Where spine and credibility matter

The surprise move that pulled out 86% of currency out of circulation does not have any precedence in the world. There was absolutely no template to follow and no experience to draw upon. Considering this, it is not surprising that economists disagreed on the efficacy of the objective and severity of the impact. However, there is a broad consensus that demonetisation has hurt the reputation of the Reserve Bank of India (RBI).

It is still not very clear who proposed the idea. Recently, RBI governor Urjit Patel told a parliamentary panel that work on demonetisation began in May 2016. Did former governor Raghuram Rajan refuse a second term because he did not support demonetisation?

The RBI had earlier said that the government advised it on November 7 to scrap high-value notes. The RBI Board cleared the move next day, hours before Prime Minister Narendra Modi’s televised address. This led to the growing perception that the RBI crumbled under government pressure. The vacant posts of independent directors in the RBI Board added to the perception.

A number of former RBI governors were anguished at the erosion of the central bank’s autonomy. Y V Reddy said that “institutional identity of the RBI has been damaged”. He said the Centre has every right to take the decision but if he were the governor, he would have simply expressed his professional disagreement over the feasibility of the move. Bimal Jalan said, “The autonomy of the RBI is a very fundamental fact and we have to maintain it”. In a recent op-ed, former deputy governor Usha Thorat wrote, “It is indeed a sad day to see one of the most respected public institutions in India becoming an object of ridicule and scorn”.

While the British were first setting up RBI, Sir Norman, the then governor of the Bank of England, commented, “It should be like a good ‘Hindoo’ wife, always tendering advice and obedient. The husband, the government, would be dominant and free to take the wifely advice or not”.

In all honesty, the RBI Act of 1934 does not empower the central bank with absolute autonomy. Section 7 of the Act states, “The central government may from time to time give such directions to the bank as it may consider necessary in public interest”. But this power has never been exercised in the last 82 years. The RBI Act and its numerous amendments have given relative autonomy to the central bank in certain monetary and regulatory functions without any political interference. The RBI is more focused on medium to long-term stability, while the government wants short-term gains. So, conflict between the central bank and the government is inevitable.

We all remember clearly former finance minister P Chidambaram’s words, “If the government has to walk alone … then we will walk alone,” when the then governor D Subbarao refused to cut policy rates in 2012. There was always an invisible line that the government never crossed. Successive governors worked painstakingly to hold up the image. Rajan with his excellent credentials managed India’s currency crisis deftly in 2013. Under his leadership, the RBI’s credibility reached new heights. He was felicitated with Central Banker of the Year award for 2016 by the British magazine The Banker.

A world view

Globally, there have been several instances of heightened tension between the elected governments and central bank governors, casting a shadow on the central banks’ independence.

The US Federal Reserve increased rates in December 2016, a year after raising it for the first time. The timing – after the presidential election – raised the usual question of whether Fed was playing politics. Donald Trump had criticised the Fed during his campaign. Similarly, soon after winning the Brexit referendum, Prime Minister Theresa May had publicly criticised the Bank of England governor for low interest rates.

In 2013, Bank of Japan governor Masaaki Shirakawa left before retirement as he disagreed with Prime Minister Shinzo Abe’s idea of stimulating growth with an expansionary monetary policy. In the same year, it was rumoured that Stanley Fischer, governor of Bank of Israel, resigned due to differences with Prime Minister Benjamin Netanyahu. Closer home, Sri Lankan Finance Minister Ravi Karunanayake referred to a comment made by Indrajit Coomaraswamy, governor of the Central Bank of Sri Lanka, at a news conference and said that “if the economy is in the hospital today, it was in the ICU during the Rajapaksa government and the governor was an attendant to it”.

The RBI has the prime responsibility to issue bank notes or declare when any series of bank notes cease to be legal tender. If the government wanted to go ahead with demonetisation and the RBI believed in it, there is no problem in Patel supporting the move. But the way it was handled it seemed like the government has encroached upon the RBI’s territory.

The question here is not the RBI’s independence but more about RBI’s credibility. The RBI seemed totally unprepared for a demonetisation exercise of this scale. They failed to do simple arithmetic: how long will it take to print new notes? How many lower denomination notes should be printed before the announcement? How much time is needed to recalibrate the ATMs?

Another question that arises is could the RBI have refrained from issuing the circular of December 19 that had to be rescinded immediately? Patel’s non-communicative demeanour made matters worse. To rebuild its credibility, senior RBI officials need to communicate more about their stance on demonetisation, its impact on the economy, new notes issued and about old notes coming back into banks. A more transparent and communicative RBI can salvage its reputation. The ball is in Patel’s court.

(The writer is a research scholar at the Indian Institute of Foreign Trade and an adviser at Policy Monks, New Delhi)