The barrage of criticism of the proposed draft of the Indian financial code (IFC) released by the finance ministry last Thursday has, unfortunately, contained more heat than light, with ill-informed criticisms being passed off as accepted wisdom.
What has attracted the greatest ire of critics is the proposed seven-member monetary policy committee (MPC), which will be charged with setting policy rates to ensure that the inflation-targeting mandate, already enshrined in the monetary policy framework agreement between the Reserve Bank of India (RBI) and the finance ministry, is fulfilled.
Recall that the MPC would replace the current system in which the RBI governor effectively has absolute power to set policy and is not bound by recommendations of the technical advisory committee.
The most often repeated criticism is that, because four of seven members of the MPC will be appointed by the finance ministry, while only three will be internal to RBI, including the governor as chairperson, somehow the independence of RBI will be lost. Those who have been chanting this as mantra appear to be unaware of the fact that RBI at present lacks any form of statutory independence.
Under the RBI Act, 1934, an antiquated law that still governs the central bank, the 21 members of the central board of directors are all, directly or indirectly, appointed by the Union government, including and most notably the governor himself. Under existing law, the government may dictate policy to RBI, which the governor will be obliged to obey. Thus, in reality, any putative independence the RBI may currently enjoy depends entirely on the strength of character of the governor to resist political pressure. This is hardly a template for good governance and leaves good monetary policy to chance.
By contrast, under the proposed new system, the MPC—critically operating not with carte blanche but charged with ensuring that the inflation target is met—will bear collective responsibility for monetary policy conduct, and its individual members, including the governor, will therefore be shielded from political interference more than in the current single decision-maker scenario.
It is harder to pressure and influence a committee of several members as opposed to influencing only one person. It is a specious and illogical argument to suggest that its functioning will be impaired merely because a majority of its members are appointed by the government—when the current arrangement creates a far greater danger that the government could browbeat the governor into doing its bidding.
Also, an MPC formed with non-RBI members, appointed from various walks of life, will bring with it diversity of opinion and plurality of ideas, whereas internal RBI members are more likely to share similar views. Further, unlike the current arrangement in which the governor is not obliged to explain the rationale for a policy decision—although, in practice, he generally does—the new system will require each member to furnish a written explanation for his/her vote on any proposed resolution, and minutes of MPC meetings will be made available for public scrutiny.
This creates far greater transparency in monetary policy conduct than our current system, in which decisions are shrouded in secrecy and in which, therefore, there is considerable leeway for the governor to act with discretion. A basic tenet of modern theory and practice of central banking is that a system which is opaque and allows discretion will invariably deliver worse outcomes than a transparent and rule-governed system, which the MPC plus the inflation targeting regime will provide.
What is more, given that the MPC will not operate in a policy vacuum, but explicitly to achieve the 4% inflation target, with a tolerance band of 2% around it, there is automatically an accountability mechanism built into the system. The public, investors or anyone else can observe whether the MPC is doing its job or not.
Each member’s personal reputation will be on the line every time he/she proposes an action that ends up jeopardizing the inflation-targeting mandate. An MPC, which repeatedly fails to meet the inflation target, will lack credibility, and this is something no government would wish to happen. In a globalized capital market, the cost of an erratic and uncertain monetary policy, with attendant volatility in interest rates and exchange rates, would be damaging economically, and therefore politically.
It could be countered, if the mandate of the MPC will ensure accountability, then why not let RBI hold a majority on the MPC? The reason is that an RBI-dominated MPC will, inevitably, be an MPC dominated by the governor himself. Junior colleagues of the governor who sit on the MPC would almost surely be reluctant to disagree with him and end up voting with him—whether because of group think, or simply due to power imbalance.
In other words, the presence of four external members is, in fact, a check on an MPC, which otherwise might be dominated by the governor, and therefore, would not be very different from the current system in which the governor is all-powerful.
The bottom line is that our current arrangement is really a non-system that functions well only if a wise and sagacious individual is in the chair. What we need is to hard-code best practice and institutionalize it, and this is exactly what the IFC, including the MPC, proposes.
