‘Scoop’ Without A Whoop: DeMo Could Never Have Been RBI’s Call; It was Government’s

Much has been made of a newspaper “scoop” which indicated that the demonetisation (DeMo) decision was based not on the Reserve Bank of India’s own conclusions but on the “advice” of the Narendra Modi government. Since many former governors, from Bimal Jalan to Y V Reddy, have since piped in on the central bank’s alleged lack of autonomy, it is worth looking at the issue in depth.

The “scoop” lay in the fact that The Indian Express got hold of the note written by the RBI to the parliamentary committee on finance ahead of the rest of the media, and not in the revelation that it was the government which advised the RBI on DeMo. The RBI note says that on 7 November it was asked by the government to consider the demonetisation of Rs 500 and Rs 1,000 notes at its board meeting the next day in order “to mitigate the triple problems of counterfeiting, terrorist financing and black money…”.

The Express then went on to editorialise its own “scoop”. It used Y V Reddy’s observations about the “credibility and reputation of the central bank” to suggest the demonetisation itself was some kind of encroachment on the RBI’s autonomy.

This is bunkum. The RBI does not have a mandate that is independent of what the elected government of the day deems to be its mandate, a point emphasised by an Economic Times editorial today (11 January). The editorial notes, that “the Reserve Bank of India or any other central bank had the duty to carry out the will of the sovereign, as articulated by the duly elected government of the day. Its job is to carry out that mandate well, planning and implementing its execution in an optimal fashion.”

As far as DeMo is concerned, there is no way the idea could have come from the central bank, and even if it had, it needed the government’s sanction. DeMo is a political and economic policy decision, and the RBI’s role was to give the right advice, if sought, and implement the policy to the best of its ability.

So the real question is whether the RBI gave the Modi government the right advice, whether this advice was heeded, and whether, after being given the mandate to exchange old notes for new, it did the job well or badly.

It is also worth expanding a bit on the question of the central bank’s autonomy. Real autonomy is required, for without it, the RBI cannot deliver even what the government wants it to do.

Take the question of monetary policy and rate setting. The RBI’s (and now the Monetary Policy Committee’s) autonomy has to be real for it to deliver on the government’s inflation or growth targets. The autonomy flows from the government’s policy goals, and is not independent of this. Contrary to what some economic analysts assume, it does not help even the government to have a “yes man” at the central bank. In a political economy, governments need external validation for their policies, and also someone to blame for hard times, and the RBI serves this purpose. If it becomes obvious that the RBI has no autonomy, it does not serve the government’s objectives too.

The US Fed’s autonomy flows from the Federal Reserve Act, which states that “the Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

While the Fed’s mandate is cast in stone, in India, the RBI’s mandate comes from an elected government, and its mandate right now is to contain retail inflation around 4 per cent over the medium term, plus or minus 2 per cent. But growth is also part of this mandate. Autonomy is needed to ensure that it delivers on this goal, and not as a benefit in itself. If these goals change, or if the government of the day decides that the central bank’s goals ought to be something else, the RBI cannot claim the right to conduct monetary policy according to its own best judgment.

More specifically about DeMo, it was entirely the government’s call. The government has accountability to the people, not the RBI, and if DeMo is judged to be a failure, the government will pay a price, not the RBI.

The most interesting bit about the Express “scoop” is not that DeMo was the government’s idea, but the kind of ideas the Reserve Bank itself was floating. Apparently, sometime in October 2014, five months after Modi was elected and pledging to clean up black money, the Raghuram Rajan-led RBI was proposing the issue of Rs 5,000 and Rs 10,000 notes as inflation had dented the value of the rupee since the last high-denomination note (Rs 1,000) was introduced 15 years ago.

The RBI was on another planet on this one. The lesson for the central bank is that it should not be living in an ivory tower, proposing ideas far removed from the needs of the political economy or a politician’s mandate.

The RBI’s autonomy is a “negotiated autonomy”, where it creates space for itself based on government-mandated objectives.

Another point is also worth making. Ask yourself: if the net result of DeMo is more financial inclusion, and more formalisation of the economy, will monetary policy work better or more badly?

If DeMo, and later GST, steadily expand the frontiers of the banking and financial system, will RBI interest rate policies have better traction or less traction?

The net result of DeMo will be a strengthening of the RBI’s ability to influence the trajectory of inflation and growth more than it is capable of now. Real autonomy flows from real power.