Economy

Central Bank Politics– RBI and the Government

The central bank is the bank that regulates the volume of currency and credit in a country and is responsible for maintaining the financial sovereignty and economic stability for that country. India’s central bank, the Reserve Bank Of India, has been propping up in the news quite a lot recently because of its dispute with the Central Government of India. The essence of the dispute is that Prime Minister, Narendra Modi, wants the central bank to hand over a part of its surplus reserves to help meet budget goals and ease restrictions on corporate lending by state banks. The RBI governor, Urjit Patel, on the other hand wants to flush out the pile of non-performing loans clogging the banking system, insulate the Rupee from emerging-market jitters, and keep a lid on inflation.

What we have here is a situation of short-term goals versus long-term goals. Narendra Modi will be campaigning for re-elections as prime minister and he needs a win in order to gain popularity and more votes. His demonetisation move that put around 86% of the currency out of circulation was not very effective in removing black money in the economy and did not gain much public support. With the surplus money that came from demonetisation, Modi believes he will be able to meet the rest of the political agenda.

Unfortunately, Modi is not taking into consideration the long-term effects of bringing the surplus money into circulation. More money in the economy would increase inflation.When the money supply increases in the economy faster than growth in real output, inflation will occur. This is because there will be more money chasing the same number of goods, therefore the increase in monetary demand causes firms to increase prices. If the monetary supply increases at the same rate as real output then prices will stay the same and inflation would be effectively managed. Modi’s agenda directly contradicts with the RBI goal to limit inflation.

This is just one of the issues that the RBI and central government fighting about. There have been other issues on which they have clashed too. This brings forth the idea of the possibility of the central bank becoming an autonomous institution. Autonomy of the central bank is not a new phenomenon. The International Monetary Fund supports the central bank’s autonomy and accountability, since it facilitates price and financial sector stability, which are conducive to sustainable economic growth. Autonomy is often confused with the term ‘independence’, it is therefore important to understand what the term means. Autonomy entails operational freedom while independence indicates a lack of institutional constraint. There are two forms of autonomy that the central bank could take– goal independence and instrument independence. A central bank enjoys goal independence when it is free to choose its goals or, at least, free to decide the actual target values for a given goal. A central bank has instrument independence when it ‘is given control over the levers of monetary policy and allowed to use them’.

An autonomous central bank would enable central bankers with a long-term decision horizon to assert their authority when faced with a government with a shorter planning horizon. They would be able to better control monetary policy with limited interference from the short-term politicians and their power struggles. A government that does not respect the central bank’s decisions and constantly infringes on their rights would sooner or later incur the wrath of the financial markets and other massive economic consequences. One example is when the Argentinian government tried to interfere with its central government affairs in 2010. The consequences of this was that it spooked investors and triggered a surge in bond yields which had significant repercussions on the economy. Another example involves the situation in Turkey. The Turkish President Recep Tayyip Erdogan’s continuous public attacks on the central bank’s independence caused the Turkish Lira to plummet and there was rise in inflation in the country.

A point of agreement has been reached between the central bank and the government though. A nine-hour board meeting was conducted which ended with the central bank agreeing to study the government demands. This also suggests that not all decisions were resolved and that there is a possibility that matters can resurface again especially since the government has proposed rules that will allow it greater supervision over the central bank. It would be in the best interest of the nation if the central back became an autonomous institution and was separated from the election politics. It would be beneficial for the whole nation.

Picture Credits : www.dnaindia.com



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