Y V Reddy: Autonomy of the central bank - changing contours in India
The Second Foundation Day Lecture by Dr Y V Reddy, Deputy Governor of the Reserve Bank of
India, at Indian Institute of Management at Indore on October 3, 2001.
Dr. Reddy is grateful to Shri Indranil Bhattacharyya, Shri Kaushik Bhattacharya, and Dr. A. Prasad for
their valuable assistance.
The references for the speech can be found on the Reserve Bank of India's website.
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Dear Dr. Saxena, distinguished faculty, respected visitors, and young friends,
I am grateful to the organisers for giving me this opportunity to be here with you today to deliver the
Second Foundation Day Lecture. The IIM, Indore has acquired a great standing and high stature
within a short span of four years and the entire credit should go to the support rendered by all, and in
particular, the devotion and dedication displayed by the faculty and students to academic excellence.
It is not easy to select a topic for today's lecture; a topic that would interest the best and brightest of
young persons, that would be of contemporary relevance and one on which something forward looking
can be explored. After some deliberation, the subject "Autonomy of the Central Bank: Changing
Contours in India" has been chosen.
During the ten years of economic reform, Reserve Bank of India (RBI) has emerged as a respected
and significant institution in public policy and its changing role as a central bank deserves to be
appreciated. In fact, a historic agreement in 1997 between Government of India and the RBI on the
termination of the system of automatic monetisation and introduction of a system of Ways and Means
Advances constitutes a watershed in public policy governing their mutual relationship. Amendments to
the legislation relating to the RBI and banking announced by Finance Minister in the budget speech for
2000-2001 and subsequent submission of draft legislations by the RBI are indicative of the evolving
institutional changes. The issues of transparency and accountability governing their operations with
each other have been addressed by Advisory Groups on Transparency in Monetary and Financial
Policies headed by the former RBI Governor, Mr. M. Narasimham (September 2000) and on Fiscal
Transparency by former Finance Secretary, Mr. M.S. Ahluwalia (June 2001). There have also been
some deliberations on the issue of appropriate provisions relating to the RBI, in the context of ongoing
review of Constitution of India by the Commission appointed for the purpose a year ago. Hence, there
is merit in taking a view on the broader issue of independence of the central bank in India, so that the
process of change is negotiated smoothly and in a consistent form, thus avoiding the danger of what
may be termed as "disjointed incrementalism" in reform through ill-defined goals.
The lecture will be in three parts. The first one defines central banking, and its independence, while
providing theoretical and empirical evidence for and against independence or autonomy (both words
are used interchangeably in this lecture though autonomy and independence could have slightly
different connotations) and explaining difficulties in its measurement. The second part reviews the
Indian experience through recourse to periodisation and makes an assessment of the current
situation. The third section focusses on the emerging issues in India and concludes with some random
thoughts on the autonomy of central banks.
What is central banking?
The central banking functions typically include not only creation of money or more broadly monetary
management, but, also often, management of public debt of Government, regulation and supervision
of banking entities, financing of developmental activities and other associated functions.
While discussing the issue of autonomy, it is necessary to recognise that the function of debt
management is essentially performed by a central bank as an agent of Government and the issue of
autonomy does not arise. In fact, this function could be in conflict with autonomy in the conduct of
monetary policy.
As regards the function of regulation and supervision, the argument for involvement of a central bank
emerges from the role of lender of last resort and the obligation to smoothly operate the payments
system. In this regard, the autonomy that the central bank exercises is no different from autonomy of
any regulator in the financial system.
As far as the developmental role is concerned, close coordination with Government necessarily arises,
which in some ways impinges on autonomy as it is in a way linked to money creation.
What is uniquely relevant for a central bank's independence is its exercise of the power to modulate
the creation of money and the price of money, which impacts on the value of money, both domestic
and external. In this context, the critical issue relates to the degrees of freedom the central bank has in
deciding whether or not to fund the Government's expenditure out of created money.
