Raghuram Rajan: The independence of the central bank
Remarks by Dr Raghuram Rajan, Governor of the Reserve Bank of India, at St. Stephen's
College, New Delhi, 3 September 2016.
* * *
Good afternoon. It is great to be invited to speak at St. Stephen's College. In 1980, I toyed
with the idea of joining my best friends in applying for admission to the BA in Economics
here. Because I had worked so hard for the IIT exam, however, I succumbed to the sunk cost
fallacy and studied Electrical Engineering. I don't regret a moment of that misspent youth but
I hope you will grant me temporary membership of your club today!
Over the last few weeks, I have outlined the RBI's approach to inflation, distressed debt,
financial inclusion, banking sector reform, and market reform. Today, I'd like to first discuss
why central banking is not as easy as it appears (just raise or cut interest rates!) and why it
needs decisions, sometimes unpopular or hard-to-explain ones, to be made under conditions
of extreme uncertainty. This will then lead in to my arguments about why we need an
independent central bank.
To set the stage, think back to the summer of 2013. After Chairman Bernanke hinted that the
United States might end quantitative easing, capital started flowing out of emerging markets,
especially those deemed to have weak macroeconomic fundamentals. India, with high fiscal
deficits, high current account deficits, and near double digit inflation, was deemed one of the
"Fragile Five" countries. The rupee plunged as debt investors scurried to safe havens. The
talk in international markets was that the rupee could reach a hundred to the dollar, and
some international commentators, knowing little about India, talked about an Indian "crisis".
In early August 2013, I was appointed to succeed Dr. Subbarao as Governor of the Reserve
Bank of India. From the Finance Ministry, I went to the RBI to prepare for the transition.
We had to get back the confidence of international investors. And that meant convincing
them that India was still an attractive place to invest in, despite the then paralyzed economic
reforms. Furthermore, they had to believe that the rupee would retain its value going forward.
So I went from room to room asking RBI staff what they were working on, and what ideas for
financial sector reform they were prepared to contemplate. We packaged our ideas into a
reform program over the medium term that could change the narrative on India, especially
given the fiscal reforms the government had initiated.
To bolster the value of the rupee, we had to give investors more certainty that future inflation
would be low. After all, it was primarily India's higher inflation with respect to the rest of the
world that led to periodic abrupt falls in rupee value. Then Deputy Governor and now my
successor, Dr. Urjit Patel, agreed to prepare a report on how we could move to a new
inflation-focused monetary regime. That would help very much in the medium term, but in the
short run we had to establish that we were not heading towards crisis. The easiest way to
demonstrate that was to show we could raise plenty of foreign exchange.
My thought turned to an iffy scheme that had been presented to me in North Block.
Essentially, bankers had told us they would bring plenty of dollars in as FCNR(B) 3 year
deposits, which they would convert to rupees and invest in India. In return, they wanted a
cheap rate at which they could convert rupees back into dollars 3 years hence. So long as
the Reserve Bank could be trusted to provide the forward dollars, this was a great deal for
the banks - they got rupee interest income and a guaranteed cheap price at which they
could swap maturing rupees back into dollars.
As I have said elsewhere, I did not think much of this scheme when I first heard of it,
dismissing it as a clever ploy by bankers to get a subsidy from a country in trouble. But it
refused to go away, and my old colleagues at the finance ministry thought it worth a try as
the crisis of confidence worsened.
I too became more favourable after thinking carefully about it. First, I weighed the balance of
risks. If we did not move the rupee back to fundamental value, every 1 rupee rise in the
dollar-rupee rate would costs us Rs 40,000 crores more in import costs. Assuming the rupee
was undervalued by Rs 3 for a couple of years, this would mean a loss of lakhs of crores to
national income. In contrast, even if the scheme was wildly successful in attracting inflows,
the payout would only be in the tens of thousands of crores. Of course, there might be
cheaper ways of restoring confidence but it was not clear what they were.
Discussions with my soon-to-be colleagues at the RBI threw up another rationale. The
bankers who proposed the scheme were saying that if the money came in, the rupee would
appreciate, and it would cost us less to offer the forward subsidy. This was self-serving and
not quite right. What was right was that if we changed the narrative on India, and the rupee
continued appreciating between the point when the money came in and the point we covered
our liabilities to the bankers in forward markets, it would cost us significantly less. In fact, we
might even make money on the deal. But what if the rupee plunged after the dollars flowed
in? There were no certainties here.
