The biggest risk that the draft financial code poses to Indian economic and financial stability is that it vests tremendous powers in the executive branch of the government.
India’s factor markets are broken. Land acquisition is next to impossible. Labour market reforms are threatened by a coalition of international agencies and molly-coddled labour unions. Banks have dud assets on their books and their nodal Ministry appears to be waking up to their problem after about fourteen months in the office. Economic growth numbers are still not convincing. In this milieu, some officials in the Ministry of Finance decided that it would serve national interest best to put up the revised draft Indian Financial Code on the website for comments.
Commentators and media did not have time to plough through the code. But, they cottoned on to the fact that a section of the code seeks to rein in the powers of the Governor of the Reserve Bank of India (RBI) with respect to the conduct of monetary policy. That was enough to paint the Ministry of Finance in one corner and RBI in another.
More precisely, it was painted as a battle between the Finance Minister and the incumbent RBI Governor. Some commentators took one look at it, thought for a second about which side of the fence they were on and took sides on that basis. A focus on the short-term, sensationalism, personalities over principles and wrong framing of issues – the quintessential Indian approach to problem-solving.
Laws governing the conduct of macro-economic policy and the financial sector will be with the country well beyond the present government and the present Governor of RBI. Framing the issue as one of a battle between the Minister and the RBI Governor is myopic. It is the UPA government that appointed the Financial Sector Legislative Reforms Commission in 2011 (FSLRC) and this commission came up with the Code. It is not an initiative of the government. This government had good reasons to abandon the work of the Commission and start afresh. But, as with many other things, it has decided to carry forward the worst policy legacies of the previous government.
Monetary policy framework
India has an inflation-targeting framework now. The Urijit Patel Committee, appointed by the RBI, recommended one. In the developed world, there is a re-examination of the focus on inflation target. The crisis of 2008 had exposed the shortcomings of undue focus only on inflation when overheating in economies manifests itself in other forms. Yet, it was somewhat reasonable for India to choose an inflation-targeting framework given its recent experience with inflation.
With their short-term political considerations, Governments of the day can and do undermine the effectiveness of monetary policy. It is barely a year since we have emerged out of such a situation. The UPA government had ravaged the Indian economy with its cumulative 60 percent plus inflation rate in five years since 2009. There was fiscal dominance of monetary policy. The governor of the RBI at that period was presented with an unenviable situation by the UPA government. Then, there were global factors. He was raising interest rates and accommodating the government’s fiscal recklessness. He did not seem to have much of a choice. This is how the UPA government undermined the Reserve Bank of India between 2009 and 2013. The Code seeks to continue that in other ways.
Not only does the Code charge RBI with responsibility for meeting inflation targets but also requires it to explain its failure to do so, when the failure is more likely to arise from the government’s fiscal policy decisions and the consequent fiscal policy dominance of monetary policy. Without a modern fiscal policy or modern and sound governance, inflation targeting with responsibility and accountability on the central bank, and none on the government will end in acrimony and sub-optimal outcomes. The Central Bank, if it is serious about its inflation mandate, in order to offset reckless fiscal policy will raise interest rates to high levels or be pliable and surrender to government diktats. Both are bad for the economy. In economics, scope for the law of unintended consequences to play out is considerable and humility is called for.
The Code envisages a monetary policy committee with majority government nominees. The casting vote given to the Governor becomes meaningless unless there is abstention. The Governor of the Reserve Bank of India does not have a role in the selection of government nominees. Given the recent record of the UPA government undermining the Central Bank, any sane proposal would contain safeguards to preserve the integrity of monetary policy from government influence, from fiscal excess and fiscal dominance.
As for a committee being a superior structure to vesting responsibility in one individual for policymaking, it is elementary logic that accountability is clear in the case of an individual whereas it is diluted and diversified away in the case of a Committee featuring a majority of government nominees with the Governor’s casting vote rendered meaningless.
