Excerpts from a speech of Dr Y.V. Reddy, in his capacity of RBI deputy governor, on ‘Autonomy of the Central Bank: Changing Contours in India’ at Indian Institute of Management at Indore on October 3, 2001.
The central banking functions typically include not only creation of money or more broadly monetary management, but, also often, management of public debt of government, regulation and supervision of banking entities, financing of developmental activities and other associated functions.
While discussing the issue of autonomy, it is necessary to recognise that the function of debt management is essentially performed by a central bank as an agent of government and the issue of autonomy does not arise. In fact, this function could be in conflict with autonomy in the conduct of monetary policy.
As regards the function of regulation and supervision, the argument for involvement of a central bank emerges from the role of lender of last resort and the obligation to smoothly operate the payments system. In this regard, the autonomy that the central bank exercises is no different from autonomy of any regulator in the financial system. As far as the developmental role is concerned, close coordination with government necessarily arises, which in some ways impinges on autonomy as it is in a way linked to money creation.
What is uniquely relevant for a central bank’s independence is its exercise of the power to modulate the creation of money and the price of money, which impacts on the value of money, both domestic and external. In this context, the critical issue relates to the degrees of freedom the central bank has in deciding whether or not to fund the government’s expenditure out of created money.
The view that central banks should be largely independent of political power and that the central bank credit to government should be formally limited is generally believed to have emerged only in 20th century. It would, however, be inappropriate to conclude that the importance of central bank’s independence was recognised only as recently as 20th century since Napoleon Bonaparte is reported to have commented in 1806, on Bank of France; “I want the bank to be in the hands of the government, but not too much”.
The evolving relationship between the government and the RBI can be broadly divided into four distinct phases.
The legislation to set up the RBI was first introduced in January 1927. The enactment, however, was made after seven years in March 1934. The RBI was set up as a privately owned and managed entity. The preamble of the Act focused on monetary stability and operations on currency and credit system in India. During this phase, which may be called infancy and uncertainty, the RBI was virtually subservient to the dictates of the government and measures were taken to curb its capacity for independent actions. In fact, threats were issued to supersede the Bank’s Board should it recommend monetary and exchange rate policies incompatible with the government’s scheme of actions. No doubt, the outbreak of war also added to the uncertainties.
Shortly after India’s independence in 1947, the RBI was nationalised in 1948. The early years were characterised by a good degree of fiscal rectitude and harmony in monetary and fiscal policy with areas of potential conflict being minimal. The fact that the rate of inflation was modest compared to other developing countries during this period is indicative of the success of macro-policy management and facilitated the task of the RBI in pursuing other developmental activities. Apart from helping to channelise credit to agriculture and industry, an important objective of the RBI was the promotion and mobilisation of savings by reinforcing the foundations of the banking system. This, however, does not mean that differences between the RBI and the government over economic policies were totally absent. For example, the RBI did not approve of the substitution of financial planning by a kind of ‘physical planning’. Once it awoke to the consequences of physical targeting during the course of the Second Plan, the RBI strove to trim the size of the subsequent Plans to match visible resources. Another illustration of differences between the government and RBI culminating in the resignation of Governor Rama Rau in 1957 is well documented.
Another major area of discord between the RBI and the government in the late 1950s related to the financing of the cooperatives and the pattern of organisation of the lending agencies. Interestingly, during the early 1960s, Governor Iengar identified four areas of potential conflict between the Bank and the central government. These were interest rate policy, deficit financing, cooperative credit policies and management of sub-standard banks. It may be of interest to note that currently, in the year 2001, these four areas are still on the top of RBI’s concerns.
This phase, from nationalisation of the RBI in 1948 till nationalisation of major commercial banks in 1969, may be considered as maturing of the RBI into a full-fledged professionally managed central bank, perhaps one of the foremost in developing countries. The mid-fifties, however, did see the beginnings of serious erosion of autonomy in the monetary policy function due to the emergence of the system of ad hoc Treasury Bills and automatic monetisation. It was agreed that RBI would replenish government’s cash balances by creation of ad hoc Treasury Bills in favour of the RBI. The ad hoc Treasury Bills, which were meant to be temporary, gained a permanent as well as a cumulative character.
The third phase that changed the contour of this relationship started with the nationalisation of major banks in 1969. While the problems experienced earlier by the RBI persisted to some extent, the change brought about a curious situation where the government became owner of a number of banks, but the supervision of these banks was, in turn, conducted by the RBI which was also owned by the government. This phase was charaterised by several features to indicate considerable influence or dominance of government over the RBI.
On the basis of one of the criteria to measure the degree of independence of various central banks during the eighties, the RBI was ranked marginally below the median level of a list of about seventy countries (including twenty-one industrialised countries).
The fourth phase or the reforming phase in the changing contour of this relationship approximately starts from 1990-91. While people in many developed countries were tired of persistent and high inflation during the earlier years, the journey of the centrally planned economies towards a market determined system also began around this time. As a result, the relationship between the central bank and the government took a new turn in many countries, resulting in the genesis of inflation targeting framework in a number of economies.
While radical changes were taking place worldwide, the Indian economy during 1990-91 experienced a severe balance of payments crisis. The crisis was clearly a fallout of the fiscal profligacy during the Eighties. During the post-reform period, the relationship between the central bank and the government took a new turn through a welcome development in the supplemental agreement between the government and the RBI in September 1994 on the abolition of the ad hoc treasury bills to be made effective from April 1997. The measure eliminated the automatic monetisation of government deficits and resulted in considerable moderation of the monetised deficit in the latter half of the Nineties. At the same time, with gradual opening up of the economy and development of domestic financial markets, the operational framework of the RBI also changed considerably with clearer articulation of policy goals and more and more public dissemination of vast amount of data relating to its operations.
It has been pointed out by some experts that the RBI, though not formally independent, has enjoyed a high degree of operational autonomy during the post-reform period. In fact, during the recent period, the RBI enjoys considerable instrument independence for attaining monetary policy objectives. Significant achievements in financial reforms including strengthening of the banking supervision capabilities of the RBI have enhanced its credibility and instrument independence.
(The full text of the speech is available at https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=88)
