How a Modi govt could significantly reduce the role of the RBI

The inevitable has happened. The Narendra Modi-led NDA is going to form the new government shortly. For a country, trapped in longstanding inertia over critical policy decisions, the decisive mandate comes as a huge relief.

It is expected that in the days to come, the policy paralysis will give way to quick decisions, resulting in rapid economic development accompanied by surging GDP.

Much before election results were announced, the media had been agog with the fate of Raghuram Rajan if BJP led government was elected. There were apprehensions that the new government will either clip the wings of the central bank governor or that a new governor will be appointed.

While there has been no action on this front until now (leaving scope for further speculation for some time at least), there is another interesting angle that has often been overlooked by analysts and now needs to be evaluated.

The development of an economy is often driven by a series of fiscal policy measures accompanied by monetary policy steps.

These two measures need to be supplemented by adequate regulatory changes to give wings to the economy, such as attracting investments from both domestic as well as foreign players.

But in the event of the government not performing well, the role of monetary policy starts acquiring significance of a larger-than-expected magnitude. It has been seen that when fiscal policy measures, along with other critical decisions by government, stop working, monetary policy starts acting as the sole instrument of economic stability and growth.

This is what precisely happened in the Manmohan Singh led UPA 2, especially post 2010. The shoddy governance started paving the way for populist measures and there were many instances of back-and-forth approach in the policy making.

FDI in retail was a classic example of things going horribly wrong. The end result of this policy is known to us now: FDI in retail failed to do anything tangible for the economy. A series of failures by the government resulted in the economy suffering from high inflation, a slowing down in growth and an increasing current account deficit.

From 2010 onwards, there was increased activism by the central bank in the country when it took on the mantle of managing economy through harsh monetary policy measures, after realising the government was flailing. Indeed, the media started paying attention to the RBI and its pronouncements over those being made from South block.

Now with a new government in place, there is scope to initiate actions that will result in the economy coming back on the growth path. As a result, the role of the RBI in stabilising economy and providing the necessary push for growth will be substantially reduced.

This reduction is highly required as monetary policy cannot be the sole driver of growth in the economy. Here is a list of prescriptions for some of the issues faced by our economy currently:

Tackle inflation by removing supply side constraints: Inflation cannot be controlled by just monetary policy measures.

The RBI has been trying to make inflation, especially food inflation, look like a demand-side issue, while it is predominately a supply-side constraint. India has enough food grains to feed its population, but two critical issues have been pushing food prices high that are 1) supply chain management of food grains and 2) pricing policy in form of procurement prices.

In the current scenario, an onion for which a farmer gets a price of Rs 3 per kg when the crop is ready is sold at a price of Rs 20 in the cities. Who is the beneficiary of this price difference? The government needs to have a look at this. Aren’t middle man and undesirable intermediaries pushing up prices?

Similarly, the procurement price of food grains has always been a political issue often used to win voters. There is a need to have serious look at the mechanism of procurement prices and ensure that prices are not hiked arbitrarily.

The Indian rupee will grow stronger by attracting more investments: The rupee has grown stronger in the last one week, just on the news that a new government is going to be at the helm of affairs. This is in contrast to what we saw last year, when there was carnage in the currency markets and the Indian rupee fell to a low of 68 against the dollar.

There is a very limited role for the RBI to stabilise the currency, although it was the prima donna in managing currency volatility.

If the new government puts a policy framework in place, the Indian rupee will become stable and keep on marginally appreciating for some time. While this may not be good for exporters in the short term, in the long run, it will provide the necessary boost to the country.

It is noteworthy that China has performed well on the export front, in spite of a stable and appreciating renmenbi against dollar. We need to make industries competitive to help them grow their exports and not primarily though measures such as the depreciation of the currency.

Forget repo rate, encourage growth and development by appropriate policy measures: Economic growth and development are not slaves of the repo rate. RBI governor himself has stated many times that the rate of interest do not decide growth rate in the country. While a high rate of interest may act as a temporary bottleneck, the right policy measures can still propel growth.

The government needs to promote the investment climate, especially the promotion of small and medium enterprises to push employment and growth. There is a need to build huge infrastructure across the country and avoid delays that often result in cost escalation. Infrastructure building has to be a private-public partnership.

While the RBI will have a role in the context of monetary policy measures, action on the part of the government will automatically dwarf the role of the RBI.

Indeed, the central bank should only provide icing on the cake in context of overall policy framework and should not be the harbinger of economic management.

In the days to come, the government will decide what kind of role the RBI has to play, not by changing governor or its key officials, but by initiating action.