Further, in their Macroeconomics textbook, Rudiger Dornbusch, Stanley Fischer and Richard Startz write that, as a practical matter, the chairman of the Federal Reserve Board can usually swing the vote as he wishes even though policy is officially set by the Federal Reserve Open Market Committee. They add that, in both Israel and New Zealand, formal decision-making authority is vested in the governor of the central bank. We would like to add that few countries have done better than New Zealand in recent decades in inflation management.
Finally, we conclude the discussion on the making of monetary policy through a Committee with some observations from a recent paper that had reviewed the transcripts of the FOMC meetings in 2009, released in 2014. What follows are verbatim quotes from the paper.
“Their conversations focus on standard macro-level indicators like the inflation rate, the unemployment rate, and growth in GDP… They rarely see the connection between sectors… By contrast, Committee members rarely devote sustained attention to the financial economy.
…they grossly underestimated the extent to which the downturn in housing prices would affect the entire economy. It was not until the summer of 2007 that the Federal Reserve even began to notice the connections between the mortgage market and the functioning of financial markets… and even then, no one expected the problems generated by bad mortgages to cascade into a full-blown financial collapse.”
The Berkeley authors continue, “Not only was there no one in the room who took an extreme position, but speakers were constantly prefacing their remarks by downplaying the significance of even what they themselves considered to be the worst-case scenario… One could argue that these group dynamics guaranteed a tendency towards a “wait and see attitude” as well as a collective attempt to balance opinions.”
There is an important lesson here. If we are aware of our pervasive cognitive limitations and failures, then we should be both humble and wary of unleashing forces whose effects we are incapable of fathoming. The authors and backers of the draft code are not given to such self-doubt, however. They shall not be distracted from their mission by such uncomfortable logic and evidence.
Undermining the RBI is the raison d’être – of the work of FSLRC and the Code. That much had been conceded by the dissenting notes appended by several members of the FSLRC itself. Yet, the protagonists have marched on relentlessly and have given us the fait accompli of The Code. In their eyes, RBI is an opaque and unaccountable institution. It needed to be curbed. However, the real purpose of The Code appears to be as much about unleashing the financial sector – global and Indian – on the unsuspecting Indian public as it is about constraining the central bank from stopping that process.
The real elephant in the room – the financial sector
Even if the authors of the Code have taken on the mission of taming the RBI, the Ministry of Finance should realise that there are more urgent and important priorities. Indeed, a non-transparent and relatively opaque central bank appears to be ideally suited to prevent the emergence of the financial sector that drives the real economy than the other way around. India did not have the problem of an overarching financial sector problem in 2008 because, as Joe Nocera put it in his New York Times article in December 2008, “the Reserve Bank of India had a bank regulator who was the anti-Greenspan and that his name was Y.V. Reddy”.
Greenspan, the apostle of financial de-regulation, admitted that he had found a fatal flaw in his model. He elaborated further on his confession in a conversation with Gillian Tett for the Council of Foreign Relations in October 2014. He said that non-financial sectors were well behaved and that animal spirits run wild in the financial sector. In effect, he admitted that it could not be left to its own devices. Of course, the empirical proof was the crisis of 2008. Given freedom to choose their own leverage (capital) ratios, financial institutions did not manage their risk and hence they made the system risky and unstable.
In a speech to the Global Economic Policy Forum in November 2013, William Dudley of the New York Fed spoke of deep-seated cultural and ethical failures in large financial institutions. Seven years after the crisis and nearly two years after his speech, the German financial regulator has catalogued the failures of control and oversight in Deutsche Bank. The Bank of England has documented practices in the Investment Banking industry that should be read by Indian bureaucrats in the Ministry of Finance. In his Presidential Address to the American Finance Association, Luigi Zingales said that contribution of finance, beyond the simple provision of credit, to economic welfare was hard to find and document and it was not because academics lacked the incentives to do so, to put it mildly. He is right. Nearly three-quarters of the revenues earned by investment banks globally came from serving other institutions in the financial system than from serving the real economy.