The view that central banks should be largely independent of political power and that the central bank
credit to government should be formally limited is generally believed to have emerged only in
20th century. It would, however, be inappropriate to conclude that the importance of central bank's
independence was recognised only as recently as 20th century since Napoleon Bonaparte is reported
to have commented in 1806, on Bank of France; "I want the bank to be in the hands of the
Government, but not too much".
As a result of monetary consequences of deficit financing that had afflicted many countries during the
First World War, the international financial community, in a series of Conferences organised by
League of Nations recognised such independence as contributing to price stability. The recent revival
of interest in the subject is attributable to several factors viz. the reforms in centrally planned
economies, the establishment of new European Central Banking arrangements and importance of
price stability in a world characterised by large cross border financial flows.
What is central bank independence?
Central bank independence generally relates to three areas viz. personnel matters; financial aspects;
and conduct of policy. Personnel independence refers to the extent to which the Government
distances itself from appointment, term of office and dismissal procedures of top central bank officials
and the governing board. It also includes the extent and nature of representation of the Government in
the governing body of the central bank. Financial independence relates to the freedom of the central
bank to decide the extent to which Government expenditure is either directly or indirectly financed via
central bank credits. Direct or automatic access of Government to central bank credits would naturally
imply that monetary policy is subordinated to fiscal policy. Finally, policy independence is related to the
flexibility given to the central bank in the formulation and execution of monetary policy.
Recent literature has stressed the difference between goal independence and instrument
independence. Goal independence refers to a situation where the central bank itself can choose the
policy priorities of stabilising output or prices at any given point of time, thus setting the goal of
monetary policy. Instrument independence implies that the central bank is only free to choose the
means to achieve the objective set by the Government. In a recent survey (Fry. M, et al 1999) of
central banks, 40 of the total 56 central banks across a broad range of economies defined
independence predominantly in terms of instrument independence. Of the remaining 16 responses,
many highlighted factors that had implications for the relationship between the Government and the
central bank.
Pros and cons in theory
Three different theories, which are by no way mutually exclusive, have been advanced in support of
autonomy of central banks, viz., dynamic or time inconsistency theory, theory of political business
cycle and the theory of public choice.
First, the most prominent argument for central bank independence is based on the time inconsistency
problem. Time inconsistency arises when the best plan currently made for some future period is no
longer optimal when that period actually starts. In the context of monetary policy, the time
inconsistency problem arises because there are incentives for a politically motivated policymaker to try
to exploit the short-run trade-off between employment and inflation. Expansionary monetary policy
may produce higher growth and employment in the short run, and, therefore, policymakers may be
tempted to pursue this policy, even in the short run although there is no guarantee that there would be
a favourable output impact. In the long run, however, such an expansionary monetary policy will
necessarily lead to higher inflation with deleterious consequences for the economy. In order to solve
the time inconsistency problem, two distinct approaches have been advanced. The 'conservative
central banker approach' postulates the appointment of a conservative central banker whose aversion
to inflation is well known which would result in low inflation because of the economic agents' belief in
the reputation of the central banker. The 'optimal contract approach' postulates the existence of an
optimal contract between the central banker and the Government. The central banker's tenure in office
is conditional upon his performance of achieving low inflation, failure of which would lead to the
repudiation of the contract of tenure. Historically, there are successful examples of both types of
models of central bank independence - while US is often seen as an example of conservative Central
Bank, New Zealand is characterised as a follower of optimal contract approach.
Second, the political business cycle theory studies the interaction between economic policy decisions
and political considerations. The best known prediction of the theory is that the business cycle mirrors
the timetable of the election cycle. Incumbent governments, in general, will use restrictive policies
early in their elected tenure raising unemployment to reduce inflation, as the election approaches. The
theory highlights the tendencies of incumbent governments to generate pre-election booms through
expansionary fiscal policies. Once the incumbents get re-elected, the policy priorities could change
towards inflation control rather than employment generation. In this respect, the theory in a way
highlights the time inconsistency behaviour of governments. As monetary policy affects the economy
with long and variable lags, even if the central bank nullifies the fiscal stimulus through monetary
tightening, its impact would typically be felt during the post-election period when the incumbents may
happen to be back in power.
