Slightly more than twenty years ago, an external payments crisis was the trigger for a turnaround in Indian economic thinking and policy. But, that turnaround, it now turns out, was not far-reaching in scope. This is evident in the latest external payments crisis. This crisis should, therefore, be used to bring about fundamental and path-breaking changes in our economic management.
The 1990s shift concentrated on “reforming” industrial and trade policies. It also made a beginning with financial sector reforms with prudential norms for the banking sector. Reforms in the capital markets were also put through, with the creation of market infrastructure institutions such as the National Stock Exchange.
It, however, left literally untouched the biggest financial sector player – the Reserve Bank of India.
Anachronistic, then and now
What should the role of the RBI be in the new Indian economy? What should its relationship with Government be? What should the economic objective of the RBI be? Should it have an independent objective at all – or should it be just the “financing” arm of Government as in the good, old days of deficit financing in the 1950s, 1960s, 1970s and 1980s? Should the objective be laid down by Government? If so, should the RBI be given operational autonomy to attain that objective? How shall the RBI be held accountable in the exercise of its powers?
These questions were left completely unaddressed in the “reforms” of 1991-92. That was quite surprising; for some key macro-economic choices – with critical implications for the RBI and, as it turns out now, for the country itself – also were made in the reforms flush of 1991-92. Foreign capital flows – free flow in both directions – were significantly relaxed in the 1990s. That is, we introduced a vastly more complex overseas dynamic into an economy with a captive central bank. Did anybody think ahead as to how this situation would evolve?
In other words, a new real economy with new and complex interfaces with the global economy and global financial markets was being forced on a colonial-era RBI with no specific, quantified mandate and objective.
And, if we note that “capital flight” from India and a run on the Indian currency in the ensuing period are quite probable, surprise should also turn into shock at how the 1990s reforms left the RBI untouched. In a worst case scenario of capital flight, both Government and RBI will absolve themselves of responsibility! For, the present hazy legal and institutional relationship between the Government and RBI would enable them to do that quite easily.
Can you imagine any economic entity without a quantified economic objective, and without being accountable to some authority?
Compared to 1991, the RBI today is even more of an anachronistic institution, amidst vastly a more complex global economy and markets.
Single-minded focus
It was the high priest – so to say – of the monetarist school of economic thought, Milton Friedman, who clearly identified what monetary policy (the central bank) can and cannot do. Friedman was ever aware of the dangers of expecting and tasking the central bank to do what it could not realistically accomplish.
We can leave aside Friedman’s single point focus that producing reasonable price stability should be the objective of the central bank (monetary authority). More important for the current Indian debate seems to be the principle behind Friedman’s expositions.
(To be sure, if the “monetary authority” does not have a single-point focus on monetary or price stability, then who else? Even Keynes in 1920 identified the dangers of extreme inflation: “As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.”)
The principle is very simple.
It is that the central bank should have a clearly defined objective; it should then develop a consistent policy framework or model to inform its decision-making in real time as new economic data keeps coming in; the policy framework should explain how near-term market and economic fluctuations are reconciled with the central bank’s final objective; and finally, most importantly, all this should be consistently, clearly and transparently communicated to the public at large.
Is all this happening at all in India?
The RBI does keep publishing voluminous documents; but ask a typical household or a business as to what the RBI actually does; one can guarantee, if not complete ignorance, a very primitive understanding. Most will say that the RBI prints currency notes, that’s about it – but here, the RBI is tasked with preventing a currency run! And, whatever the RBI does or does not achieve in that regard will directly impact all those households and businesses in their everyday economics!.
Payments crisis
The foregoing is not meant to be some abstract exposition on central banking and financial markets.
Even the “upcoming” payments crisis – with some $ 170 billion of foreign currency debt coming due for payment by March 2014 -- can potentially be handled if Indian policymakers radically alter their thinking and actions on the lines advocated by Milton Friedman.
First, identify the root economic cause of the problem. Then, put together a consistent policy framework to address the cause (not the symptoms) and carry it through, even if it causes near-term economic pain. Such voluntary pain should be preferable to anything imposed by global financial markets.
If global markets understand Indian authorities’ conviction and resolution, it may even be possible to roll-over much of the maturing debt on mutually acceptable terms.
But, such an approach would mean large-scale fundamental reform of the RBI. Are we ready for that?
(The author is a Chennai-based financial consultant.)