The Government has opened up the issue of the relationship between the Finance Ministry and the RBI. The public criticism by each protagonist about the other in the weeks leading up to the 19 November board meeting, was unbecoming. Fortunately, the fears of a serious breakdown and possible resignation have turned out to be misplaced. A process has been initiated to revisit the provisioning for risk management from RBI’s profits and to assert greater influence of the Government, through its nominee and chosen board directors, on RBI’s exercise of its regulatory authority over banks.

The spat about the transfer of RBI profits was misplaced. It is true that a large part of RBI’s profit arises from seignorage, which is the profit made from the vast difference between the face value of notes issued and the cost of producing and distributing them. This arises because the Government has given RBI this right and all the gains arising from that should be transferred to the Government. The finance ministry has always cast covetous eyes on all that easy money. That led to a change and now the RBI transfers its entire surplus, after making some provision for contingency reserves, some special development funds and a revaluation reserve for unrealised mark-to-market gains/losses.

The revaluation reserve represents unrealised capital gains or losses. Thus, its holdings of foreign exchange may go up in terms of rupees; but this gain is not distributable as this reserve is required for exchange market interventions and it is the value in terms of foreign exchange that matters.

At the end of 2017-18 the size of RBI’s balance sheet was Rs 36176 billion which is about 22 percent of GDP comparable to that of the US Federal Reserve and substantially less than the balance sheets of the ECB and the Bank of Japan. About 53 percent of it on the liabilities side consists of the value of currency notes issued and on the assets side 73 percent consists of its holdings of foreign exchange assets. The size of the balance sheet will go up or down depending on whether liquidity is being pumped in or withdrawn.

The Contingency Fund amounts to Rs 2321 billion which does not seem unreasonably high given the size of its balance sheet.  However, a closer analysis of potential risks may suggest a higher or lower level provisioning and will have to be examined by the group that has been set up to examine the economic capital base for the RBI. One hopes that this will be a group of independent professionals who will look at the issue from the primary goal of maintaining the credibility and rating of the RBI in the eyes of bond market investors.

The other issues raised by the representatives of the government were immediate concerns about easier credit for MSMEs and NBFCs. The real question here is is not about the legitimacy of these concerns but more about the autonomy of the RBI in the exercise of the regulatory function assigned to it and the accountability for the outcome.

Central bank autonomy has always been a concern for governments, not just in India but just about everywhere. This is because they exercise functions, like currency issue and regulatory oversight, that rest on the sovereign power of government. The fear is that the goals of democratically elected governments will be too heavily influenced by pain-averse voters and will not give sufficient priority to stability and predictability. Distancing monetary and banking regulation from the political executive holds out the promise of financial stability, solvency of banking institutions and the predictability of interest rates and exchange rates. This is particularly essential for the stability of financial markets when they are open to foreign capital flows, which is the case now in India.

An additional concern in India is that the government is the biggest borrower in the market and lays claim to about 80 percent of household financial savings.  Moreover, it owns banks and insurance companies that account for about 70 percent of financial intermediation and which are under very direct political control. That creates a genuine fear that the government’s goals for financial market policy will be narrowly determined by its interests as a large borrower and bank owner or by the populist measures to win votes. India is now a very open market-oriented economy that needs transparent and credible financial markets. Hence RBI autonomy in its core functions is absolutely a must.

But autonomy has to go hand in hand with a clear structure of accountability.  A Government appointed interventionist board is not that.  It fact it would actually erode the autonomy and credibility of the RBI and increase the perception of political interference. A better approach would be to follow the Monetary Policy Committee model, where RBI is held publicly accountable for departures from a clear target with specified margins of tolerance.

Targets for financial stability are more difficult but could be framed in terms of tolerable levels of non-performing assets. But the flip side of this is that the RBI should be allowed to do what is necessary for staying within the target with no distinction between public and private banks and greater regulatory supervision of non-bank financial companies.

Such a structure of tight accountability still does not address the issue which worries the government - the subsidiary status given to the goal of maintaining growth momentum and the incentives to invest.  There is no simple metric which can measure this.  But some measure of accountability could come from an officially constituted body of independent economists and market analysts who may give quarterly reports on this issue.

We need to move beyond inflation targeting. This is happening even in the New Zealand and UK which pioneered this approach. A transparent structure of autonomy and accountability that considers, besides inflation, other goals like financial stability and the investment climate can both reinforce autonomy and help to meet the Government’s legitimate concerns.