Draft financial code: By undermining RBI’s independence, govt is playing with fire

If indeed the second draft of the Indian Financial Code, released on Thursday for public comments, is implemented in its entirety, Reserve Bank of India (RBI) governor will have no veto power in the proposed seven-member Monetary Policy Committee (MPC) that will have a dominant say in setting interest rates and that is not good news for the economy.

The matter of veto power is highly critical given the proposal is that four out of the seven members in the MPC should be from the government’s side. This means the full control to chart the course of monetary policy will be with the government and not the RBI. The monetary policy, as we know it today, will cease to exist.

This will effectively undermine the independence of the central bank — an institution that has guarded the economy well from the pre-independent days, through multiple crisis-phases. The RBI is probably among the few public institutions India can be proud of with impeccable integrity and proven track record. The government shouldn’t do the blunder of killing the RBI’s power to have a final say on the monetary policy.

As Firstpost has pointed out here and here , the NDA government has been on a collision course with the central bank from its early days.

This was clear when the finance ministry tried to cut the central bank down to size by mooting the idea to shift the power of debt management from the institution. The decision was, however, reversed later when RBI put up a stiff opposition. Compared with the separation of debt management, denying the RBI the veto in MPC is a much more serious issue. If the government sticks to the plan, it can run into a serious, direct face-off with the central bank this time around.

At present, the monetary policy is framed by the central bank after factoring in the recommendations of an expert advisory committee, assessing multiple economic indicators in domestic and global markets and, finally, consulting with the finance minister on the broader policy direction. The final decision, however, rests with the governor.

But, under the proposed framework, RBI governor will be one of the several members of the committee and the government will dictate the policy. In effect, the power to decide the country’s monetary policy will be shifted from an independent, credible institution to the political interests of the government, for whom monetary policy will then be among the many tools under disposal to work operate in line with its political agenda.

This will give room to major conflict of interests in the functioning of the MPC. For instance, a government-controlled MPC can push for a rate cut, even if the RBI is not fully convinced with the signals emanating from the inflation-front. The RBI will then be forced to sing the same tune of the finance ministry. This can put the economy in serious trouble in the long term.

There have been clear contradictions in the past between the RBI and government over the desired monetary policy outcome. Remember P Chidambaram, when he publicly expressed his displeasure on the RBI’s reluctance to cut rates when he said ‘the government will walk alone” its path to revive growth, if required. Also, there have been instances when finance ministers practically announced the policy, hours before the RBI did so.

The difference is that the RBI undertakes the complex process of monetary policy formulation keeping in mind the long-term good of the economy, regardless of the immediate consequences, sometimes unpleasant to the ruling government. Previous RBI governors D Subbarao and Y V Reddy, who have preferred to describe the tensions with the governments on policy issues as ‘constructive tensions’, has batted for sufficient autonomy in its functions in the larger interest of the country. To safeguard the economy, it is highly critical that central bank enjoys dominance in policy decisions.

Sidelining the central bank according to political whims and fancies of politics, the government will risk making India’s economy a black spot in the eyes of rest of the world with no credible, independent monetary policy framework. An RBI, with little control on the monetary policy, will not be a favorite in the eyes of global investors and international rating agencies, which would do no good for India, which is aspiring to become a global economic power.

The short message is this: stripping the powers of the RBI in doing what it does best will be one of the biggest policy blunders of the Narendra Modi government. The government shouldn’t do that.