The interest rate debate

The battle lines have been drawn. On the one side, you have Reserve Bank of India Governor Raghuram Rajan, who has dug in his heels against the latest draft of the Indian Financial Code (IFC). On the other side, you have those in the Union Finance Ministry. As per the latest draft of the IFC, a proposed seven-member monetary policy committee (MPC) will be charged with setting policy rates to ensure that the inflation-targeting mandate is maintained. The all-powerful committee will have four representatives of the government and only three from the central bank, including the ‘RBI Chairperson’, a move that would effectively transfer the RBI’s present interest rate-determining powers to the Finance Ministry. Further, it said that the RBI “must form a Monetary Policy Committee (MPC) to decide by majority vote on the Policy Rate needed to achieve the inflation target”. At present, the RBI Governor consults a Technical Advisory Committee but does not necessarily go by the majority opinion.

It is fair to suggest that the debate across most media outlets has been heavily in <g data-gr-id="38">favour</g> of Raghuram Rajan, whose expertise in monetary policy management is widely respected. However, with India’s monetary policy at stake, it is imperative to present the other side of the debate. According to those in  favour of the RBI Governor, including this newspaper, the Finance Ministry’s revised draft of the Indian Financial Code, seeks to undermine the financial independence of the central bank—an institution that has constantly shielded the economy from volatility in global markets. Through this draft report, the Finance Ministry is trying to shift the onus of determining monetary policy from an autonomous central bank to a government, which may manipulate it to suit its political agenda.

The underlying rationale behind such a stand is that since four of the seven members of the MPC will be appointed by the government, the central bank will lose its independence. However, in its current form, the RBI does lack any sort of statutory independence. As per the RBI Act of 1934, all 21 members of the central board of directors, including the Governor himself, are appointed by the Government of India in one way or another. One interpretation of the existing law clearly stipulates that the government can dictate policy to the central bank, which the RBI Governor will be obliged to follow. Therefore, any apparent independence that the RBI may enjoy is clearly dependent on how its Governor responds to political pressure.

Under Rajan, the RBI has admittedly shown a great deal of independence from political and corporate pressures.  However, certain experts have argued that such a model, where the RBI Governor is the sole arbitrator of a nation’s monetary policy, will not leave the institution in good health. What if the next Governor does not possess Rajan’s strength of character? As the sole arbitrator of monetary policy, such a Governor will constantly be under pressure to toe the government’s line at the expense of public interest. The assumption that all four government-appointed members will be the lackeys of the government is clearly false. The case in point, ironically, is current RBI Governor Raghuram Rajan, who is, for all intensive purposes, someone appointed by the government.

By contrast, under the proposed MPC system, all seven members will bear the collective responsibility for the nation’s monetary policy outlook. Logic clearly states that it would difficult to pressure all seven members rather than one RBI Governor. Moreover, under the IFC draft rules, each member will have to produce a written draft, explaining why he/she voted on a particular policy measure, in addition to the fact that the minutes of the MPC meeting will be made available for public scrutiny. Under the current system, some have argued that the decision-making process is shrouded in secrecy. The proposed new system, therefore, will enable a more transparent and robust decision-making process. And finally, the fundamental check on the MPC’s activities will come from its explicit mandate of achieving the 4% inflation target, with a tolerance band of 2% around it.