IFC will replace 19 extant laws, some of which, like the RBI Act and Insurance Act, date back to 1934 and 1938 respectively. IFC should therefore be made effective sooner rather than later. It should certainly not be allowed to flounder on the specious grounds of its impact on RBI autonomy.

It is, therefore, indeed a pity that public discussion on IFC has focussed entirely on the relationship between government and RBI. Even more mischievous is the attempt by some influential western newspapers like the Financial Times of London, to portray IFC as the Modi government’s attempt to curb the powers of the incumbent RBI Governor.

In all likelihood, Raghuram Rajan will not be in this position when IFC becomes effective about three years from now. The debate would be far more productive if it focussed on whether or not IFC would bring financial sector regulation in India up to global standards.

IFC does well to clearly segregate the roles of RBI and the Financial Sector Authority, with the former being responsible for the conduct of monetary policy and banking sector regulation. Moreover, the establishment of an independent Public Debt Management Agency will help both in improving public debt management and better fixing RBI’s accountability for its principal tasks of maintaining price stability and prudentially managing the banking sector.

IFC stipulates in Sections 263-267 specific measures that will make the operation of monetary policy far more transparent and objective. This will be a huge improvement on the present day ‘alchemist’ like approach towards monetary policy making, in which RBI can get away without any explanation for its chosen policy stance or reasons for which the Governor may choose to exercise his veto over the majority advice of the technical committee.

IFC prises open the black box of monetary policy making by requiring each member of the Monetary Policy Committee (MPC) to make a single statement giving reasons for voting for or against the resolution being considered.

Furthermore the draft IFC requires resolutions adopted by MPC meetings to be released immediately after the meeting and the minutes to be made public after 14 days.

The full transcript has to be published after three years. These laudable provisions for full disclosure will ensure that MPC members act rationally and responsibly and not be driven by petty loyalties or narrow vested interests.

Going by the same logic – that MPC members will behave rationally in pursuit of their given objective – it is not necessary to have four government nominees on the MPC. A better alternative would be to have the seven-member MPC (and not five as recommended by the Urjit Patel committee) comprised of the Governor (it is not clear why the IFC wants to change his title to Chairman), two members nominated by the RBI Board, three government nominees and an RBI employee nominated by the Governor.

IFC stipulates that a senior government official will also participate in MPC meetings. While being a non-voting member, he will surely influence the proceedings. This composition will result in a balanced MPC that would encourage greater cooperation between government and RBI.

The Governor would be expected to use the considerable analytical resources at his disposal and powers of suasion to convince MPC of RBI’s point of view. The Governor does not need to have a veto which some have argued for. Giving a veto to the Governor over the majority view is both disrespectful to members of MPC and also assumes supra-natural powers for the Governor.

IFC (Section 267) requires that in case the inflation target is not met, RBI would submit a report to the Centre giving reasons for the failure, remedial measures to be taken and the timeline for achieving the target. No further action is envisaged.

Would it not be more effective if a failure to meet the target triggers some punitive action like resignation of the entire MPC? This could prevent the usual spectacle of ‘passing the blame’ and instead encourage constructive cooperation between RBI and government.

In a liberal democracy like ours, all key policy decisions should ideally be subject at least to parliamentary scrutiny if not its approval. Despite the Indian elite’s disdain of the political class, elected MPs do represent our peoples’ aspirations and concerns.

Therefore, the government should place its ‘inflation target agreement’ with RBI in Parliament and invite debate on it. Moreover, like in most advanced economies, the RBI Governor accompanied by MPC should be required to periodically depose before the Parliamentary Standing Committee on Finance.
It is time that those who are answerable to the people also get a chance to question the policy makers. A positive externality will be to raise financial awareness among politicians.

Rajiv Kumar
This article was published on July 30, 2015, in TOI