The world’s strongmen are eroding the autonomy of central banks. Exhibit A: India

Whatever the differences over the demonetisation fallout, there is near consensus over one collateral damage: the reputation of the country’s central bank, the Reserve Bank of India (RBI), has taken a severe beating after 86% of the country’s currency (by value) was withdrawn and not replaced on time. But, worse, there is a growing perception that the central bank buckled under government pressure and rubber-stamped demonetisation. Fingers are pointing at governor Urjit Patel for readily agreeing; this may be jumping to conclusions but governor Patel’s non-communicative mien has not helped matters.

Three former RBI governors have publicly lamented the erosion of the central bank’s relative autonomy. Former governor Y V Reddy expressed concern about the knocks the RBI is taking: “For the RBI, for a central bank, reputational risk is the worst risk…And if this is happening in the international opinion, I would say that it is a national problem now and it is not just a political issue.” Even Reddy’s predecessor, Bimal Jalan, chimed in with his concerns over threats to the RBI’s autonomy. The opening line of former deputy governor Usha Thorat’s recent op-ed was anguish-laden: “It is indeed a sad day to see one of the most respected public institutions in India becoming an object of ridicule and scorn.”

India is only playing catch-up

On closer scrutiny, though, this shouldn’t come as a surprise. India is only following a global trend. The world over, in countries with right-wing governments headed by perceived “strongmen,” the executive has locked horns with serving central bank governors, and in some cases even abrogated the relative autonomy of the central bank. India is only playing catch-up: the refusal to extend former governor Raghuram Rajan’s term, and the growing public perception of Patel’s inability to dissent, further reinforces the notion of India tacking on to a global trend.

Two recent examples testify to the global pattern’s prevalence. President-elect Donald Trump denounced US Federal Reserve chief Janet Yellen on his campaign trail, claiming she was playing politics with interest rates (translation: she was keeping interest rates deliberately low to help Hillary Clinton) and should be replaced. Whether he will follow through on that promise will be known only after Jan. 18.

In England, soon after securing the referendum supporting Brexit, Conservative Party grandees—notably Michael Gove and former foreign secretary William Hague—tore into Bank of England (BoE) governor Mark Carney. They were taking their cue from prime minister Theresa May who, at an earlier party conference, had slammed the BoE for the low interest rates and quantitative easing since it short-changed savers. Carney has since dropped dark hints of resigning.

The relationship between elected politicians and central bankers has always been fraught. The 2008 trans-Atlantic financial crisis has deepened the chasm with central banks being increasingly asked to take on quasi-fiscal responsibilities. This has resulted in increasing institutional friction.

In Japan, soon after prime minister Shinzo Abe assumed office in December 2012, he leaned on the Bank of Japan (BoJ) to print more money and to bump up its inflation target from 1% to 2%; both measures would require the BoJ to pursue an expansionary monetary policy. This, the government hoped, would provide the necessary growth stimulus to the economy and finally help Japan escape the pernicious deflationary trap that’s plagued the economy for over 10 years. BoJ governor Masaaki Shirakawa was initially reluctant and when the pressure continued to pile on, he resigned in February 2013, two months before he was due to retire.

The Hungarian president and head of the right-wing party Fidesz, Viktor Orban (who recently built barbed wire fences to keep out immigrants), used his majority powers in parliament to browbeat the central bank into submission. He even went to the extent of replacing the sitting governor with long-time Fidesz politician Gyorgy Matolcsy. Interestingly, Matolcsy currently faces myriad allegations of cronyism and misuse of public funds, including those of the central bank to window-dress the government’s fiscal health.

Closer home, Sri Lanka has been witnessing heightened tensions between central bank governor Indrajit Coomaraswamy and finance minister Ravi Karunanayake.

