Regulation confusion

The Financial System Stability Assessment Update for India, issued by the IMF and the World Bank, finds that the regulatory regime for the financial sector is largely in compliance with international standards, but it shines a light on the need for greater independence for regulatory agencies. In this context, the RBI Act, and thus the RBI, is fundamentally flawed in two respects. The first problem is monetary policy. The government has contracted monetary policy out to the RBI. But in return for wielding that power, what is the outcome the RBI is responsible for? That has not been defined. Unelected officials cannot be given power without accountability. The strategy in use all over the world is that the ministry of finance writes a letter to the central bank in which a numerical inflation target is established, and the latter is held accountable for achieving it. If this were done, the persistent inflation crises that India suffers from would not come about, and it would obviate several distortionary measures politicians take in an emergency to try and control prices.

The second problem with the RBI has to do with conflicts of interest. The RBI regulates banks, so it has a bias in favour of keeping interest rates low in order to hide the problems in banking, which leads to high inflation. The RBI is investment banker to the government, so it has a bias in favour of keeping interest rates low in order to easily hawk government bonds (which, too, leads to high inflation). There are several other functions, all clashing with each other. The incoherence of policy and communication at the RBI is often attributed to staff quality. It may reflect, instead, the impossibility of achieving the array of objectives that are sought to be addressed.

The RBI Act was drafted in 1934 as a temporary measure. The RBI is now nearly 80 years old. It may be time to rewrite the RBI Act. Its British authors did not design the RBI as a monetary authority for a modern market economy with a $2 trillion GDP. The knowledge available globally on how to do monetary policy was also not in place at the time. Indeed, the UK wrote a brand new legislation for monetary policy in 1997. Yet, India is stuck in the groove etched in 1934.

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