No proof required: Making RBI accountable

No proof required: Making RBI accountable

Context

The first year of operation of the Monetary Policy Committee has imposed considerable costs on the economy with very few benefits. What explains its decisions?

Facts today

The CPI inflation this fiscal year, at 2.7 per cent, is the lowest in the last 40 years, real policy rates are the highest in the last 14 years and industrial production, the fifth lowest in 21 years. GDP growth is at sub-6 per cent levels, from an 8.5 per cent level just two years ago

Controversial decision of the MPC to stubbornly raise the real repo rate

One of the most cited reasons for the RBI being so obstinate in not lowering real repo rates is that the MPC, being a new institution, had to show its independence from the Centre. Then why, just one month into the job, did the MPC cut rates in October 2016?

MPC defended its action as follows: Last month (August 2016) inflation data came in at 5 per cent, the repo rate is at 6.5 per cent, and unlike Raghuram Rajan, the MPC believes that the appropriate real repo rate for the Indian economy, in a world of declining and low inflation, is 1.25 per cent, some 50 basis points lower than the Rajan rate

Possible Explanation: One popular explanation for the MPC acting in this high-handed manner is that it was “forced” into the decision of demonetisation, much against its wishes. However, it is very unlikely that RBI Governor Urjit Patel was not told about the impending demonetisation — we know that Rajan knew, and opposed, it. We can easily infer that if Patel had opposed demonetisation, he would not have accepted the job.

Gainers

Gainers — behind the MPC scene:

• It is easy to identify the winners with real rates being the third highest in the world (behind Brazil and Russia)
• The regulator (RBI) sets real interest rates so high that bankers find it worthwhile to safely loan to the government by buying more government securities than mandated by the SLR
• Presently, the banks’ share of government securities is about 10 percentage points higher than mandated

Foreign Investors

The second group that benefits are foreign investors: They borrow at less than 2 per cent in their home countries, buy Indian government bonds (thanks to the MPC) yielding an exorbitant 7 per cent, do not hedge exposures, and laugh their way to the bank.

Political Opposition

• The third group that benefits from high real interest rates is the political Opposition.
• You have to be living in a cave not to have noticed the spring in the step of every Opposition politician since the announcement, end of August, of 5.7 per cent GDP growth
• This ammunition is just in time for state elections
•  It is universally-acknowledged that PM Narendra Modi’s popularity remains very high; also universally accepted is the fact that the only way for the Opposition to dent this popularity is if India has slow GDP growth, and low employment growth
• And it is also universally acknowledged that employment and GDP growth are correlated — that is high real interest rates are an important cause of low GDP growth.
• Not so curiously, the political opposition failed to mention RBI policy in their critical comments about the effect of demonetisation on GDP growth. The opposition chose to mention the tail (demonetisation) affecting growth, and not the biggest elephant (high interest rates) obstructing GDP growth.

Losers from MPC actions

• Losers from MPC policy are the Indian economy, the Indian government, and the politicians in charge of the economy
• In addition, interest payments are affected by RBI policy, and such payments account for over 96 per cent of the budgeted fiscal deficit for 2017-18; in 2015/16, they accounted for “only” 83 per cent.

Conclusion

The independence of the RBI, and MPC, is sacrosanct. But other countries have also encountered the problem of an institution not adhering to its mandate, going astray as it were. The most prominent example of an independent institution being made answerable to the people is the US FED