More than just monetary policy

Bank of Israel governor Stanley Fischer resigned ahead of his retirement date, sparking off rumours of differences with prime minister Benjamin Netanyahu. Fischer subsequently joined the Federal Reserve as vice-chairman. A year ago, he had delivered a speech on central bank independence, in which he made an interesting point, one that resonates with the Indian situation. He said: “…there is a distinction between the terms monetary policy independence and central bank independence. In the literature that developed before the global financial crisis, central bank independence referred to independence from political influences in the setting of monetary policy. But many central banks have roles outside monetary policy—in particular, bank regulation and supervision. These roles are in certain cases granted their own level of independence…”

This point has also been made by former governor Y V Reddy: “There are two types of confusion… my own suspicion is that the institutional identity of the RBI has been damaged… the RBI is the monetary authority, yes. But it is also a full-service central bank. It is in charge of many other things. The recent emphasis appeared as though monetary policy is the main function. The governor is accountable to monetary policy. Then he is not accountable to regulation, he is not accountable to currency coins? There is a confusion about relative importance. That relative importance is being decided more outside than within.”

Successive governments have found ways of corroding each of these different independent roles. For instance, under the previous Congress-led government, former finance minister Pranab Mukherjee (currently the country’s president) set up in 2013 a new financial sector monitoring body, called Financial Stability and Development Council, to be chaired by the finance minister. This was a clear intrusion; the central bank’s mandate includes financial stability. The RBI governor was put on par with other regulators, which betrays a flawed understanding of a central bank’s role and remit.

The Australian example is instructive. The governor of the Reserve Bank of Australia chairs the single integrated prudential regulator, the Australian Prudential Regulation Authority, as well as the Council of Financial Regulators.

Rule by fiat

The process of emasculating the RBI seems to have accelerated now. The surgical changes to RBI’s governance structure are telling: The government’s unwillingness to fill up vacant posts of independent directors is believed to have accelerated the passage of the demonetisation proposal and helped obtain the central bank’s acquiescence overnight. Ordinarily, the central bank would have debated and dissented, after assessing the logistical nightmare of not only distributing fresh cash to the wide network of bank branches across the country but also recalibrating and replenishing over 200,000 ATMs across the country.

Subsequent RBI submissions to parliament’s committee on finance disclosed that the central bank had acted on government advice.

Truth be told, the RBI Act does not empower the central bank with absolute autonomy, but the RBI does have relative autonomy allowing it to pursue certain monetary and regulatory functions with some degree of independence, free from political pressure. Saying “no” in the interest of avoiding short-term volatility and ensuring the economy’s long-term health is part of the job. Tinkering with this fine balance will have massive repercussions, including undermining investor confidence in various asset markets.

The article first appeared in www.qz.com on January 15, 2017, and can also be read read here

Book Review: Repo And Its Masters

A RBI governor remembers his doughty fights, but cuts down on the math

WHO MOVED MY INTEREST RATE?
BY DUVVURI SUBBARAO
VIKING | PAGES: 323 | RS. 699

Central banks have been labelled exotic beasts: rarely seen in public, much less understood. Realisation of what central bankers do has been seeping in slowly. Over the past few decades, as bond and currency trading acquired gargantuan propor­ti­­ons, the arcane world of dealers kept a close watch on every statement coming out of central banks, parsing each phrase and analysing each nuance. Any action, or the faintest hint of a future one, had the potential to affect currency prices, bond rates and indi­vidual fortunes. This need for analysis and interpretation also produced a large tribe of writers called ‘central bank watchers’.

Over time, as societies overwhelmingly bec­a­me dependent on debt— for housing, education or buying their next television—larger sections of the population got interested in the central bank’s actions. Any increase or dec­­rease in interest rates, or liquidity conditions, had a direct impact on household incomes and lifestyles. And yet, despite this growing interface, cen­­tral banking remains shrouded in a mysterious and inscrutable cloak.

