In Defence of the RBI — The Lender of Last Resort

This piece has largely been adapted from Duvvuri Subbarao’s book 'Who moved by interest rate?’, where he chronicles his journey as the RBI governor. We have also relied extensively on speeches made by top RBI personnel

When all else fails, the central bank will stretch its arms to save the financial institution of the country. This little nugget encapsulates what the central bank does rather succinctly. It is after all the lender of last resort and a fundamental pillar that keeps the economy afloat. But to this day, it still remains a largely opaque institution despite everybody having an opinion on what it should or should not do. So today our story will focus on the quintessential anti-hero of our time — The Reserve Bank of India and hopefully try and put up a spirited defence for the institution. But before that, a note on what it is that the Reserve Bank of India actually does.

RBIs Mandate

Perhaps the least understood aspect of the Reserve Bank of India is its mandate. While responsibilities of the RBI are more expansive than other central banks, all of them centre around one large theme — Price Stability. It implies avoiding both prolonged inflation and deflation which in turn spurs high levels of economic activity and employment. The interpretation of this mandate, however, can vary depending on your political inclinations. Back in 2013, the then finance minister of the country, Mr Chidambaram was probed about his frustration with the Reserve Bank and its stance on interest rates — a tool that the bank uses to achieve its objective of maintaining stable prices. In what was a visible departure from standard protocol, Chidambaram publicly expressed his dissatisfaction by stating that the ‘mandate must be understood as part of a larger mandate of promoting growth’ and not in isolation.

However, Central Banks world over, including the RBI interprets the mandate exactly as Chidambaram intended with one minor alteration i.e. the mandate is understood as part of a larger mandate of promoting ‘long-term’ growth. This requires taking a long-term view even if the path to price stability might entail significant short-term pains. The ruling party, whose future rests on more short-term accomplishments might show little sympathy for such considerations but this only strengthens the case for an impartial assessment of the economic scenario by an autonomous body (RBI) and so to play cheerleader to the government’s whims and fancies would be detrimental to the growth cause of the Indian Economy.

Another similar criticism comes from Market participants and industry veterans who clamour for low-interest rates. A low-interest rate scenario often helps spur economic activity by getting more people to borrow and spend, but it also entails dangerous antecedents that might eventually lead to periods of sustained price increases affecting large swathes of the Indian population [See- Inflation]. As the former chair of the Federal Reserve (The American Equivalent of the RBI) once noted — ‘In the eighteen and a half years I was there, I got a huge number of letters or notes or whatever, urging us to lower interest rates. On the side of getting letters which say you’ve got to tighten [raise rates], it was a zero.’ It is virtually impossible for the large collective Indian public who routinely face the wrath of inflation to have an audience with the Governor. So it is paramount that the bank heeds to the concern of the voiceless in an attempt to balance the act.

Point of Interest : Investors who keep professing the long term value investing mantra must bear in mind that it is counter intuitive to keep criticizing the RBI for hiking interest rates. Perhaps, every once in a while its best to side with the RBI considering they have your ‘long term interests’ at heart

Can’t you see the Future?

“When the outcomes are bad, clients often blame their advisors for not seeing the handwriting on the wall — forgetting that it was written in invisible ink that became legible only afterwards.”- Daniel Kahneman

Another often cited criticism of the Reserve Bank of India is that it consistently fails to forecast inflation and growth rates accurately. According to the critics, this is a rather serious transgression on the part of the bank, mainly due to the fact that these numbers are then used to justify the monetary policy calibrations [changing interest rates etc.] needed to achieve the intended objectives of price stability. How could the collective wisdom of the Monetary Policy Committee, the governor, the deputy governors, the modelling experts and other technical advisors all be so woefully inadequate to deal with what seems like a rather straightforward problem?

To answer that question we must first look at the data that’s used to predict these future outcomes. As Duvvuri Subbarao, the former Governor of the RBI points out — “The Reserve Bank operates within the universe of knowledge available in real time, and that universe is largely shaped by data. If the data are reliable and available in good time, policy response can be accurate and confident. But the Reserve Bank is oftentimes wrong-footed because of the questionable quality of data.” This questionable data can often lead to seemingly puzzling assessments that might not be in line with reality and the governor and his team will have to often rely on the qualitative assessment of ground realities and their experience to decide on interest rates.

Another seeming problem with any kind of forecasting is the degree of uncertainty inherent in making predictions. Very few people could predict the fall in oil prices or the subsequent easing of inflationary pressures on the Indian economy and so to assume that we can, in fact, predict uncertainties consistently in the future is a very misguided opinion. Our economy is inextricably tied to the larger global economic fabric and any ripple on this vast network of interconnected webs can affect India as much as any other country. This is not to suggest that the RBI should be immune to criticism for getting things wrong but instead, that the criticisms must be predicated on a sound understanding of the difficulties inherent in predicting the future.

Thought for the day: Actions that seem prudent in foresight can look irresponsibly negligent in hindsight

Autonomy and Independence

‘My time at the central bank is up and that is why I have decided to leave my post definitively, with the satisfaction of my duty fulfilled,’ — Mr Martin Redrado, Former Central Bank chief of Argentina (2010)

In his now-famous speech titled — “On the Importance of Independent Regulatory Institutions — The Case of the Central Bank”, Viral Acharya, the deputy governor of the RBI argues succinctly with great clarity on the dangers of undermining the autonomy and independence of the Reserve Bank. In it, he quotes the case of Mr Martin Redrado, chief of Argentina’s central bank who had to resign following a face-off with the country’s president over his refusal to transfer reserves from the bank to the government’s coffers. This prompted an immediate reaction from the markets* and the international media began to speculate over whether the autonomy and the independence of the Central Bank had been compromised. Mr Viral Acharya was invoking this unpleasant episode to remind the public of the importance of an independent Central Bank. But this wasn’t a gentle reminder of the sorts business schools send to their students asking them to submit their coursework on time. This was made with intent.

