Is govt trying to overpower RBI governor? All you need to know, and how it affects you

Voices

The recently released Indian Financial Code (IFC) by the Finance Sector Legislative Reforms Commission (FSLRC) under the Finance Ministry on July 23 has since been subject to controversy and heated debate. The main bone of contention is over how much control the government and the Reserve Bank of India can have over the monetary policy of the country. But what does that really mean, and how does that affect the common man?

First, what is monetary policy?

According to the International Monetary Fund, ‘Monetary Policy’ is the first line of defense in stabilizing the economy when there is a downturn. To put it simply, monetary policy is adjusting the supply of money in an economy to keep the economy stable. It aims to pace economic growth. When the bank increases money supply by reducing interest rates of loans given by banks, thereby providing more money in the market, it is expansionary. When it does the opposite, that is decreasing money supply and increasing interest rates, it becomes contractionary. These steps are taken according to the situation in the country.

For this the RBI uses various instruments, namely changing the interest rates, defining bank reserves (setting up money reserve limit for the central banks in the country), bank rate policy, open market operations, selective credit controls, etc.

What’s all the fuss about?

The issue is related to a recommendation by the FSLRC stating that the proposed seven members Monetary Policy Committee (MPC) will have four members appointed by the Finance Ministry and the rest three, appointed by the RBI. There is also debate over the proposal to dissolve the veto power of the governor, which gives him the sole right to decide on the country’s monetary policies.

Currently the veto power of the governor gives him the authority to individually handle monetary policy and due to this power he is not bound by the recommendations of the technical advisory committee.

So this is the question: who should have more control over monetary policy, the government or the RBI?

Two sides of the debate

Those who are not in agreement with the recommendations of the FSLRC state that taking the veto power away from the governor and allowing four out of seven members to be appointed by the government will lead to political interference.

Financial Times argues that this system, wherein the Union Government would ‘meddle’ into the affairs of the RBI, must not be adopted. The argument is that if politicians are allowed to decide on the interest rates in the country, it is highly possible that it may lead to what economists call time-consistency, the promise to put a lid on prices for temporary relief, but something which could affect the economy in the longer run. FT states that voters prefer low interest rates and a fast growing money supply. Politicians could then give in to that due to political considerations, and not go by what is good for the economy. The RBI governor, with the power to veto in the present system, can take the final decision based on what he or she thinks is good for the economy. Economist Ajit Ranade states that MPC members must have longer tenures and must not be political appointees who tend to be biased. He says that no country in the world has political appointees to control monetary policy.

There are, however, those who agree with FLRC recommendations. Rajeshwari Sengupta, Assistant Professor at the Indira Gandhi Institute of Development Research, Mumbai and Vivek Dehejia, an economist and columnist with Mint, do not find this to be an issue to worry. Writing for Mint they state that the RBI at present lacks any form of statutory independence as it is governed under the RBI Act, 1934 and so this recommendation will not really change the system drastically.

The RBI Act, 1934 governs the Reserve Bank of India, which is the central bank for India. The 21 Members of the Central Board of Directors are all, directly or indirectly appointed by the union government and the fact that the governor himself is appointed by the union government clearly shows the control of RBI lies with the union government as of now, they say. Dehejia and Sengupta argue that according to this Act, the governor, who is appointed by the Union Government, is obliged to obey the government and that the independence of the governor to take decisions on the monetary policies of the country depends solely on his strength to take upon the pressure by the government.

How does it actually affect you?

We might not be directly concerned about monetary policy and the recommendations given by the FSLRC, but it can have a major impact on our lives. Here’s a situation that will help explain its importance. Imagine there is a committee, in which there are three experts from the RBI and four political appointees. The RBI members, in view of the inflation and low deficit (or any other reason) decide to raise interest rates. But elections are about to take place and no government would want to displease the public, and in fact wants to roll out populist schemes, and they do not want to raise interest rates. There will be a tussle, but the political appointees will have their way as they are more in number and governor does not have the veto anymore. As a result, while interest rates will reduce in the short run, the inflation will remain high in the long run, which is to the detriment of citizens.

The above is however an illustration of the fears of many, and need not necessarily be the case if the FSLRC recommendations are accepted.

Is there more to the controversy?

The issue is politicized mainly because of the fact that this recommendation was changed in the second draft. As reported by Mint , the first draft by the FSLRC which was then headed by SC judge, Justice BN Sri Krishna, suggested a seven member ‘Monetary Policy Committee’ with majority of them from RBI and the current veto power of the governor was retained. This report came out in March 2013, when the UPA was in power.

However on December 22, 2013, the Finance Ministry constituted a three member expert group which submitted a second draft which was made public on July 23, 2015, when the NDA came in power. Though the report was drafted by the FSLRC, Justice Sri Krishna maintained that the revised IFC reflects the finance ministry’s views.

Finance Minister Arun Jaitley, Minister of State for Finance Jayant Sinha and Chief Economic Advisor Arvind Subramanian have so far distanced themselves from the recommendations and the controversy.

Update:

In a press conference held after the Monetary Policy review, on August 4, Raghuram Rajan, Governor of RBI, said that the RBI and the government have "agreed broadly" on the MPC. More importantly he also highlighted that he has not opposed to the RBI Governor’s veto power being taken away. Rajan also said that committee based structure can handle pressure in a much better way than a single person and that committees can ensure greater continuity in policy. He also said that the situation will not change if the veto power is retained. However, Rajan did not speak out on the structure of the MPC.