Former Reserve Bank of India governor Duv­vuri Subbarao makes a valiant attempt to lift this veil and demystify a central bank’s workings. This is a first and we hope this will enthuse others to share their views. But there are two ways of viewing the book’s purpose. One, in trying to explain a central bank’s operations, Subbarao creates an opportunity to justify his actions dur­ing 2008-13, a period of stubbornly high inf­l­ation, extraordinary exchange rate volat­ility and an unprecedented (and unbroken) spree of interest rate increases. A converse view is also possible: its primary function is to rationalise his actions and he uses it to dec­ode the RBI’s actions and working styles. Which set of lenses have been used? The narrative str­u­cture and the tenor seems to suggest it’s the latter.

This becomes clear as one ploughs thr­ough an otherwise eminently readable account. The book’s pre-launch publicity focused on the governor’s well-publicised conflicts with former Union finance ministers P. Chidambaram and Pranab Mukherjee. Central bankers have traditionally shared antagonistic relationships with fiscal authorities. The book dwells at length on Subbarao’s differences of opinion with Chida­m­baram and Pranab, and how rising prices and a slowing economy widened the rift between Mumbai’s Mint Street and Delhi’s Raisina Hill.

But, with due apologies to Shakespeare, met­hinks the governor doth complain a bit. This is not to imply he was wrong in his stand on interest rates. Subbarao stood up against the collective might of the government, Parliament, a misinfor­med finance sector and uninformed commentariat by defending his right to raise interest 13 times in quick succession. He explains quite expansively why the situation warranted such drastic action. The fiscal and monetary expansion post the 2008 trans-Atlantic financial crisis, without adequate investment in production and supply capacities, embedded inflationary tendencies in the economy. Given political leaders’ reluctance to tighten fiscal reins, it was left to the monetary authority to attempt demand compression through interest rate increases.

Face-offs between monetary and fiscal auth­orities are built into the design; Subbarao mentions as much in the book. In times of crisis, both work in lockstep, as was evident after the 2008 meltdown. But, the impact of an expansionary fiscal policy on inflation and economic growth was ignored by the political class and India’s cossetted business interests. Much of the book describes this clash of ideals.

But there are gaps in Subbarao’s acc­ounts—both when describing clashes with North Block or when recounting challenges faced during vital post-crisis moments. Here are two examples.

First, there’s no mention of his immediate predecessor’s track record. Subba­rao mentions Y.V. Reddy only in passing while mentioning how crisis forced him to rev­erse his predecessor’s string of interest rate increases. We are not asking for public display of dirty laundry. Reddy too had to contend with a frequently (and publicly) remonstrating finance ministry. Reddy’s interest rate increases, to burst speculative asset market bubbles, earned him unstinted praise from economists and observers worldwide.

But, here’s the thing. Subbarao was fin­ance secretary when Reddy was busy inc­reasing interest rates to stave off risks. Interestingly, even Chidambaram was fin­ance minister during that period and he made public his displeasures with Reddy’s insistence on rate hikes. It would have been interesting, and more honest, if the book also disclosed Subbarao’s role as Chidambaram’s finance secretary in his engagements with Reddy, and the lessons learnt from those interactions before moving to RBI. Subbarao limits his interface with Reddy to discussions on RBI’s balance-sheet; I am sure there must be more. If the governor is going to reveal all about his skirmishes with political authorities, his interaction with RBI as finance secretary should also be fair game.

Two, there’s not enough explanation about how the RBI managed its balance-sheet in the aftermath of the crisis. Or, enough inside dope about the crisis days following the closure of Lehman Brothers. Subbarao describes how the monetary tap was kept open at full tilt to give the financial sector confidence that funds were always available. This was largely a signalling and confidence-building measure to avoid payment imbroglios or defaults which get amplified into panic during crisis times. As part of the strategy, RBI kept repo rates (the interest rate at which RBI lends to banks against government securities) low; but the reverse repo rate (interest rate at which RBI accepts money from banks against securities) was always kept 1.5 per cent higher. This was particularly true of December 2008.