The bottom line was that the scheme was a measured risk, with a probability that the RBI
would lose money, a certainty that the bankers would make money, but also a reasonable
chance that the country would be significantly better off. Having obtained the concurrence of
the Finance Ministry, the RBI Governor had to decide.
Policy making is about deciding in the face of uncertainty, after weighing the alternatives as
best as one can. On the day I was to take over, with no good options on the table, I had to
choose the least bad one. I decided to go ahead.
The afternoon of September 4th 2013, we announced the package of measures. The
FCNR(B) scheme drew in $26 billion, more than any of us anticipated. But more important,
confidence picked up, the rupee continued strengthening beyond when the money came in,
partly because the global investor mood as well as Indian electoral projections also changed,
and we covered our forward swaps cheaply. We are fully covered for outflows today and
have made money on the deal. The rupee has been one of the most stable emerging market
currencies since then.
Of course, in hindsight it seems like it was the obvious thing to do because it worked. The
reality is we will never know for certain! Perhaps it was the other elements of the package,
perhaps it was everything together. Autobiographies are always written as if the author had it
all mapped out with perfect foresight, ignoring the risks and uncertainties at that time. This
misleads, as much as those beautiful photographs of a past holiday abstract from the heat,
the mosquitoes, and the lack of connectivity. Policy making invariably involves taking
measured risks in the face of uncertainty.
Clearly, we do not want to be in the position we were in August 2013 ever again.
Macroeconomic stability is of paramount importance for India. Equally clearly, drawing from
this experience, the central bank must have the resources, the knowledge, and the
professionalism to act when the situation warrants. In the rest of this talk, I want to explain
why this means India needs a strong and independent RBI to ensure macroeconomic
stability. Then I will discuss what I think is needed to ensure such independence going
forward.
The need for macroeconomic stability
Growth is good, but growth with stability is better, especially in a poor country where so many
people live at the margin. For the RBI, it means ensuring growth does not exceed our
potential, adopting prudential policies that reduce our risk, and building sufficient buffers that
the country is protected against shocks.
Having your cake and eating it too: interest rates and the exchange rate
This mission, however, exposes the central bank to criticism. If we try and bring down
inflation, interest rates will remain higher than borrowers desire. If inflation comes down, the
currency will depreciate less than some exporters desire. If we push the banks to clean up,
banks may be less tolerant towards habitual non-payers. Whatever we do, someone will
object. The RBI then becomes the favorite scapegoat for underperformance - if exports are
not picking up, it is because interest rates are too high and because the exchange rate is too
strong.
Unlike the complainants, the RBI does not have the luxury of economic inconsistency. If we
start buying dollars in a big way to depreciate the exchange rate, we will be able to buy fewer
government bonds if we are to maintain control over liquidity. The consequence will be
higher interest rates in bond market. Moreover, the depreciated exchange rate will mean
higher inflation, which in turn will mean higher policy interest rates given the inflation
objective the government has set for us. Once again, this means higher interest rates. Just
look at Brazil or Russia to understand you cannot have a significantly depreciated exchange
rate and lower interest rates at the same time if you want stable growth!
First year economics: there is no free lunch. RBI dividend policy
A fundamental lesson in economics is there is no free lunch. This can be seen in the matter
of the RBI dividend: Some commentators seem to suggest that public sector banks could be
recapitalized entirely if only the RBI paid a larger dividend to the Government. Let me explain
why matters are not so simple. If what follows is complicated, trust me, it is. But pay
attention, students, especially because it is about your money. I am sure you will understand.
How does the RBI generate surplus profits? We, of course, print the currency held by the
public, as well as issue deposits (i.e. reserves) to commercial banks. Those are our fixed
liabilities. As we issue these liabilities, we buy financial assets from the market. We do not
pay interest on our liabilities. However the financial assets we hold, typically domestic and
foreign government bonds, do pay interest. So we generate a large net interest income
simply because we pay nothing on virtually all our liabilities.
Our total costs, largely for currency printing and banker commissions, amount to only about
1/7th of our total net interest income. So we earn a large surplus profit because of the RBI's
role as the manager of the country's currency. This belongs entirely to the country's citizens.
Therefore, after setting aside what is needed to be retained as equity capital to maintain the
creditworthiness of the RBI, the RBI Board pays out the remaining surplus to the RBI's
owner, the Government.
The RBI Board has decided it wants the RBI to have an international AAA rating so that RBI
can undertake international transactions easily, even when the Government is in perceived
difficulty - in the midst of the Taper Tantrum, no bank questioned our ability to deliver on the
FCNR(B) swaps, even though the liability could have been tens of thousands of crores.
