It is quite true that words spoken can be more cutting than even a two-edged sword, metaphorically speaking, especially when we look into the bad blood that runs between government and Reserve Bank of India. The central bank has stolen the limelight currently, after deputy governor Viral Acharya last week made some bold comments in public on its independent standing and government intervention. The matter has turned critical, and once again RBI and government has entered into a war of words. Guess what! Government officials may blame RBI for talking about regulatory matters openly, but in a big relief for Governor Urjit Patel, the central bank’s union has taken up cudgels on his behalf.

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What has happened is that, Acharya spoke on government and RBI on Friday. The topic was “On the Importance of Independent Regulatory Institutions – The Case of the Central Bank”. Following this, it was revealed that senior officials spoke to news agency Reuters about the government's fears that this could tarnish the country’s image among investors.

They reportedly were upset about the rift going public.

These officials reportedly told the news agency that, it was “very unfortunate” that the RBI took the matter public. One official even added saying, “The government respects the autonomy and independence of the RBI but they must understand their responsibility.”

Later, All India Reserve Bank Employees Association issued a statement mentioning that, Acharya’s view were not a "sudden outburst" but the result of a "long simmering discontent, reported in India Today.

The statement of RBI’s union further boldly mentioned that, the governments, due to its short, election-to-election tenures, are prone to "putting pressure on the RBI to fall in line.” It also asked "right-minded people" and "experts" to persuade the government to let the RBI do its job in an "unfettered" manner.

This has surely made for a very fluid situation. Interestingly, many would believe the issues between government and RBI began from demonetisation drive, but if you look closely, the problems were already there even during Raghuram Rajan’s reign as he was accused of being too outspoken.

In 2016, Rajan spoke on various issues in like the intolerance debate and has used many quotes in describing India’s growth when compared with other developing countries. This was not taken well by government officials, and many even mentioned that Rajan could do less of commenting on issues which are not related to monetary policy and economy. However, Rajan broke the ice on what a central bank leader should speak in public.

This led to a section of government officials opposing a second term for Rajan as RBI governor. Rajan then made a decision to step down at the end of his term in September 2016.

Just after a month of Rajan’s exit, the government announced demonetisation drive, which banned the high denomination currency notes of Rs 500 and Rs 1000 to curb black money and finance terrorism.

Urjit Patel who also worked under Rajan was appointed as RBI governor and has been in role since September 2016. Demonetisation created another a course of issues between RBI and government. When RBI released its financial report for FY17, many raised eyebrows as to how much black money was caught, as almost 98.96% of banned specified bank notes (SBN) were back into system.

This led to beginning of another blame game, where RBI governor was questioned for mismanagement.

Hence, it feels like the accumulating frustrations finally broke out in a flood via Acharya last week.

So, what did he really say? Here are few statements made by Acharya.

A central bank performs several important functions for the economy: it controls the money supply; sets the rate of interest on borrowing and lending money; manages the external sector including the exchange rate; supervises and regulates the financial sector, notably banks; it often regulates credit and foreign exchange markets; and, seeks to ensure financial stability, domestic as well as on the external front.

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. Its tasks being somewhat complex and technical, central banks are ideally headed and manned by technocrats or field experts – typically economists, academics, commercial bankers, and occasionally private sector representatives, appointed by the government but not elected to the office.

This architecture reflects the acceptance of the thesis that central banks should be allowed to exercise their powers independently.

A government’s horizon of decision-making is rendered short, like the duration of a T20 match (to use a cricketing analogy), 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.

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, 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.

While they clearly have to factor in the immediate consequences of their policy decisions, central bankers can afford to take a pause, reflect, and ask the question as to what would be the long-term consequences of their, as well as government’s, policies. Indeed, by their mandate central banks are committed to stabilise the economy over business and financial cycles, and hence, have to peer into the medium to long term.

Undermining the Independence of the Central Bank

Now, although the central bank is formally organised to be separate from the government, its effective horizon of decision-making can be reduced for short-term gains by the government, if it so desires, through a variety of mechanisms, inter alia,

  • Appointing government (or government-affiliated) officials rather than technocrats to key central bank positions, such as Governor, and more generally, senior management;
  • Pursuing steady attrition and erosion of statutory powers of the central bank through piece-meal legislative amendments that directly or indirectly eat at separation of the central bank from the government;
  • Blocking or opposing rule-based central banking policies, and favoring instead discretionary or joint decision-making with direct government interventions; and,
  • Setting up parallel regulatory agencies with weaker statutory powers and/or encouraging development of unregulated (or lightly regulated) entities that perform financial intermediation functions outside the purview of the central bank.

If such efforts are successful, they induce policy myopia in the economy that substitutes macroeconomic stability with punctuated arrival of financial crises.

Therefore, there are several reasons why enshrining and maintaining central bank independence ends up being an inclusive reform for the economy; and conversely, undermining such independence a regressive, extractive one: 

  • When the government is seen often making efforts to dilute the central bank’s policies and effectively coercing the central bank into such dilutions, banks and private sector spend more time lobbying for policies that suit them individually, at the cost of collective good, rather than investing in value creation and growth.
  • When governance of the central bank is undermined, it is unlikely to attract or be able to retain the brightest minds that thrive on the ability to debate freely, think independently, and effect change; attrition of central bank powers results in attrition of its human capital and deterioration of its efficiency and expertise over time.
  • When important parts of financial intermediation are kept outside the purview of the central bank, systemic risks can build up in “shadow banking” with private gains in good times to a small set of players but at substantive costs to future generations in the form of unchecked financial fragility.

Acharya said, "As such, the divergence in horizon of decision-making between government and the central bank that I have highlighted need not lead to any operational incompatibility as long as it is well-understood and well-accepted by both parties that it is precisely given this divergence that the central bank is formally separated from the executive office and meant to conduct its functions in an independent manner."