Finally, the fusion of politics and economics over the last thirty years has resulted in the theory of
public choice, establishing itself as an important proponent of central bank independence. In the
context of reducing budget deficit, the primary solution offered in public choice theory is a
constitutional amendment for a pre-specified stipulation on central bank credit to government.
Nevertheless, in recent years, as a secondary solution to the deficit problem, some public choice
theorists put forward the case of an independent central bank. The basic contentions of these
economists are: unless there are constitutional or institutional constraints to the contrary, a democracy
contains a bias towards deficit finance; thus they operate within the premise that politicians do not
necessarily pursue public interest but are more concerned with their personal or political agenda. In
this context, some economists explicitly talk about central bank independence by providing a solution
which will ensure not only low inflation but also act as an effective institutional constraint.
While the above arguments build up a strong case for central bank independence, the issue has not
been decisively settled and there are powerful forces aligned against according such independence to
central banks.
First, detractors of autonomy argue that an independent central bank lacks democratic legitimacy.
Curiously, such detractors derive strength from Milton Friedman's statement that money is too
important an issue to be left to the whims of central bankers.
Secondly, independence may lead to frictions between the fiscal and the monetary authorities and the
resulting costs of these frictions between monetary and fiscal policy may be somewhat costly for
society, thus inhibiting the development process.
Thirdly, there may be significant divergence in the preference pattern of independent central banks
and the society at large. A strong central bank may impose its outlook on society resulting in a
suboptimal state in terms of economic welfare. Adequate sources of accountability can, however,
counteract and circumvent these problems. In fact, the opinions in this context differ widely on the
relative importance between growth vis-à-vis inflation as objectives of monetary policy.
At a pragmatic level, the basic issue is one of reconciling adequate independence with appropriate
accountability to ensure that central banks are responsive to societal concerns.
Measures of central bank independence
It is difficult to measure the degree of independence of various central banks. It has pointed out that
actual, as opposed to formal independence, hinges not only on legislation but also on several factors
such as informal arrangements with governments, the quality of the personnel in the bank as well as
Government and the personal characteristics of key individuals. Obviously, some other factors are
virtually impossible to quantify. Existing research has, therefore, generally focused primarily on legal
independence, mostly in the industrialised countries. Legal independence measures may be a better
proxy for actual independence in some countries where informal relations are not dominant. Thus,
various proxies may be useful to get a complete picture, since they capture different aspects of
independence.
In quantifying the degree of independence, economists typically assign scorecards on different
aspects of central banking. The final degree of independence is measured as the weighted sum of
'marks' obtained under different heads such as indices of political and economic independence; index
aggregated from a number of basic legal characteristics of central bank charters; index based on
issues relating to composition of board members, frequency of transfers of central bank governors,
etc. Recent attempts made to construct measures of central bank independence using different criteria
and examine correlations among them reveal that the factors that affect central bank independence
are highly diverse and the importance of each of these factors may have weights that vary markedly
across countries, time and circumstances.
The existing indices of central bank independence are clearly incomplete and at best noisy indicators
of actual independence, though this does not mean that they are uninformative. In brief, it is possible
to differentiate between legal independence, informal independence and contextual independence of
central banks.
Central bank independence and economic performance
An inverse relationship between central bank independence and the level of inflation is supported by
most empirical studies during the post Bretton-Woods period. The proponents for central bank
independence generally cite empirical evidences of negative cross-country correlation between
average inflation and the degree of central bank independence. It is, however, possible to question the
veracity of this relationship. As already mentioned, there are significant measurement problems
relating to central bank independence. Furthermore, researchers argue that the causal relationship
observed between central bank independence and low and stable inflation might be influenced by
some other common factors such as the extent of inflation averseness and the credibility that the
central bank enjoys. While many Latin American countries changed the legal and operational
framework, the change was prompted by people's aversion to high and chronic inflation. The causality
between the rate of inflation and the degree of independence of the central bank may be viewed as
bi-directional, since it would be argued that persistent high inflation led to changes in the operational
framework in many countries.
It needs to be emphasised that central bank, independence by itself cannot ensure monetary policy
credibility, which, to an extent, depends on the overall credibility of Government policy as a whole.