The financial sector differs from non-financial economy in two crucial respects, if not more. When a financial institution collapses, other firms in the industry become shaky. The risk of contagion is real. This is especially true of investment banks. In other industries, it works the other way around. Surviving competitors benefit. In financial markets, rising prices usually beget more demand and falling prices more supply. This is the opposite of what economic textbooks tell novice students about demand and supply in the economy. Finance is prone to inherent instability, given the interplay of greed and fear. Irrationality is both predictable and systematic. That is why theories in finance and economics are not definite statements but points of departure. They are not falsifiable because they are context-dependent. Efficient financial markets are not a theory but a model and a poor one at that.
Volatility and opacity are desirable
Publishing Minutes and transcripts of the meetings of the Monetary Policy Committee may all sound western but they are not necessarily modern. Both do not mean the same thing. In a recent comprehensive exhaustive interview, William White, former Deputy Governor of the Bank of Canada and presently, the Chief Economist of the OECD questions the economic relevance and usefulness of monetary policy transparency:
“We at the BIS first started reflecting on this issue in 2004 when the Fed started talking about ‘measured’ increases in interest rates, which was code for 25 basis points per meeting. If you think about a Sharpe Ratio, where the differential between the borrowing rate and the lending rate are going down, but the variance is basically going to zero, then transparency of this sort is really an invitation to take on leverage and that is precisely what people did. And I think it is the kind of stuff they are doing today.”
On monetary policy transparency, he had this to say: “I go back to my early days of Bank of Canada when we brought in inflation targeting, about three months after New Zealand. Subsequently, and only gradually, the mantra of transparency became more firmly embedded. And I can remember talking to John Crow who was then the Governor and saying to him that it was a huge step to go from “Trust me to do the right thing” to “Now I’m going to tell you what I am going to do in future”. Moreover, I remember saying to him I did not recall ever having a discussion of this issue at the Bank of Canada. We just morphed into it. Basically, I think it had its roots in all the academic stuff about economic agents having rational expectations. And that assumption too is, I think, fundamentally flawed.”
Volatility, rather than transparency, keeps financial market participants in line. Otherwise, systemic stability becomes an endangered species under the onslaught of their excessive risk-taking.
In his book on the New York Money Market, Charles Goodhart, former member of the Monetary Policy Committee and Professor-Emeritus at the London School of Economics wrote: “In the pre-Fed days with which the history deals, the call money rate dove and soared. There was no stability—and a good thing, Goodhart reasons. In a society predisposed to speculate, as America was and is, he writes, unpredictable spikes in borrowing rates kept the players more or less honest. “On the basis of its record,” he writes of the Second Federal Reserve District before there was a Federal Reserve, “the financial system as constituted in the years 1900-1913 must be considered successful to an extent rarely equalled in the United States. And that notwithstanding the Panic of 1907.”
Whether volatility is desirable or not depends on the context. It is not undesirable, per se. Some of the post-1980s fetishes of the financial sector – policy transparency, predictability and financial innovations – have been repeated so often with a view to elevate them to the status of gospel truths or doctrines that are beyond questioning and discussion. Yet, after the crisis of 2008, the West is reflecting on these previously deeply held beliefs. In India, the crisis of 2008 has never happened and we can continue to march to the drumbeat of financial liberalisation that the rest of the world is quietly retreating from. Either the authors of the Code are living inside a balloon or they think that India is an island, exempt from the malefic influences and motivation of the global financial sector.
Risk of policy capture by the financial sector
It is hard to come up with a cogent and rational explanation of their determination to dilute or remove powers of the RBI to regulate the financial sector, placing it under the Government. The Financial Stability and Development Council, will be headed by the Minister for Finance and there will be an independent banking regulator eventually. RBI will be responsible only for monetary policy and inflation targeting with a monetary policy committee stuffed with government nominees doing the job. FSLRC did a hair-split on capital controls management by proposing that decisions on capital inflows are taken by the government and on capital outflows by RBI. The Code places the responsibility for all capital controls in the hands of the Government with just an obligation for it to consult RBI.
