Central Banks and Independence: Myth and Reality

The significance of the Central Bank’s independence once again came into the limelight when the RBI’s Deputy Governor, Viral Acharya, concluded his A D Shroff Memorial Lecture in a fiery voice cautioning 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.” On the other hand, governments that “invest in Central Bank independence”, according to him, “will enjoy lower costs of borrowing, the love of international investors, and longer lifespans.”

Conceptually, there is evidence to the effect that the Central Bank’s independence benefits a nation with price stability. For, literature reveals that decision makers who are subjected to election-cycles tend to act more in a short-sighted manner for they have an obligation to deliver their proclaimed manifestos, that too, with the accompanying element of ‘immediacy’. But such short-termism often turns out to be inflation-biased. As against this embedded weakness of elected leadership, a Central Bank, having longer horizons of decision making vis-à-vis elected governments, can afford to factor in medium to long-term consequences into its decision making and thereby could stabilize the economy over business and financial cycles. 

When we talk about independence of Central Bank, what we essentially mean here is: the Central Bank must be given a limited and clearly defined mandate for achieving the assigned inflation target.  For, such a clear and limited mandate alone enables the Parliament and the public to monitor and evaluate the performance of the Central Bank. Secondly, such well-defined mandate also helps avoid overburdening of Central Bank.  Incidentally, with the appointment of Monetary Policy Committee (MPC) two years back, Reserve Bank of India [our Central Bank] is made solely responsible for managing the inflation rate in the country within the mandated range.  And, by formalising this arrangement through appropriate enactments, government has strengthened the independence of the RBI. 

That said, it must also be admitted here that independence of Central Bank does not mean isolation from the democratically elected institutions, which is why there should always be a dialogue between the Central Bank and the government. But before getting into the nitty-gritty of such a dialogue, let us first look at the discordant elements that have crept in, in the recent past, between the two. As cited by Acharya in the said lecture, the first one is: RBI’s demand for making the regulatory powers of public sector banks ownership-neutral. In short, what it calls for is: that “the government should acknowledge full operational authority and independence in supervision and regulation” of banks by the RBI, as it did in the case of monetary policy.  The second one is the row over the RBI’s burgeoning reserves, a part of which the government is eyeing for bridging its fiscal gap, which the RBI is resenting heartily. And the third one is: the proposed appointment of an independent payments regulator by the government, which the RBI perceives as an encroachment on its turf. 

In the same vein, the government too is having certain grouses against the RBI. One, it argues that having allowed regulatory forbearance on NPAs of banks for quite long, imposing stringent rules now—rules that are more rigorous than even international norms—for identification of quality assets particularly, its doing away with all restructuring schemes and asking banks to make higher provisions, is adversely impacting credit growth. Similarly, it also questioned the wisdom of the RBI in placing some PSBs under prompt corrective action, for it could lead to liquidity crisis, which, in its view might threaten inclusive growth.

Thus, there are questions emanating from both sides which need to be answered. But what is to be appreciated here by the warring parties is: that there are no readymade answers for them. Of course, it does not mean they are insurmountable. All that they call for is: a constructive dialogue between the regulator and the government to understand each other’s perspective and to draw a workable template, the ultimate execution of which shall ensure stability in the markets. And importantly, it is to be noted that any adverse comment by the government is potential enough to undermine the confidence of market players in RBI.  

Here, it is also necessary to appreciate the fact that in a democratic setup, no one is independent, for in the ecosystem, everyone is ultimately accountable to someone or the other. And it is equally necessary to appreciate that ‘independence’ is not something that is ‘given’; rather, it reflects more in one’s action. Incidentally, we have been witnessing such actions all through from the RBI. For instance, even well before the establishment of Monetary Policy Committee, there are occasions in the past when RBI remained un-influenced by the government’s desire for lowering interest rates so as to stimulate growth in economy. And another important point here is that one must “not to confuse independence” as Mark Carney, governor, Bank of England said, “with omnipotence.” 

That being the reality, the RBI—for instance, as the government commented recently in the context of the fraud in PNB—should have asserted itself in supervising banks and bringing out the fault lines to the notice of the owner, the government. For, it has regulatory powers, under the Banking Regulation Act, 1949—which are indeed vast in scope—to regulate banks’ lending activities through physical inspection of banks and their financial audit from time to time and also through its nominee directors in the boards of Public Sector Banks. 

In the same vein, the government should have articulated its political needs with the RBI and sought a way forward to pursue them without, of course, derailing the economy. Instead if they clamour for independence or ride over the other, that too, from public forums, they would only be doing injustice to the economy, for all such acts are sure to set markets on fire, or to borrow Acharya’s words, they are sure to “ignite economic fire.” It is of course, for them to either set the economy on fire or douse the fire, “But will they?” — no, it’s not a lament but a timely challenge to them.