Central bank independence is a means, the end being an appropriate division of responsibility
between the monetary and the fiscal authority and policy coordination. There is a need to articulate the
division of responsibility and policy priorities to the economic agents. Such articulation reduces
uncertainties often inherent in economic decisions. If an institutional structure is not in place, there is a
chance that policy coordination would depend entirely upon the personal equations among
policymakers and the risk of it breaking down subsequently with changes in the persons at top can not
be ruled out.
Indian situation: a review
The evolving relationship between the Government and the RBI can be broadly divided into four
distinct phases.
The legislation to set up the RBI was first introduced in January 1927. The enactment, however, was
made after seven years in March 1934. The RBI was set up as a privately owned and managed entity.
The preamble of the Act focused on monetary stability and operations on currency and credit system
in India. During this phase, which may be called infancy and uncertainty, the RBI was virtually
subservient to the dictates of the Government and measures were taken to curb its capacity for
independent actions. In fact, threats were issued to supersede the Bank's Board should it recommend
monetary and exchange rate policies incompatible with the Government's scheme of actions. No
doubt, the outbreak of war also added to the uncertainties.
Shortly after India's independence in 1947, the RBI was nationalised in 1948. The early years were
characterised by a good degree of fiscal rectitude and harmony in monetary and fiscal policy with
areas of potential conflict being minimal. The fact that the rate of inflation was modest compared to
other developing countries during this period is indicative of the success of macro-policy management
and facilitated the task of the RBI in pursuing other developmental activities. During this period, the
RBI was vigorously involved in promoting the institutionalisation of credit to agriculture and industry in
pursuant to the overall objectives of the respective Five-Year Plans. Apart from helping to channelise
credit to agriculture and industry, an important objective of the RBI was the promotion and mobilisation
of savings by reinforcing the foundations of the banking system. This, however, does not mean that
differences between the RBI and the Government over economic policies were totally absent. For
example, the RBI did not approve of the substitution of financial planning by a kind of 'physical
planning'. Once it awoke to the consequences of physical targeting during the course of the Second
Plan, the RBI strove to trim the size of the subsequent Plans to match visible resources. Another
illustration of differences between the Government and RBI culminating in the resignation of Governor
Rama Rau in 1957 is well documented (Balachandran G, 1998).
Another major area of discord between the RBI and the Government in the late 1950s related to the
financing of the cooperatives and the pattern of organisation of the lending agencies. Interestingly,
during the early 1960s, Governor Iengar identified four areas of potential conflict between the Bank
and the central government. These were interest rate policy, deficit financing, cooperative credit
policies and management of sub-standard banks. It may be of interest to note that currently, in the
year 2001, these four areas are still on the top of RBI's concerns.
This phase, from nationalisation of the RBI in 1948 till nationalisation of major commercial banks in
1969, may be considered as maturing of the RBI into a full-fledged professionally managed central
bank, perhaps one of the foremost in developing countries. The mid-fifties, however, did see the
beginnings of serious erosion of autonomy in the monetary policy function due to the emergence of
the system of ad hoc Treasury Bills and automatic monetisation. It was agreed that RBI would
replenish Government's cash balances by creation of ad hoc Treasury Bills in favour of the RBI. The
ad hoc Treasury Bills, which were meant to be temporary, gained a permanent as well as a cumulative
character. Indeed, it became an attractive source of financing Government expenditures since it was
available at an interest rate pegged at 4.6 percent per annum since 1974, i.e., actually at a negative
real interest rate.
The third phase that changed the contour of this relationship started with the nationalisation of major
banks in 1969. While the problems experienced earlier by the RBI persisted to some extent, the
change brought about a curious situation where the Government became owner of a number of banks,
but the supervision of these banks was, in turn, conducted by the RBI which was also owned by the
Government. The situation, however, was not unique to India and was somewhat similar to that of
France. The fundamental factor affecting the relationship was the combined effect of Government's
ownership of major commercial banks and the persistence of high fiscal deficits, which posed serious
problems for prudent monetary management. For easy access of market borrowing, the interest rates
were administered and the Statutory Liquidity Ratio (SLR) requirements of the banking sector were
periodically hiked. In this regard, the nationalisation of banks and transfer of ownership to Government
provided a captive market for the government. Simultaneously, recourse to the RBI credit was also
high, leading to high levels of monetisation. To neutralise the effect of monetisation on the price level,
the RBI, in turn, had to intermittently increase the Cash Reserve Ratio (CRR) requirements of the
banking sector. This phase was charaterised by several features to indicate considerable influence or
dominance of Government over the RBI.
