Initiating a discussion on ‘Contextualising Banking and Monetary Policy’ at ORF-Chennai on 4 March 2018, Dr J Sadakkadulla, former Regional Director of the Reserve Bank of India (RBI), said accountability and freedom to operate were the two most important needs of a central bank. They were not to be seen as conflicting with each other either, but be seen instead as they existed in tandem.
Differentiating between fiscal policy and monetary policy, Dr Sadakkadulla explained that fiscal policy was entirely in the domain of the government while monetary policy was decided by the central bank. Fiscal policy was the result of the deliberate action taken by the government to influence the economy through changes in spending and taxation, ie, policy made through the budget.
It was in general more long term and structural compared to monetary policy. Monetary policy affected macro-economics, and was aimed at objectives of employment and maintaining stability of GDP. However, the two went hand in hand. This meant that although the freedom to operate independently was imperative to the central bank, monetary policy and fiscal policy often impacted on each other.
It is often asked of the central bank – why it does not print more currency as it likes and/or as it needs? Generally, Dr. Sadakkadulla noted, the RBI took the view that currency in circulation should be equal to goods and services that need to be exchanged. If not, money loses its value. Maintaining the value of currency was one of the core responsibilities of the RBI. Internal price-stability is maintained through safeguarding purchasing power and the external value, through purchasing power parity.
The main role of the RBI and all central banks was to control inflation, Dr. Sadakkadulla said. India has adopted an inflation target of 4 percent (+/-2%), but it was important to not see inflation as necessarily a bad thing. Inflation, he explained, is a by-product of economic activity, akin to smoke that is a by-product of cooking. While smoke is not desirable it still occurs when cooking.
“We cook in order to feed ourselves, which makes cooking a productive activity,” the speaker explained. “The more we cook, the more smoke we produce. It is clear we cannot eliminate smoke by simply not cooking but we can control it. Similarly, economic activity results in inflation. The more activity there is, the more the inflation. Inflation is inevitable, but it needs to be controlled. Most economists agree controlled inflation is a better alternative to deflation.”
If the RBI is not able to control inflation, it is accountable to the Central Government. The Monetary Policy Framework Agreement was signed in February 2015, between the Government of India and the RBI. Though the central bank already had a monetary framework and was implementing the monetary policy, the newly-designed statutory framework means that the RBI has to give an explanation in the form of a report to the Government, if it failed to reach the specified inflation targets.
As Dr Sadakkadulla explained, the RBI has to provide reasons for failure, remedial actions as well as an estimated time within which the target will be achieved. The RBI is further mandated to publish a monetary policy report every six months, explaining the sources of inflation and the forecasts of inflation.
Other important monetary policy questions for central banks included when to expand money supply and/or when to reduce interest rate. Interest rates affect the external value of money. Usually, the norm was that if inflation is high ‘dear money policy’ is followed – that is to increase interest rates thereby making borrowing more expensive.If currency is depreciating then the central bank was expected to restrict loans at high interest rates.
Dr Sadakkadulla listed and discussed several significant measures that shaped and impacted on monetary policy framework over the years. These included delinking budget-deficit from its automatic monetization in 1994 and the Fiscal Responsibility and Budget Management (FRBM) Act of 2003, which set a target of three percent GDP for fiscal deficit. The long list also included the RBI withdrawing from participation in the primary issues of the Central Government in April 2006, the Insolvency and Bankruptcy Code and the Asset Quality Review in 2016. The switch from Wholesale Price Index (WPI) and the adoption of Consumer Price Index (CPI) and increasing the reverse-repo rate as a money supply mechanism were also a part of the process.
Several and varied concerns about banking in India were raised during the interactive session. Financial inclusion was seen as a big challenge for India. Many people are left out of and deprived of the banking system. Instead, the informal system, with money-lenders, was a bigger force in the country. Looking to the future, many asked if interest-free banking could become a reality in India.
The stability of the financial system in the country was also seen as facing severe challenges. While in the US, 50 percent of the population was involved in financial and stock markets, in India, the Harshad Mehta and Ketan Parekh scams, among others, had shattered the hopes of the common man. It was important to find solutions to fraud and fake bank receipts, Dr Sadakkadulla said.
He concluded that banking was indeed a risky business -- essentially we were taking money from one person and giving it to someone else, without knowing if they will pay it back. In order to secure banking, we needed to accept certain norms of regulation that would be standardised and universal. These would create an atmosphere of security. In this regard, he advocated the Basel III norms to improve regulation, supervision and risk management.
The Basel I, II & III were norms put forward by the Basel Committee on Banking Supervision (BCBS), after several central banks around the world deliberated on issues related to banking such as minimum capital requirements. However, Basel I & II were criticised for allowing Banks to take on additional types of risks which resulted in the subprime financial crisis in 2008 and in direct response to this the BCBS published the Basel III in 2009 focusing primarily on issues related to the risk of a bank run.
These apart, compared to the US, Dr Sadakkadulla said that banking in India was marked by conservatism. “In the West, people are willing to spend money before having it,” he said. “This is because they saw the potential in generating more money. In India there is a strong saving culture,” he recalled.
‘RBI conservatism’ was the strength of the banking system in the country, Dr Sadakkadulla opined. RBI reforms have been slow, but he insisted this was intentionally so. Incremental-change was the way RBI proceeded, so as not to go back and reverse a policy later on. The RBI was not in a hurry for full capital account convertibility. However, looking to the future, we needed financial market integration for better monetary transmission. Development of safe and secure payment systems across the country were also important factors.
When trying to understand economic policy, one fundamental law stood out more than others, Dr Sadakkadulla said: “wants are unlimited, whereas resources are limited. This was the motivation for nations needing to have a sound monetary and fiscal policy -- to help meet first our needs and then our wants with the limited resources we possessed. Apart from this, we needed to constantly evolve our economic-thinking, Dr Sadakkadulla said.
This report was prepared by Dr. Vinitha Revi, Research Associate, Observer Research Foundation, Chennai Chapter
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