Why we have a central bank
Inflation is back in the news and attention has willy nilly turned on the RBI. This would lead us to recognise what it is mandated to do and to assess how much of it it actually achieves.
The establishment of some of the oldest central banks of the world was inspired by the problem of maintaining financial stability. It was recognised that when private commercial banks fail, whether due to malfeasance or misjudgment, they not only harm their trusting depositors but can also take down with them the rest of the financial system. The latter can take place when banks have lent to one another, which is not uncommon. In the crisis that ensues there is a collapse of credit which in turn leads to a downturn in economic activity. To avoid this the central bank was conceived of as the lender of last resort, pre-empting a run on banks and giving them time to put their books back in order. However, its stance as the lender of last resort is accompanied by the central bank adopting a tough regulatory stance, whereby it stays hawk-eyed towards the activities of banks, particularly risky lending. This is necessary as the knowledge that they can always resort to the lender-of-last-resort facility may leave banks less than diligent or even indulge in plain dishonesty.
With the rise of neo-liberalism, the central tenet of which of which is that markets should be given free play, the regulatory role of central banks took a back seat. Central banks came to be primarily mandated with the control of inflation. It is hardly the case that central banks were unconcerned with inflation earlier, but they were at the same time concerned with financial stability and the level of economic activity. In India, the RBI pursued a ‘multiple indicators approach’, implying concern for outcomes other than inflation, including even the balance of payments. Developments in economic theory discouraged such catholicity by arguing that leaving economic activity in as an objective of monetary policy leads to higher inflation. It should be noted that this argument privileges low inflation over low unemployment, favouring owners of financial wealth over workers. However, inflation targeting came to define monetary policy in the OECD economies. Not to be left behind in the race to adopt the architecture of the west the Government of India instituted inflation targeting as the sole objective of monetary policy. The RBI was permitted to exceed or fall short of a targeted inflation rate of 4 percent by a margin of 2 percentage points. This was hailed by the government as the adoption of the ‘modern monetary policy framework’ by India, and came into effect from the year 2016-17.
Till his unfortunate departure while in office, the late Arun Jaitley as Finance Minister projected the attainment of macroeconomic stability, represented by slowing inflation, as a major achievement of his government. Adherence to fiscal discipline and inflation targeting were taken to be the instruments. Throughout Mr. Jaitley’s tenure, inflation remained within the range envisaged within the inflation targeting regime agreed to between the government and the RBI. But have all of the RBI’s mandate as a central bank been met as a result? I believe not.
In 2018, within three years of the adoption of inflation targeting a crisis engulfed IL&FS, a non-bank financial company in the infrastructure space. It defaulted on several of its obligations, including repayment of bank loans and the redemption of commercial paper. The IL&FS was not just another ‘shadow bank’, it operated over one hundred subsidiaries and was sitting on debt of 94000 crores. Given this, its default is likely to have had a chilling effect on the investors, banks and mutual finds associated with it both directly or indirectly. Since then, in 2019 a run on the Punjab and Maharashtra Cooperative Bank had to be averted by imposing withdrawal limits. It was discovered that fictitious accounts, reportedly over 21000, had been created so that the books would tally even as deposits were siphoned off as loans to the promoters. While in the case of IL&FS some part of the problem may have been caused by a slowing economy outright fraud underlay the crisis at PMC Bank. And now in 2020 the RBI curbs have had to be placed on withdrawals from the Sri Guru Raghavendra Sahakara Bank at Bengaluru. Even if it is too early to declare that financial instability prevails in India it is not too early to ask if the RBI’s responsibility to regulate the financial sector may have taken a back seat after inflation targeting implicitly took centrestage in the understanding of what are its assigned tasks. Fixation with the inflation rate may have led it to avert its eyes off the loan books of the banks.
Even apart from regulatory infirmity, it is not as if the RBI is doing spectacularly on the inflation targeting front either. At over 7 percent the inflation rate in December is the highest in 5 years. This may not be reason to panic for the price rise could be seasonal and may well abate, but it does raise a question about the efficacy of inflation targeting as a means of inflation control. Rather than burden the Iay reader with technicalities, it would be sufficient to say that inflation led by rising prices of food stuffs cannot quickly or easily be contained by the mode of control underlying inflation targeting. It would require enhancing supplies; this requires imports in the short run. Be that as it may, the extent of failure of inflation targeting right now is substantial indeed; the inflation rate has exceeded the permissible range of error by 65 percent. This must give pause as to how much the shift to the ‘modern monetary policy framework’ has delivered. It may have been possible to stay within the target so far mainly due to both declining food and, for a phase, oil prices.
Finally, we come to what the common (wo)man on the street very likely considers is the RBI’s principal mandate, the management of the currency such that trade is facilitated. There was a time in Europe when commercial banks issued bills that were treated as currency. Since then the monopoly on the note issue has been assigned to the central bank, and this is the situation today in India. Why is it then that there is an absolute shortage of small denomination notes in the bazaars of India? ‘Bazaar’ is only a word for a site of commerce; from the north to the south of the country, from airports to village stores, trade and production is held up due to the absence of notes and coins of the denomination appropriate to the transaction. The RBI and the Government of India showed themselves to be entirely out of touch with the reality when in 2016 the 1000 rupee note was replaced with a 2000 rupee note. It is anybody’s guess whether the daily wage for a labourer is much more than 500 rupees in much of the country. Small denomination notes are either unavailable, or of so shabby an appearance that it makes you wonder whether those responsible for the management of our economy take any pride in discharging their task. In this department India’s central bank fails substantially.
Pulapre Balakrishnan is Professor, Ashoka University and Senior Fellow, IIM Kozhikode