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RBI: In search of radical institutional reforms

T.B. Kapali

IT is now well understood that the Reserve Bank of India faces severe constraints being a central bank. This is primarily because the RBI has to don many hats - that of monetary authority, debt manager for the Government and last but not the least, havin g to be exchange rate manager also.

The on-going convulsions with respect to the rupee and the Government securities market has evoked a highly confusing response from the central bank - with the RBI seen tightening money at one point only to dilute that stance immediately thereafter. That confusion into which central bank response has been thrown is ample testimony to the burdensome (for the central bank) institutional arrangements obtaining currently in the Indian financial markets.

Here is a situation where the RBI has perforce to maintain soft interest rates if it is to succeed in the task of shepherding a mammoth public debt borrowing programme through the market. An equally important goal is to ensure the availability of competi tively-priced credit for the broader economy. An accommodative monetary stance though conflicts squarely with the central bank's responsibilities with respect to the exchange rate of the rupee.

This conflict in objectives has come into sharp focus in the past few years - with the size of Government borrowings increasing exponentially even as a gradually ( financially ) opening-up Indian economy renders the country's external sector more vulnera ble to the swings and pressures of international capital movements.

The poignant thing here is that confusion and uncertainty (flowing from the RBI's predicament) are not confined only to the world of central banking and the financial markets. It very directly affects the real economy too. What kind of economic planning can be done at the level of a firm in the midst of the prevailing hotchpotch arrangements with respect to interest rates and exchange rates?

Uncertainty in interest rates and exchange rates, of course, is an unavoidable risk factor even in the most advanced markets. But the effort has always been to structure such institutional arrangements which will contribute to lowering that risk.

That is, there will not be any doubts as to what the central bank's policy focus (say of the Fed or the BoE) is going to be. Differences in views will be only about whether or not the central bank would adopt a particular course of action to attain its o bjective.

Is such a clarity about the central bank's objectives possible in India?

Wholesale changes in the institutional arrangements relating to the RBI vis-a-vis its link with the Government seem necessary in the Indian situation. Not only will that make life a lot easier for the central bank. Such structural changes could also the pave the way for the flowering of the domestic financial markets.

The root of the problem appears to be the large Government deficits and the Government's ability to draw on the ``expertise and resources'' of the RBI in bridging its budget gaps. The incipient move towards a legislation on Fiscal Responsibility (FR), of course, would seem to address the problem but a FR Act would represent only a half-way approach.

Even the philosophical objections to an Act which could constrain the spending powers of a ``development'' oriented Government are quite strong. Indeed, in a country like India, the Government cannot dispossess itself of the ``kickstarting'' abilities o f a flexible and well-directed (spending) fiscal policy. Comparisons with the euro zone, the US and so on (in terms of limits on deficits, debt) are not pertinent at all.

One has to note that even in an environment where a FR Act is in operation, the RBI would continue to be public debt manager. More radical would be an arrangement where there is a clear divorce between the RBI and the Government.

In such an arrangement, the Government will be left to manage its debt/borrowings on its own. While the demands of the market could discipline the Government (the SLR could be drastically lowered), the RBI will be left free to conduct monetary policy wit hout being hemmed in by public debt responsibilities.

An expansionary fiscal policy in such an environment (without the shackles of FR) - through the medium of higher bond financed deficits - could be counteracted say, by accommodative monetary policy, to mitigate any adverse impact on interest rates/growth . The levers could work in the opposite direction also though one is not envisaging fiscal restraint in India. Critical in any such arrangement would be the need to free the RBI of exchange rate responsibilities also.