Interestingly, this rate difference converted RBI—usually known as a lender of last resort—into a borrower of last resort. Banks would occasionally use the repo window to smoothen temporary mismatches, but would dump far excess cash with RBI’s reverse repo window. Clearly, credit aversion in the immediate aftermath of the crisis forced banks to seek safe havens for their surplus cash. Given money’s fungible character, we also do not know if banks borrowed from the repo window, turned around and tipped over the same money at the reverse repo window, thereby earning a neat 1.5 per cent without breaking into a sweat. The central bank’s annual report for 2008-09 (June 30 year-ending) highlights this anomaly: outstanding repos shrunk to Rs 895 crore (previous year Rs 22,805 crore) and rev­erse repos swelled to Rs 88,335 crore (previous year Rs 300 crore). This surely had some consequences and it would have been interesting to know Subbarao’s views.

But, beyond this, Subbarao has done a superb task of shedding some light on a central bank’s specialised role, especially by making it accessible to a wider spectrum of readers. He uses simple language and infuses some humour when necessary. It stops short of being a complete masterclass because encounters with the political class keep intruding. But somebody needed to talk about these incidents because the public rarely gets to know how both institutions interact. Yet, it also doesn’t do full justice to the political economy of Indian central banking. So, what is it, a book on central banking or an expose? I see it as setting the record straight.

This book review first appeared in Outlook magazine and can also be read here

RBI’s Priorities And Concerns

The pressure on the RBI to cut rates will intensify now because of two immediate reasons — G8 central banks are re-hydrating their economies to keep the credit lines lubricated and China has cut its rates

IN LESS than a week of taking over his new assignment, Reserve Bank governor Duvvuri Subbarao decided to hold a press conference and talk about some macro issues. This is unusual. Typically, a central banker takes some time to settle down before speaking out about the problems of the day. But, given that he chose to address the media so soon after taking over, it is perhaps an indication of the troubled times we live in. Or, perhaps, it’s symptomatic of the confusion roiling the asset markets, making them swing between the two extremes of heightened expectations and mounting uncertainties.

There are signs of ambiguity everywhere — whether it’s in the inflation numbers or growth impulses, whether it’s in the drag effect of a global slowdown or the intense volatility experienced by the markets. Therefore, it was a welcome sign that Subbarao decided to break with convention and spelt out his priorities. While Subbarao has taken to his new role (and its obligatory nuanced statements) with surprising agility, he did outline, rather pointedly, some of the RBI’s concerns and priorities.

But many other concerns remain unspoken and there are any number of surprises (“known unknowns”, as Subbarao calls them) strewn along the central bank’s path to attaining economic growth with price stability. The global sell-off arising out of the collapse of three Wall Street icons — Lehman Brothers, Merrill Lynch and AIG — are the latest “known unknowns”. Much of the advice dished out for the governor so far focuses on obvious concerns, some unfinished agenda and a few minor issues. The obvious ones are: unease over the rate of inflation and speculation over the future course of monetary tightening. The incomplete tasks include financial sector reforms and addressing the capital deficit in PSU banks. The minor issues involve tinkering with products and processes in the currency and interest rate markets. But, Subbarao still has to keep his guard up for a host of wide-ranging issues, including the aftermath of the global credit squeeze.

Elections are round the corner and the governor is bound to be inundated with demands to loosen the monetary taps, some of which were quite presciently tightened by his predecessor. With crude prices having now dipped below $100, the requests to ease interest rates have acquired a new force. Add to that the latest WPI numbers — which dropped to 12.1% for the week ended August 30, from 12.34% the week before — and the clamours for an interest rate cut are already getting louder. Subbarao needs to watch out. Crude prices are still higher than the prices charged by oil marketing companies. But, more importantly, Opec recently decided to undertake a production cut. Although this has so far failed to rattle markets — primarily because of the global economic slowdown — the danger of further production cuts or sudden disruptions in oil production cannot be ruled out.

