Fiscal policy interests vs Monetary policy interests

No government has not faced tussles between the central bank and the central government. In India, After Duvvuri Subbarao and Raghuram Rajan, the latest to join the club was the current RBI chief Urjit Patel via his deputy Viral Acharya.

 Most differences between the RBI and the Centre in the past used to be over issues such as interest rates and when attempts were made to take way some functions such as debt management from the central bank.

The primary reason behind the tussle is mostly their core objectives, with central bank targeting to control inflation while government targeting growth. In macroeconomic terms, growth is always coupled with inflation,as growth increases spending and spending increasing the demand and there by inflation. Hence the tussle is objectively linked in the balance. However,this time it was different.

What's wrong this time ?

In the financial stability council meeting, govt made a proposal  to hive-off the public debt management function from the RBI and talks demanded that RBI should ease it's reserves. Following this ,the government invoked section 7 of RBI act.

 

What is Section 7 and why it is being seen as an extreme step against the RBI

Section 7 of the RBI Act has come into spotlight amid the war between the Central government and the Reserve Bank of India (RBI). The provision in the RBI Act empowers the government to issue directions to the RBI.

The government has invoked Section 7 which has never been used before. Exercising powers under this section, the government has sent several letters to the RBI governor Urjit Patel in recent weeks on issues ranging from liquidity for non-banking financial companies (NBFCs), capital requirement for weak banks and lending to micro, small and medium enterprises (MSMEs) .

What is Section 7?
The RBI is an entity independent of the government as it takes its own decisions. However, in certain instances, it has to listen to the government. This provision in the RBI Act is contained in its Section 7 which says:

(1) The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.

(2) Subject to any such directions, the general superintendence and direction of the affairs and business of the Bank shall be entrusted to a Central Board of Directors which may exercise all powers and do all acts and things which may be exercised or done by the Bank.

(3) Save as otherwise provided in regulations made by the Central Board, the Governor and in his absence the Deputy Governor nominated by him in this behalf, shall also have powers of general superintendence and direction of the affairs and the business of the Bank, and may exercise all powers and do all acts and things which may be exercised or done by the Bank.]

Clearly, the section empowers the government to issue directions in public interest to the central bank, which otherwise does not take orders from the government.

Why has the government invoked Section 7?


The government and RBI have been at loggerheads over a few issues for some time now. The government believed that easing of lending rules for the banks under the prompt corrective action (PCA) framework could help reduce pressure on MSMEs. However, the regulator stood its ground arguing that such a move would put the clock back and undo clean-up efforts. With the credit markets tightening after the IL&FS default in September, non-banking finance companies lobbied the government for more liquidity. But RBI maintained its position since the banking system did not witness any spike in borrowing costs and the market was just repricing risk in an evolving situation.

The government and the RBI disagree on a large number of important issues such as classification of non-performing assets (NPAs) and setting up of a payments regulator independent of the RBI.

Why is Section 7 seen as an extreme measure?


This section has never been used in till now. It was not used even when the country was close to default in the dark days of 1991, nor in the aftermath of the 2008 global financial crisis. It is not clear how this Section operates since it has never been used. The aggressive move could scandalise a section of academia and experts, while raising questions about the government’s intentions and the impact on RBI's autonomy.
 

Analysis

 

When it comes to choosing between politicians and technocrats, the intelligentsia would reflexively choose the latter. Technocrats are highly educated. Most importantly, they are thought to be better capable of focusing on outcomes over the long-term instead of being guided by short-term considerations such as impending elections.

 

If, technocrats are more capable of taking long-term decisions, why leave fiscal policy in the hands of elected representatives? How about a Fiscal Policy Committee that will implement the FRBM Act with more grit than politicians have shown?

The reason that fiscal policy has not been delegated to technocrats is that it has multiple welfare and distributional effects that are best-weighed by elected representatives. Monetary policy, with its focus on inflation, is believed to be less complex in its impact and hence relatively easier to delegate to technocrats.

However, this contention is increasingly coming to be questioned. Monetary policy too can have important distributional consequences and hence vesting it in technocrats can be doubtful. Low interest rates, such as those that followed the financial crisis of 2008, advantage of borrowers over savers; they advantage owners of assets over those who don’t own any. Again, the impact of monetary policy on exchange rates and financial stability again has wider implications that cannot be left entirely to technocrats.
 

Following the financial crisis, that’s precisely what we have seen in the U.S. and in Western Europe, with the many political consequences that have ensued. When the United States decided to rewrite regulations for banks, it did not leave the matter to regulators. It was the

U.S. Congress that passed the Dodd-Frank Act that defined the framework for regulation.

Paul Tucker, a former Deputy Governor of the Bank of England, highlights three essentiality for this conflict of interest,

 

  •  The objective of policy must be clearly defined.
  • The instrument for achieving the policy must be spelt out.
  •  A mechanism for accountability must be in place.

 Information on these principles must be widely disseminated so that the public understands what’s going on and why.

These principles are clearly reflected in the mandate for India’s Monetary Policy Committee. There is an objective, namely, the inflation rate, for which a band is specified. The policy instrument is the interest rate. Accountability is ensured by the RBI having to explain to Parliament any deviation from the inflation band.

 

Technocrats, in general, must be subject to political oversight.
The issues that Acharya has raised can and should be resolved through discussion with the government. The RBI should not try to become what Tucker calls an “overmighty citizen”. That will not serve the cause of the RBI or the nation. Autonomy should be a key part of central bank,at the same time accountability and co-op is prerequisite of this model.