On the basis of one of the criteria (Cukierman, 1992) to measure the degree of independence of
various central banks during the 'eighties, the RBI was ranked marginally below the median level of a
list of about seventy countries (including twenty-one industrialised countries). This represented a
limited degree of statutory autonomy because in general, central banks in developing countries
enjoyed little independence from the Government at this time. As such, the measurements seem to
reflect the intent of the 1948 nationalisation of the RBI, which was to ensure a greater coordination of
monetary, economic and financial policies.
The fourth phase or the reforming phase in the changing contour of this relationship approximately
starts from 1990-91. Major changes in the monetary policy framework took place in many countries
around this time. While people in many developed countries were tired of persistent and high inflation
during the earlier years, the journey of the centrally planned economies towards a market determined
system also began around this time. As a result, the relationship between the central bank and the
government took a new turn in many countries, resulting in the genesis of inflation targeting framework
in a number of economies.
While radical changes were taking place worldwide, the Indian economy during 1990-91 experienced
a severe balance of payments crisis. The crisis was clearly a fallout of the fiscal profligacy during the
Eighties. During the post-reform period, the relationship between the central bank and the Government
took a new turn through a welcome development in the supplemental agreement between the
Government and the RBI in September 1994 on the abolition of the ad hoc treasury bills to be made
effective from April 1997. The measure eliminated the automatic monetisation of Government deficits
and resulted in considerable moderation of the monetised deficit in the latter half of the Nineties. At the
same time, with gradual opening up of the economy and development of domestic financial markets,
the operational framework of the RBI also changed considerably with clearer articulation of policy
goals and more and more public dissemination of vast amount of data relating to its operations.
Partly as a result of such institutional changes in recent years, inflation in India has been moderate
relative to other developing countries despite high fiscal deficit, and most inflationary episodes have
been caused by exogenous supply-side factors. As far as public finances are concerned, the
Government generally relied on domestic sources to finance the deficit. It has been pointed out by
some experts that the RBI, though not formally independent, has enjoyed a high degree of operational
autonomy during the post-reform period. In fact, during the recent period, the RBI enjoys considerable
instrument independence for attaining monetary policy objectives. Significant achievements in financial
reforms including strengthening of the banking supervision capabilities of the RBI have enhanced its
credibility and instrument independence.
Current status
In terms of redefining the functions of the RBI, enabling a movement towards meaningful autonomy,
Governor Jalan's statement on Monetary and Credit Policy on April 19, 2001 is a landmark event.
First, it was decided to divest RBI of all the ownership functions in commercial banking, development
finance and securities trading entities. Secondly, a beginning was made in recommending divestiture
of RBI's supervisory functions in regard to cooperative banks, which would presumably be extended to
non-banking financial companies and later to all commercial banks. Thirdly, the RBI signalled initiation
of steps for separation of Government debt management function from monetary policy. These
measures would enable the RBI to primarily focus on its role as monetary authority and enhance the
possibility of a move towards greater autonomy.
Three other developments in recent years are expected to have far reaching ramifications in the
operational framework of monetary policy in India. The first was the tabling of the Fiscal Responsibility
and Budget Management Legislation, which aims at the medium-term management of the fiscal deficit.
The objective of the legislation is to impose fiscal discipline on Government spending and ensure a
transparent and accountable fiscal system.
The second development was the coordinated endeavour of the Government of India and the RBI to
consider the implementation of International Financial Standards and Codes. Among the ten Advisory
Groups constituted for this purpose, the Advisory Group on Fiscal Transparency (Chairman : Mr. M.S.
