RBI Is Legally Bound To Lose Its Battles For Independence With The Government

It was another January, a decade ago, but some of the actors are the same. On 12 January 2005, in the course of a speech, then Reserve Bank of India (RBI) Governor Yaga Venugopal Reddy said he was uncomfortable with the rise in the inflow of money by foreign institutional investors (FIIs, as foreign portfolio investors were then termed) into Indian markets. He suggested that there could be a cap on their investment, a sort of tax.

Reddy was not speaking out of turn. Inflows of foreign currency into the Indian economy mattered a lot to the RBI. With the previous decade having seen the East Asian crisis, a currency crisis that had singed India too, the Governor had reasons to be concerned. Of course, whether a cap or taxation was the best way to address the problem was open to debate.

As soon as the newswires spread the headlines, finance minister Palaniappan Chidambaram asked his staff to call the business news channels to his North Block office. The minister’s statement to the channels was terse but clear. The government will not impose impose any tax on the FIIs and had no plans to do so either. Moreover, the minister also forced Reddy to retract. The channels ran the news on a continuous loop before the markets opened next morning.

Fast forward to another January, six years later. Speaking at the launch of his collection of speeches, Global Crisis, Recession and Uneven Recovery, it was Reddy’s turn to return the favour. “Yes, the RBI is independent. I have the permission of my Finance Minister to say so”, he said while describing the scope of independence that the RBI exercised. Chidambaram, who released the book, was more diplomatic but acknowledged that differences between the finance ministry and RBI were inevitable, at times. Hindu Business Line reporting on the event termed it “Embrace of the Gladiators”.

As Reddy himself remarked at the event, in terms of law, RBI has very little independence but “in terms of actual functioning, there has been considerable freedom”. It is a question of circumstance. This is an important caveat. Chapter II, clause 7 (1) of the RBI Act of 1934 notes “The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest”. The Bank only enjoys the role of a principal-agent relation with the central government. It has no autonomy, to speak of but freedom within those constraints, subject to fulfilling its task. And when it has not done so, the government has stepped in to issue directions. It has happened earlier; it will happen in future, too.

The first of these occurred when Mrs Indira Gandhi nationalised banks in 1969, as set out in Volume III, History of the Reserve Bank of India. Then RBI Governor L.K. Jha simply carried the can. The book states clearly: “Within the Reserve Bank, the first discussion on nationalization took place on 23 July, [the bank nationalisation ordinance had been issued five days earlier on 19th July] at a meeting of the Committee of the Central Board. The proceedings were not recorded except for a cryptic remark: ‘There was a brief discussion on the implications of bank nationalization ordinance.’ ”

Thirty-six years later, when Chidambaram rapped the Governor’s knuckle on how much money from abroad the Indian economy could absorb, he was reiterating the same principle.

However, it was not Chidambaram who finally made it clear who is the boss in the financial family. That honour is reserved for Pranab Mukherjee, who stepped into his shoes briefly. In the guise of intervening in a dispute between the insurance sector regulator Insurance Regulatory and Development Authority (IRDA) and the markets regulator, Securities and Exchange Board of India (SEBI), Mukherjee issued an ordinance in June 2010 that effectively ended RBI’s role as the first among equals in the financial sector. The ordinance, replaced eventually by an Act, the Securities and Insurance Laws (Amendment and Validation) Act made the finance minister the head of a committee to decide on any dispute between financial sector regulators. Mukherjee’s ordinance drew upon the central government’s power vis a vis the RBI. The principal had decided that it would change the role of the agent. Whither autonomy?

The Ordinance did more. Till that point, it was a given that RBI’s operational freedom to set rules for the financial sector would override that of other regulators in the sector. It would and could, for instance, keep the markets for currency derivatives under its control, even though SEBI, rightfully, felt that as the regulator for all financial markets, the domain ought to be its. After the passage of this Act, the RBI would never be able to assume that its decision would prevail.

Mukherjee followed up the Act with the largest-ever plan to redraw the autonomy of the RBI. The Financial Sector Legislative Reforms Commission (FSLRC) which he set up (though Chidambaram had done the initial spade work) has been categorical about a vastly reduced remit for the RBI. Instead of a full service regulator, RBI would only decide the monetary policy, supervise banks and the payments system. All financial markets would pass under the rubric of the United Financial Agency. It got praised and panned liberally—as Reddy made clear in this interview; “the MoF should be a coordinator and not an arbitrator between regulators”.

The next nail in the autonomy debate was the finance ministry’s decision to set RBI an explicit inflation targeting role. The decision was steered by Governor Raghuram Rajan when he set up the committee under deputy governor Urjit Patel to provide the conceptual framework.

Rajan and his predecessor Duvvuri Subbarao had second thoughts on the FSLRC recommendations in several areas, though they had supported the thrust of the FSLRC report prior to becoming governors. Even the setting up of the Monetary Policy Committee, one of the objectives set by FSLRC, got into controversy. The composition of the proposed seven-member committee was changed to six after long negotiations between Rajan and the finance ministry.

The running theme through all these episodes where the finance ministry and the RBI squared off is RBI autonomy. Demonetisation, albeit one of the most difficult challenges for the RBI in its over 75-year-old history, is thus a red herring. As I had argued earlier, it is RBI’s lack of attention to some management issues that had left it gasping in the demonetisation exercise.

The assorted voices that have become vocal are instead reviving an old battle. And in most of these battles Mint Road has come out the worse. To call this episode as the first time where RBI autonomy has been challenged as the RBI employees union has claimed, is consequently, disingenuous.

So, Reddy is right that he’s fought hard to retain RBI’s space. Yet he is not the only one. He is also not right that he always succeeded. And he is certainly not right, that the demonetisation is an episode where RBI’s autonomy has been questioned.

Previous governments have instead dealt real blows to the autonomy of the RBI Governor. Asking RBI to manage the currency crisis does not question its role by a long shot. Indeed by the time the full architecture envisaged by Indian Financial Code is unveiled, RBI would have shrunk drastically, anyway.