*Point of Interest: Within a month of Mr. Redrado’s resignation, Argentine sovereign bond yields and the annual premium cost for buying insurance against loss from default on Argentine government bonds (measured as the sovereign credit default swap spread) shot up by about 2.5 per cent. In english it means investors were becoming increasingly skeptical of the government’s ability to pay back their loans.

Viral Acharya’s speech was out of the ordinary because it came against the backdrop of media reports claiming that the Government was likely to raid the reserves of the ‘Reserve’ Bank of India, in a move that was both unprecedented and fraught with untold perils.

For starters, any government that issues its own currency could, in theory, ask the central bank to print as much money as it can. This might sound like a very compelling narrative, but printing money is only a stop-gap solution and can often have devastating consequences in the long term [See: Hyper-Inflation]. This is why governments cannot depend on central banks to fund their operations and must instead rely on generating their own revenue (tax etc.) or borrow money from other market players (banks etc.) like everyone else. Unfortunately, despite regulations (FRBM Act 2003) explicitly stating how governments have to be prudent with their spending, they often go on spending sprees that aren’t always needed/warranted (populist measures) and when excessive spending outstrips revenues, the government panics and resorts to desperate measures to continue keeping pace with its spending habits especially when elections are around the corner.

No Diwali No fun

Resorting to desperate measures is one thing but forcing RBI to transfer its reserves is a whole different matter. This move prompted a rather strong reaction from one observer who likened it to selling family heirlooms to spend on crackers during Diwali. Despite the witty analogy, we don’t quite think it’s an entirely accurate description. Let us explain. Despite the government’s grouse with the RBI, it routinely transfers extra reserves at the end of the financial year post a review. Last year alone, the RBI transferred its entire profits for the year, towards the government’s bank account. It also issued an interim dividend (part of its profits) for this year, an unprecedented move in itself. So raiding the reserves doesn’t accomplish much except deplete resources from the RBI that would have come in handy much later in the year. It’s more like selling family heirlooms to burn crackers when it’s not even Diwali and when Diwali actually comes by, you are left with no heirlooms, no money, no crackers and a very bland festival.

Another seeming problem with raiding reserves is it undermines the authority and the good judgement of the RBI. The former economic advisor for the government claimed that the RBI had excess reserves by citing examples of several other central banks holding much lower reserves than India does. While there might actually be merit to this argument it must be noted that the Indian economy is very different from other economies and to apply a similar logic here would be detrimental to the cause. Also, if the government keeps deciding whats the appropriate levels ought to be, it may as well become a precedent for future governments to do the same. It’s like asking your 5-year-old kid to budget for the family expenses. Your kid will likely blow all your money on candy, video games and toys — an excellent idea to maximise utility in the short term but a terrible long-term proposition nonetheless.

The PCA Framework

A final grouse for the government has been the Prompt Corrective Action Framework (PCA) implemented by the RBI to keep wayward banks in check. In a speech titled “Prompt Corrective Action: An Essential Element of Financial Stability Framework” Viral Acharya goes on to argue that early intervention and resolution, designed to help banks regain health by preserving capital can prevent catastrophic failures in the banking system. On the face of it, it makes little sense for the average reader to contemplate why the government would have reservations about a move that’s intended to protect the integrity of the financial system. But on closer inspection, it becomes very evident that banks subjected to PCA norms have found it particularly difficult to keep lending as they used to in the good old days.

The framework imposes certain lending restrictions on banks. At a time when SMEs and entrepreneurs are actively seeking credit, this move can infact hamper growth and the government isn’t particularly pleased about the tightening credit situation [A situation where there is less money to borrow], especially after the NBFC crisis [Read more here]. However, it must be noted that banks falling under the PCA ambit have been lending considerable sums of money to people who haven’t been diligent in paying back, creating what is now known as the ‘bad loan’ epidemic in India. Also, in the event of mass defaults, these banks have very little money (capital) of their own to cover for such losses and this ultimately exposes depositors, i.e. you, fellow reader to cover for them. As Viral Acharya states “While the deposits typically are insured up to a certain level, economic history shows that more often than not the ultimate costs of paying off all deposits fall on the sovereign [government and through it tax payers], especially in the case of large, complex and inter-connected banks”

Conclusion

He’s the hero Gotham deserves, but not the one it needs right now. So we’ll hunt him. Because he can take it. Because he’s not our hero. He’s a silent guardian. A watchful protector — Inspector Gordon, The Batman Series

In the closing scenes of the famous Movie, The Dark Knight, the Gotham City Police force is seen chasing Batman in what seems like an anticlimactic ending to a superhero movie. Unlike a traditional ‘Knight in the Shining Armour’, Batman is no noble hero. He isn’t the person people look up to and he doesn’t inspire or offer hope as Superman does. Instead, he is the product of a city whose terrors and demons can only be fought by an equally ruthless adversary and maybe, just maybe, that’s what the Reserve Bank is trying to do after all. In a world rife with systemic flaws, we perhaps need institutions that can be ruthless and act in a manner that is both impartial and impervious to dark forces that may try to derail the growth story of this country. Maybe what we need is an institution that can acquiesce short-term gains, for a better future for our kids. Maybe what this country needs is a regulator that can foster better compliance standards in financial institutions and create more responsible stakeholders.

Maybe, just Maybe, what this country needs is a Dark Knight

This piece deliberately focuses on providing the RBI perspective. We have stayed away from criticising the institution because there are enough out there providing the opposite view.