Building a better credit policy speech

Financial Express, 31 July 2009

Most of us found it hard to understand the 124 pages that RBI recently put out. Understanding RBI is better achieved by watching what they do instead of hearing what they say they do: by analysing the (limited) data that they put out, instead of reading their prose.

RBI does a lot of things. It sets the short-term interest rate, trades on the currency market, performs investment banking as an agent of the government, regulates banks, regulates parts of the currency and fixed income markets, runs a bond exchange and a bond depository, etc. Most of these functions conflict with each other.

Several expert committees have argued that institution building in India requires shedding the extraneous functions. There is a particular urgency in shedding the functions where there are conflicts of interest with the core business of monetary policy (i.e., that of setting the short term rate).

In the short term, we have to treat the confused mission of the organisation as a given. What, then, is a constructive agenda for doing better in running RBI? One key problem is that of transparency. International comparisons show that RBI is one of the least transparent central banks in the world. In the recent decade, most central banks have made progress towards greater transparency, but RBI has not. RBI scores near the bottom in international tables in terms of either the level or the change in transparency. China, Pakistan and Bangladesh all have better scores than RBI on transparency, and have made progress on increasing transparency in the last decade (while RBI has not).

Transparency is important for good governance, going beyond the technical aspects where transparency matters in obtaining an effective central bank. There is now a consensus in India that every government agency must be subject to stringent transparency and accountability requirements. The need of the hour for the leadership at MOF and RBI is that of achieving transparency and accountability at RBI.

How can progress be obtained? The heart of central bank transparency is communicating the thought process of the central bank, and how it will react to various events in the future. The central bank can obviously not say what it will do in December. But when markets face a well functioning central bank, they can anticipate what it will do in December under various scenarios of what the world will look like in December.

Decision making in RBI reflects the tugs and pulls of four compulsions. The first is the core business of monetary policy, i.e. central banking. This involves looking at business cycle conditions, forecasting GDP growth and inflation, and setting the interest rate. The second is trading on the currency market. The third is about doing investment banking for the government. The fourth dimension is a motherly attitude towards poorly regulated banks, where RBI worries about the profitability and maturity mismatches of banks when setting interest rates.

For RBI to be transparent, it has to talk fully and honestly about these four tugs and pulls. It must have a truthful discussion about how it approaches all these four problems and about how it will resolve the tensions between them. The governor's speech must be no more than 2000 words of plain english, articulating how these four factors come together in the thought process, and how RBI will react to various scenarios. The market must know how RBI will behave, conditioning on future data. Once the market has understood the central bank, they will return to watching the economy (confident in knowing what the central bank will do when faced with various scenarios) and not need to watch the central bank. Indeed, intense effort in interpreting every phrase of a central bank signifies a failure to communicate on the part of the central bank.

Writing such a credit policy speech is hard, but it can and should be done. It will require honesty about issues such as currency trading, maturity mismatches of banks, or profitability of banks, where RBI is presently non-transparent. This would be healthy progress. The present structure of the speech that comes out with each credit policy is out of touch with the way good central banks work, and needs to be scrapped.

Reserve money (or M0) is the sum of RBI's holdings of foreign exchange reserves and Indian government bonds. In a proper central bank, changes in M0 are the consequence of a fully articulated monetary policy strategy. At RBI, M0 bounces around owing to conflicts of interest. Sometimes, the pressure of deficit financing forces RBI to buy more government bonds, thus driving up M0. Sometimes, the pressure of currency pegging forces RBI to buy US dollars, thus driving up M0. This is surely not the right way. At the same time, however bad be the present way, it is important to articulate it fully, and release copious data with the blow-by-blow action. The market and the public and Parliament must have a keen understanding of the rules of engagement through which RBI buys or sells government bonds or dollars, and what it is doing every day.

The main point here is that there is a useful distinction between (a) a properly structured monetary policy strategy and (b) transparency. India deserves a central bank which has both. Until the RBI Act is substantially modified, the first is out of reach. However messy the realities of RBI decision making might be, India deserves the second. This can and should be done, even if it means putting out some dirty laundry.

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