Ahluwalia) and the Advisory Group on Transparency in Monetary and Financial Policies (Chairman :
Shri M. Narasimham) have suggested some important changes in the operational conduct of monetary
and fiscal policies and highlighted the need for better coordination between them.
The third relates to the budget speech in February 2000, wherein the Finance Minister had noted that
in the fast changing world of modern finance, it has become necessary to accord greater operational
flexibility to the RBI for the conduct of monetary policy and regulation of the financial system and that
accordingly, he intends to bring to Parliament proposals for amending the relevant legislation.
In this regard, the RBI constituted an Internal Committee to review the existing legal provisions in both
the Reserve Bank of India Act and the Banking Regulation Act so as to bring about suitable
amendments in them to provide sufficient operational flexibility to the RBI for conducting monetary
policy, guiding the development of the financial sector and securing the stability of the financial system
as a whole. The Committee made a host of recommendations that include providing the RBI the
flexibility in respect of monetary policy instruments, supervisory effectiveness, prudential deregulation
and governance of financial markets. It has also recommended further strengthening of institutions in
the light of structural changes due to ongoing reforms and encourage transparency and integrity of
operations. Furthermore, in a liberalised environment, maintaining financial stability is an important
additional objective of policy and the RBI should have the operational maneuverability to manage and
limit the damage on account of volatility/contagion transmitted via the international economy.
Emerging issues
The emerging issues relating to autonomy of RBI can be addressed at several levels.
First, at the level of the Constitution, the RBI finds a place in Entry 38 of List 1 of Schedule VII of the
Constitution of India "subjecting the Bank's policies to the wisdom of the executive and legislative
wings of the Union" (Prasad. R, 2001). There are only a few instances of references to autonomy of
central bank in the Constitution and obviously such a reference is neither a necessary nor a sufficient
condition for ensuring appropriate level of autonomy. Yet there is an influential view such as that
expressed by Dr. N.L. Mitra, formerly Director, National Institute of Law in favour of an appropriate
provision in the Indian Constitution.
Second, at the level of legislative framework, several suggestions have been made to ensure
appropriate autonomy and many of them are under consideration. In particular, proposed Fiscal
Responsibility and Budget Management Bill and other amendments to Reserve Bank of India Act
would cover significant ground. Several other suggestions relating to legal framework, particularly
those relating to defining the objectives of and imparting transparency in monetary policy as
recommended by the Advisory Groups are yet to be taken up.
Third, at the policy level, there are three important constraints on the operational autonomy even
within the existing legal framework. One, the continued fiscal dominance, including large temporary
mismatches between receipts and expenditures of Government warranting large involuntary financing
of credit needs of Government by the RBI. Two, the predominance of publicly owned financial
intermediaries and non-financial public enterprises, which has created a blurring of the demarcation
between funding of and by Government vis-à-vis public sector as a whole. Three, the relatively
underdeveloped state of financial markets partly due to legal and institutional constraints, which blunts
the effectiveness of instruments of monetary policy. These issues need to be resolved to enhance
genuine autonomy.
Fourth, at the operational and procedural level, there is a problem of "old habits die hard". In a
deregulated environment, there is considerable scope to reduce micro-management issues in the
relations between the Government and the RBI.
Fifth, at the level of degree of transparency, there is a temptation to continue, what has been termed
as the "joint-family approach". The approach ignores basic tenets of accounting principles in regard to
transactions between RBI and Government. It gives satisfaction to all participants that all of them are
working together for growth and stability. In the process, however, the integrity of the respective
balance sheets of Government and RBI gets eroded making both autonomy and accountability difficult
to assess.
Random thoughts
In the light of theory, practice and the Indian experience I would like to share with you some of my
thoughts on the subject. These are structured around emerging new realities, issues of coordination,
transparency, accountability and credibility.
Generally, independence of central bank is discussed in terms of independence, or in a broader
sense, from political, executive and legislative power. With emergence of powerful economic interests
in the form of multinationals or dominant domestic corporates and their large stakes in capital markets,
in the larger context of powerful influences outside of the executive wing of Government, it may be
necessary to also ensure independence of central bank operations.
While pr