Also, the slowing down of the inflation rate might be slightly misleading. For one, the inflation index is still growing above the RBI’s comfort levels. But, beyond that, on a disaggregated basis, there are some essential products and manufactured items that are still showing rising prices. There are also two other factors that can’t be overlooked — the base effect might be finally wearing off and, therefore, it is important to look at the week-on-week growth in the index, which clocked 0.2% for August 30, after rising marginally in the previous week. In fact, the September 12 report by the Goldman Sachs Asia economics research team forecasts inflation peaking to 13.5% by November before beginning to cool off. Plus, the rupee’s continuous depreciation against the dollar over the past few days, despite the RBI’s attempts at intervention, could complicate attempts to tamp down inflationary expectations. The rupee will continue to be under pressure as foreign investors rush to sell their equity holdings and buy dollars.

The pressure to cut rates will also intensify now because of two immediate reasons — G-8 central banks are re-hydrating their economies to keep the credit lines lubricated and China has cut its rates. But, developed country banks are caught in an asset blow-out and need additional liquidity to keep their heads above water which Indian banks, thankfully, don’t. Export-driven China, on the other hand, sees large parts of its economy affected by the US developments and has therefore opted to chase growth. India has a strong domestic market and even the consensus growth forecast of 7-7.5% is pretty good by international standards.

The monetary tightening was conducted to squeeze out excess demand, a partial reason for the build-up of inflationary expectations. This is what Subbarao said at his maiden press conference: “The current high level of domestic inflation reflects a combination of supply-side pressures as well as demand-side factors… Though demand is not the main problem, in the absence of further flexibility on the supply side, demand management has to be part of the solution. Dampening demand and anchoring inflation expectations has been the logic behind Reserve Bank’s monetary stance.” One of the methods used was increasing cash reserve ratio (CRR) and the repo rate. This was to ensure a slowdown in the runaway growth in bank credit. Former governor Y V Reddy pressed the panic buttons when credit-deposit ratio crossed 80%, indicating that banks were borrowing short term to finance long-term assets.

Subbarao’s observation about systemic rigidities — “absence of further flexibility…” — is unlikely to be set right any time soon. Plus, as the RBI’s annual report points out, the fisc is expected to come under increasing stress from, among other things, implementation of the sixth pay commission, lower petro-product duties, higher fertiliser subsidies and farm debt waivers. Therefore, perforce, demand-side management will have to remain the focus of the RBI’s strategy. But, the expectations of monetary easing are also unlikely to fade away soon. The market will be looking at the governor pretty closely — to see whether he can indeed walk the lonely path reserved for central bank governors, insulated from the influence of markets and, most importantly, from the fiscal side across the fence.

Publilshed as an Op-Ed in The Economic Times (September 17, 2008)

Will RBI Join The Give-Away Party?

With a fiscally expansionary budget, the RBI will once again have to keep a close watch on the monetary situation. So expecting interest rate cuts at this point seems counter-intuitive

It’s odd, but somehow the heart goes out to RBI governor Y V Reddy. Yet again, the bill for the party will end up on his desk. Given the pile-up of other issues that require the governor’s full-time attention, the additional cost of reining in the after-effects of finance minister P Chidambaram’s budget jamboree is sure to extract a heavy toll.

Sure, the FM has done what he had to, given the circumstances. Some may even argue that his hand was probably forced to a certain extent by a party diktat. The Rs 60,000-crore farm loan waiver and his petulant response to repeated questions about it betray some of the occupational hazards of framing a budget during election times. But, to his credit, he has still tried to focus on the larger issue at hand — keeping the economy humming and trying to insulate it, as far as possible, from the shock waves of an impending global slowdown. This he has tried to achieve through two measures — trying to ensure that consumption growth in the economy continues apace and that the engine of industrial production does not slow down. At this stage, he is keen to achieve these ends with the help of some fiscal stimulus.