The code mandates that RBI publish a report on the costs and benefits of its capital controls decisions within a month of taking such decisions. It is rather naïve if not diabolical. Policy decisions have longer impacts and some of the benefits and costs may not even be quantifiable. Further, the costs and benefits of actions taken are not conclusive proof of the wisdom or folly of such actions since alternative decision-paths might have been more damaging. The impossibility of constructing counterfactual scenarios (falsifiability) is what limits the usefulness, relevance and applicability of economic and financial theories.
Central Bank Independence – context matters
This is applicable to the ‘theory’ of central bank independence. It is not cast in stone. In this regard, Ben Bernanke was right: “The role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive [government borrowing and] monetization of government debt, the virtue of an independence central bank is its ability to say “no” to the government. [In a liquidity trap], however, excessive [government borrowing] and money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances [of a liquidity trap], greater cooperation for a time between the [monetary] and the fiscal authorities is in no way inconsistent with the independence of […] central bank[s], any more than cooperation between two independent nations in pursuit of a common objective [or, for that matter, cooperation between central banks and fiscal authorities to facilitate war finance] is consistent with the principle of national sovereignty.”
The Indian economy is inflation prone and fiscal populism, is its biggest contributor. From loan waivers to corporate give-aways, fiscal policy primes the pump needlessly on many occasions for non-economic considerations. In addition, laws encourage fragmentation of production and Indian supply-side operates at well below its productive capacity. That mostly explains India’s inability to sustain high economic growth rates beyond a few years. Economy quickly overheats when demand picks up because supply is unable to respond. Further, the corporate-officialdom-banking sector nexus results in too many loans in good times turning bad when economy peaks and drops. There is thus plenty of reason in the Indian context for the central bank to remain in a perpetual vigilant and adversarial mode. It provides the vital check and balance.
In the West, on the other hand, central bank independence has resulted in a policy vacuum in other areas and loose monetary policy and easy money is the only answer to all economic challenges. Central bankers do not seem to mind the unhealthy behavioural signals they are sending and incentives that they are creating with their unconventional monetary policies. Intentionally or otherwise, they have pandered to the interests of the financial sector. They need to be challenged. That is why, much as it is necessary that central bank independence be tamed in the West, it is necessary that it be preserved and fostered in India and in many similarly placed countries.
Fix the factor markets first before ‘fixing’ RBI
In the final analysis, the biggest risk that the draft financial code poses to Indian economic and financial stability is that it vests tremendous powers in the executive branch of the government that is vulnerable, and has proven to be so, for all forms of capture. Policy capture by the financial sector may not happen immediately but there should be no doubt that the Code lays the foundation for the capture of policy and thus of the economy by the financial sector, to happen. That is why it should be placed in the deep freezer or be subjected to fresh thinking with wider consultation.
For now, the urgent and real challenge for India is that its factor markets are broken and they need fixing. India’s Opposition parties resist the reform of its factor markets. That places India’s medium and long-term economic future in jeopardy. Instead of developing a missionary focus on them, whoever chose to put the revised draft of The Code on the website of the Ministry of Finance has caused a needless distraction. Some in the broader community too have chosen to sensationalise it and conflate the issue at hand – the threat of allowing the interests of the financial sector to dominate economic stability and economic goals of the nation – with personality clashes. This is myopia, par excellence.
RBI has been a more effective watchdog of the Indian financial system than its counterparts in the West. That is to be preserved and not sacrificed under the pretext of making RBI accountable. This game needs to be understood and the Government of India, at the highest levels, should disengage from it.
Anantha nageswaran is co-founder and fellow at the takshashila institution.