Central banks and the rule of law

Context: Two recent developments in India underline the need to inspire the rule of law in the functioning of central banks (CBs).

What are these two recent developments and the reasons behind it?

The Monetary Policy Committee (MPC) normally makes policy announcements in line with a predictable schedule. But on May 4, it went off the schedule and increased the policy rate by 40 basis points. Markets were surprised by this and the 10-year government bond yield jumped. The inflationary outlook had not changed between the last MPC meeting of April 8 and the off-schedule announcement of May 4. So, why the RBI did this?

– One possibility relates to the exchange rate. Over the last year, the US dollar has appreciated by 8%. Holding other things constant, this means the normal rupee depreciation should be about 8%. The RBI seems to be countering this by selling reserves, and by responding to the large hike by the US Fed that was coming a few hours after the RBI’s surprise announcement.

The second development is the public statement of the co-founder and chief executive officer of a NASDAQ-listed crypto exchange that his company disabled the Unified Payments Interface (UPI) system from its platform due to informal pressure from the RBI. The company had earlier announced that they would build systems in India whereby investors could receive/send money using UPI. The National Payments Corporation of India (NPCI) came out with a negative press release, and all Indian banks refused to do business with the exchange. Such ostracisation by banks, with or without the involvement of the RBI, is tantamount to violating the Supreme Court order striking down the RBI ban on cryptocurrency.

What are the recommendations of FSLRC wrt integrating rule of law in and independence of financial agencies?

Financial Sector Legislative Reforms Commission (FSLRC) recommended three pillars:

Pillar one- Regulation-making function of all SRAs, which is relevant in India as the RBI has been given the role of financial regulation for the payments and banking industries (and some other components). There is a problem of democratic legitimacy when unelected officials write law.

– The solution lies in technical expertise that is displayed, in consultation and control of all regulation-making process by an expert board where private persons have a majority. All these elements address the problem of “the administrative state”, the rule of officials, and generate legitimacy in the writing of law by the agency.

Pillar two – Executive functions of investigations, prosecutions and punishments. There is a case for political independence here. It should not be possible for the political masters to trigger punishments for their enemies.

– This requires processes, encoded in parliamentary law, which enshrine separation of powers, define and limit the powers of investigation, require due process in prosecutorial decisions, hygiene in how hearings take place, etc.

Pillar three: Monetary Policy is defined as the control of the short interest rate of the economy. There is a role for political independence here.

– It should not be possible for the political masters to trigger a rate cut prior to a tough election. Most of the developed world has gravitated towards an independent expert MPC structure for the discharge of this function.

What are some other issues with the functioning of RBI?

The mandate of RBI at present has an improbable combination of functions, ranging from running an exchange to investment banking for the Union government and state governments.

The sheer scope of this mandate induces innumerable conflicts and rule of law concerns.

Source: This post is based on the article “Central banks and the rule of law” published in Business Standard on 19th May 22.