Look at what the FM is up against — the average growth of industrial production has dropped from 11% at the end of the last fiscal year to a monthly average of 9% till November. In December, it was only 7.6% and, if the average industrial production growth rate tends to stay between 5-7% in the second half of the year, the average rate for the year is likely to be below even 9%. That’s a sharp drop from the previous year. The main items dragging the index down have been consumer durables and the auto sector.

The Economic Survey also forecasts that the year is likely to end with an overall real GDP growth of 8.7%, a full 100 basis point lower than the previous year’s 9.7%. Add to this the fear of the unknown — no fix on the extent of the sub-prime damage in the western economies and the resultant economic slowdown, or the degree to which this event will impact the Indian economy.

So, how will the finance minister achieve the twin objectives? For the consumer, he has done two things — made goods cheaper by cutting excise duty and providing them with more spending power by restructuring income tax slabs. With an eye to the industrial production index in particular, he has reduced excise duty on small cars and two-wheelers (sales of which had been hit the hardest). He has also cut the median excise duty rate to spur consumption of daily household items. Given that a large part of the growth impetus during past few months, in the face of slowing down consumption, has been predicated on investment, the FM has introduced some policy changes in the budget to keep the momentum going — removed some long-standing glitches to facilitate higher trading volumes in corporate bonds, promised to develop a bond and currency derivatives market, extended tax breaks for construction of hospitals and hotels.

It’s too early to figure out whether this combination will indeed work in spurring higher consumption levels and therefore keep the industrial shop floors buzzing. But one thing is certain: not addressing the real issues is unlikely to sort out the inflation issue or immediately bring people back into the consumption mode. Take the pressures on the food economy. Is it going to go away with the Rs 60,000-crore farm debt waiver?

Unlikely, since the farmer still has no solutions on sourcing improved inputs (such as seeds or fertilisers) or even an efficient and reliant system for selling his produce. There is also no appreciable investment in improving the infrastructure which delivers agricultural produce from the farm gate to our plates. Therefore, despite the FM’s pious statements about inflation in his budget speech — “Keeping inflation under check is one of the cornerstones of our policy” — food inflation (spurred on to some extent by global factors) is likely to continue to haunt the economy for some more time to come. The Economic Survey observes: “The behaviour of agricultural prices, including essential consumption items, will be critical, given falling poverty and rapidly rising per capita income…Domestic supply management is…critical to stabilising inflation expectations, moderating pressures for upward revision in wages and prices, and containing pressures for cost push inflation through monetary and fiscal accommodation.” 

Second, will lower car and two-wheeler prices (assuming all the auto producers do agree to pass on the duty cuts) really inspire consumers to be liberal with their wallets? Again, doubtful. A careful look at the auto industry sales figures reveals that it was actually lower interest rates that catalysed record sales of the past couple of years. Once rates hardened, sales also dropped. Therefore, to get those motorbikes and tiny cars rolling out of the shop once again, what’s needed is not only a firm control on current inflation, but on expectations of what it’ll be in the future. Since the fiscal design does not explicitly state how it will lower inflationary expectations — and hence interest rates — in the next few months, the efficacy of the entire package is on test.

But, beyond that, the RBI will have its own set of headaches arising out of the budget and other public policy. For one, its authority as an enforcer of credit discipline in the banking system seems to have been undermined once more by a trigger-happy government. Second, the pay commission’s award is surely going to add another little twist to the on-going inflation story.

In addition, the RBI has used monetary policy in the past few months to bludgeon runaway demand and bring inflationary pressures under control. With such a fiscally expansionary budget, the RBI will once again have to keep a close watch on the monetary situation. So expecting interest rate cuts at this point seems   counter-intuitive. Unless, of course, the RBI also decides to join in the pre-election giveaway party.

Published as an Op-Ed in The Economic Times (March 6, 2008)