Based on sophisticated risk analysis by the RBI's staff, the Board has decided in the last
three years that the RBI's equity position, currently around 10 lakh crores, is enough for the
purpose. It therefore has paid out the entire surplus generated to the Government,
amounting to about Rs 66,000 crores each in the last two years, without holding anything
back. This is of the order of magnitude of the dividends paid by the entire public sector to the
Government. In my three years at the RBI, we have paid almost as much dividend to the
government as in the entire previous decade. Yet some suggest we should pay more, a
special dividend over and above the surplus we generate.
Even if it were legally possible to pay unrealized surplus (it is not), and even if the Board
were convinced a higher dividend would not compromise the creditworthiness of the RBI,
there is a more fundamental economic reason why a special dividend would not help the
Government with its budgetary constraints.
Here's why: Much of the surplus we make comes from the interest we get on government
assets or from the capital gains we make off other market participants. When we pay this to
the government as dividends, we are putting back into the system the money we made from
it - there is no additional money printing or reserve creation involved.1 But when we pay a
special dividend to the government, we have to create additional permanent reserves, or
more colloquially, print money. Every year, we have in mind a growth rate of permanent
reserves consistent with the economy's cash needs and our inflation goals. Given that
budgeted growth rate, to accommodate the special dividend we will have to withdraw an
equivalent amount of money from the public by selling government bonds in our portfolio (or
alternatively, doing fewer open market purchases than we budgeted).
Of course, the Government can use the special dividend to spend, reducing its public
borrowing by that amount. But the RBI will have to sell bonds of exactly that amount to the
public in order to stick to its target for money creation. The overall net sale of Government
bonds by the Government and the RBI combined to the public (that is, the effective public
sector borrowing requirement) will not change. But the entire objective of financing
Government spending with a special RBI dividend is to reduce overall Government bond
sales to the public. That objective is not achieved!
The bottom line is that the RBI should transfer to the government the entire surplus, retaining
just enough buffers that are consistent with good central bank risk management practice.
Indeed, this year the Board paid out an extra 8,000 crores than was promised to the
Government around budget time. Separately, the government can infuse capital into the
banks. The two decisions need not be linked. There are no creative ways of extracting more
money from the RBI - there is no free lunch! Instead, the Government should acknowledge
its substantial equity position in the RBI and subtract it from its outstanding debt when it
announces its net debt position. That would satisfy all concerned without monetary damage.
If what I have said just now seems complicated, it is, but it is also the correct economic
reasoning. Similar detailed rationales lead us to turn down demands to cut interest rates in
the face of high inflation, to depreciate or appreciate the exchange rate depending on the
whim of the moment, to use foreign exchange reserves to fund projects, to display
forbearance in classifying bad loans or waived farmer loans as NPAs, and so on...
We have been tasked with a job of maintaining macroeconomic stability, and often that task
requires us to refuse seemingly obvious and attractive proposals. The reason why we have
to do what we have to do may not be easy for every unspecialized person, even ones with
substantial economics training, to grasp quickly. Of course, we still must explain to the best
of our ability but we also need to create a structure where the public trusts the central bank to
do the right thing. This then is why we need a trusted independent central bank.
Central bank independence
In this environment, where the central bank has to occasionally stand firm against the highest
echelons of central and state government, recall the words of my predecessor, Dr. Subbarao,
when he said "I do hope the Finance Minister will one day say, 'I am often frustrated by the
Reserve Bank, so frustrated that I want to go for a walk, even if I have to walk alone. But
thank God, the Reserve Bank exists.'" I would go a little further. The Reserve Bank cannot
just exist, its ability to say "No!" has to be protected. At the same time, the central bank
cannot become free of all constraints, it has to work under a framework set by the
Government. This requires a number of actions.
Outline responsibilities of the RBI
When the responsibilities of the RBI are fuzzy, its actions can continuously be questioned.
Instead, if the constitutional authorities outline a framework for the responsibilities of the RBI,
it can take actions consistent with those responsibilities and be held to outcomes. The
inflation objectives recently set for the RBI by the Government are an example of what is
needed. Critics can lambast the RBI if it fails continuously to meet the objectives, but if they
want it to lower interest rates even when the RBI barely meets its objectives, they should
instead petition the Government to change the objectives.
Similarly, the RBI Board has adopted a risk management framework which indicates the level
of equity the RBI needs, given the risks it faces. The dividend policy of the RBI then becomes
a technical matter of how much residual surplus is available each year after bolstering equity.
Frameworks thus reduce the space for differences.
