Whither central bank independence

For the past five years, the relations between the government and the Reserve Bank of India (RBI) have been debated. Much of this debate, however, is based on an inadequate understanding of central bank independence.


Central banks perform four functions: Price stabilisation, which is essential for maintaining trust in the currency; financial sector development and stability, in particular, because of it being the lender of the last resort, especially for banks; reducing volatility in and maximising of output and employment; supporting government borrowing when appropriate; and, very importantly, restraining the use of such borrowing when necessary. 


 Central banks, however, are creatures of governments, which give them some independence or autonomy. This is to ensure that people have trust and confidence in matters relating to money and finance. At the same time, governments have to ensure that central banks are accountable.


The emphasis on autonomy and accountability varies, depending on the context. To illustrate, during times of crisis and structural transformation, coordination between the government and central banks takes precedence over autonomy. 


The period of the 1970s was one of confusion for central banks, with the collapse of the Bretton Woods system, the onset of the significant euro-dollar market, and severe inflation, partly caused by the oil shock in 1973. The US Federal Reserve’s success in containing inflation during 1979-82 shifted focus to price stability and increased the role of central banks. The dominance of market ideology in the 1980s also contributed to a reduction in the role of the government in an economy. Consequently, the independence of central banks and inflation targeting dominated policy thinking, especially in the Anglo-Saxon world.


The global financial crisis of 2008, however, raised doubts about the efficacy of the nature of central bank independence. Ironically, central banks had to address the problem, which, in some ways, they caused.


There have been three features of the response of central banks to this crisis, namely, (a) unconventional monetary measures; (b) closer coordination with governments and other regulators; and (c) reviewing the approach to central banking. In brief, the emphasis on a single objective and independence stands diluted globally.


Now a decade after the global crisis in 2008, central banks are being attacked by political leaderships. This could be due to governments looking for a scapegoat for the current problems they face, or to the ineffectiveness of monetary policy in many countries, or to the monetary authorities running out of options.


The world is now searching for a new framework. In any case, to quote Professor Charles Goodhart: “The idea of the central bank as an independent institution will be put aside.” 


How independent has the RBI been?


To answer this, we must bear in mind that central banking became an instrument of planned development after 1950. The RBI had to create money whenever the government wanted it. This lasted till 1996. 

Illustration: Ajay Mohanty

In 1969, private banks were nationalised by ignoring the RBI’s views. The transmission of monetary policy through the banking system depended thus on the cooperation of the government.


Since the financial sector reforms of the 1990s, however, there have been two elements relevant to independence, namely, an end to automatic monetisation and regulation of public sector banks consistent with global standards as well as opening up banking for the private sector. Fiscal dominance, however, continued, constraining the exercise of independence in monetary policy. 


In the late 1990s, suggestions were made to adopt inflation targeting, which the RBI opposed. But in 2016, at the instance of the RBI, the government amended the RBI Act to introduce inflation targeting. An institutional mechanism for an independent monetary policy was also put in place.


Since 2016, prima facie, the objectives of monetary policy set by the government have been met but the period was characterised by unprecedented tensions between the RBI and the government. 


Personnel independence was diluted in the manner of appointment to the RBI board and of senior functionaries. Financial independence was threatened by demands made by the government on the annual surplus and even the reserves, apart from introducing the concept of advance dividend. 


Operational independence was eroded by statements from government officials on the board of the RBI, culminating in the unprecedented act of giving notice under Section VII of the RBI Act to give directions. The contentious operational matters included liquidity and regulating banks, especially public sector banks. 


An indication of a recent shift in policy has been given by the governor in his recent speech on “Evolving Role of Central Banks”, delivered on June 17, 2019. He said, “... the fact remains that though the focus of monetary policy is mainly on inflation and growth, the underlying theme has always been financial stability.”


The signal from RBI Governor Shaktikanta Das is that the balance will tilt in favour of the inter-dependence of policies and implicit coordination with the government and the full service nature of the RBI. The next step will presumably be in favour of negotiation for greater autonomy for the RBI within the ambit of the government’s policies, in preference to asserting independence.


This will test everyone’s skills and patience as the art of central banking lies in convincing the people that the RBI is independent, while assuring the government that its policies are consistent with the government’s intentions.

 The author is former governor, Reserve Bank of India

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