The RBI's role in macroeconomic stability is, however, still fuzzy. While RBI clearly has
responsibility for the safety and soundness of credit institutions and the stability of the
external account, there are some areas that are hazier. For example, with an inflation
focused framework, the RBI's ability to be accommodative depends on fiscal prudence from
the center and states. How much should the RBI warn on fiscal profligacy, including the
building up of contingent liabilities, and when should such warning be seen as interfering in
the legitimate decisions of the elected representatives of the people? This is an area where
clarity would be useful.
Strengthen oversight
The freedom the RBI has to take operational decisions such as the FCNR (B) swap
arrangement, albeit invariably in consultation with the Finance Ministry, is important.
However, there are always government entities that are seeking oversight over various
aspects of the RBI's activities. Multiple layers of scrutiny, especially by entities that do not
have the technical understanding, will only hamper decision making. Instead, the
government-appointed RBI Board, which includes ex-officio government officials as well as
government appointees, should continue to play its key oversight role. In this regard, all
important RBI decisions including budgets, licenses, regulation, and supervision are now
either approved by the Board or one of its sub-committees. Vacancies in the RBI Board,
which have remained unfilled for many months now, should be filled quickly so that the full
expertise and oversight of the Board can be utilized.
It is also important that Parliament understand what the central bank is doing. The Governor
and Deputy Governors interact regularly with various parliamentary committees, but we have
also initiated a six-monthly interaction with the Parliamentary Standing Committee on
Finance, where the Governor reports on the activities of the Bank, and the Committee offers
its views and concerns.
Rank of RBI Governor
There is a reason why Central Bank Governors sit at the table along with the Finance
Ministers in G-20 meetings. It is that the Central Bank Governor, unlike other regulators or
government secretaries, has command over significant policy levers and has to occasionally
disagree with the most powerful people in the country.
It is dangerous to have a de facto powerful position with low de jure status. Today, the RBI
Governor has the salary of the Cabinet Secretary. He or she is appointed by the Prime
Minister in consultation with the Finance Minister. The Governor's rank in the government
hierarchy is not defined but it is generally agreed that decisions will only be explained only to
the Prime Minister and the Finance Minister. There is an informal understanding in India that
the Governor has the room to make needed decisions. In the interests of macroeconomic
stability, none of this should be changed, though if these issues are ever revisited, there may
be some virtue in explicitly setting the Governor's rank commensurate with her position as
the most important technocrat in charge of economic policy in the country.
Communication
I do not fool myself into thinking that reporters and TV cameras follow me around everywhere
because I am a magnetic speaker. They follow RBI Governors around because they may
offer market-moving information on policy. Fortunately, I have escaped unintentionally saying
anything that moves markets.
At the same time, while different RBI Governors have different approaches to
communication, no one can dispense with it. Unlike a developed country, where the Central
Bank Chairman can offer periodic Delphic pronouncements about the course of monetary
policy, and occasionally remonstrate with Parliament or the government about the course of
fiscal policy, in our developing democracy the RBI Governor has to continuously make the
case for the actions the central bank is taking, including the many structural reforms that are
underway.
Indeed, communication is as much about educating as it is about informing. For instance,
even as I explained to entrepreneurs and retail borrowers why interest rates were not falling
faster, I had to use the price of dosas to explain to pensioners why they were actually better
off earning lower nominal but higher real interest rates. Public understanding can help ease
the way for reforms, as well as increase support for policies. The RBI Governor therefore has
to explain again and again.
Occasionally, of course, the Governor has to warn about the dangers of certain courses of
action or certain tendencies in the economy for growth and macroeconomic stability. Finally,
the Governor is also a role model for the youth in this country, and should therefore not duck
the responsibility to urge them to follow the highest standards of citizenship when he or she
is invited to speak directly to them.
Conclusion
My parents could give me a wonderful childhood and a great education in this country. We all
grow up with such debts, and public service is a way to partially repay them. However, the
last few years, working with dedicated colleagues at the RBI and the Finance Ministry, have
been so fulfilling that I think I have received rather than given. I believe we have undertaken
important reforms in payments, in banking, in the conduct of monetary policy and liquidity
management, in financial markets, and in the resolution of distress, as well as within the RBI
itself. Only time will tell whether they will have lasting impact, but I tried to do the best job I
could, without fear or favor. This is the last public speech I will give in India for a while - my
successor has to take over the RBI's communication and I want to get out of his way. It has
been an honor to work for the country and especially to talk to people like you, its future.
Thanks for listening to me.