The MPC in the revised IFC

Indian Express, 5 August 2015

The central problem that India faces is that of obtaining greater State capacity: of a government that effectively delivers what the political leadership desires. This requires a full re-engineering of government, with an emphasis on clarity of objectives, rule of law, and accountability. These things are defined in laws. In one field, finance, the revised Indian Financial Code opens the way to State capacity.

We in India transitioned from colonialism followed by socialism. Now we are trying to build a market economy, and are beset with malfunctioning government organisations. Too often, government organisations meddle unreasonably in the economy, fail to competently do the things that are needed to be done, and engage in excesses of corruption, laziness and arbitrary power.

The question of the age is: How to setup the regulatory apparatus that will power high growth? If we setup a regulator as a controller of a sector, there are no limits upon the actions of the regulator, and misbehaviour is likely. Each regulator must have clarity of objectives, limited powers, and ample accountability mechanisms.

Regulators are given the power to write law in the form of "regulations". A well structured process is required with checks and balances, to avoid the abuses of unelected officials writing law. Regulators perform the executive function of enforcing the law. Formal procedures must be in place to avoid abuse of power. Regulators perform a quasi-judicial function in writing orders. This requires an adversarial hearing. Once an order is passed, it should be subject to judicial review.

The law defines the DNA of the regulator on all these fronts. In order to obtain better functioning of regulators, we need to rewrite the law. In one field, finance, a comprehensive rewrite of the law has been done in the form of the draft Indian Financial Code. Justice Srikrishna's Commission worked from 2011 to 2013. A large volume of public comments were received. The Ministry of Finance has come out with a revised draft, with many technical improvements. In parallel, the Ministry of Finance has begun constructing the financial regulatory institutions required to enforce the law. Once it is enacted and enforced, India will achieve a modern financial system.

Public discussions about the IFC have focused on the organisation of monetary policy. India is now in the early stages of the process of establishment of the Monetary Policy Committee.

The key intuition is that of a bench of judges. A bench of 5 or 7 judges obtains a better answer than any one judge. No matter how skilled, any one judge can be wrong. A good bench gives a better outcome by bringing multiple perspectives. When there is one judge, there are pressures on him and all kinds of considerations and deal-making can come into play. It is much harder to pressurise an entire committee. This gives greater independence. No one person should control the committee, else we fall back to the problems of one judge.

External members are particularly important from the viewpoint of diversity of viewpoint. Colleagues within a central bank are likely to have shared assumptions, a shared worldview, and reticence in breaking with the ranks. External members bring a fresh perspective and independence of thought and thus improve the outcome.

As an example, consider the recent experience. RBI has a `Technical Advisory Committee? (TAC) which is composed of all external members. In 2014, the TAC was the first in understanding the collapse of demand in the economy, and favoured rate cuts. The Governor thought differently at the time. But the TAC was proved right when the Governor chose to make two unexpected inter-meeting rate cuts in January and March 2015. If the external TAC members had had the formal power of voting in the MPC, then rate cuts would have come in January and September 2014. We stand to obtain such gains by shifting power in rate setting from an individual to a committee.

External members would come from all walks of life. Some could have connections into the world of business. They would have better appreciated the difficulties of demand conditions in India in 2014 and 2015 and possibly voted in favour of much larger rate cuts. Such diversity of perspective caters to obtaining the best outcomes for the country.

How large should rate changes be? RBI has followed the style of central banks worldwide, raising or cutting at 25 bps at a time. However, the monetary policy transmission in India works differently. Given the malfunctioning financial system, a 25 bps rate change makes a negligible difference to the cost of funds of households and firms. External members, who are more grounded in the realities, could possibly argue in favour of much bigger moves, given the differences between the realities of the Indian financial system, as opposed to the conventions of other central banks.

There is a lot of talk about independence of RBI. Under the present law, RBI does not have independence. The Government has the power to give directions to RBI on anything at all, without needing to offer a rationale and without transparency. Whether it is exchange rate policy or rate setting, the Government has the power to give directions under the present law. Under the proposed law, RBI will have greater independence. But the independent authority to set the interest rates will vest with the MPC and not with the Governor. This will give greater institutional stability and predictability.

Too much of the discussion is focusing on who appoints the MPC members. We must remember that the Governor, Deputy Governors and all board members of the RBI are appointed by the government. The same appointment procedure should be used for MPC members.

There is a clamour for deeper economic reforms. The revised IFC is the deeper reform which will establish State capacity, reset the role of the government in the economy, and reduce the cost of doing business. As with all reforms, this will face resistence from incumbent government agencies. However, there are no political barriers to this reform in the form of opposition by voters. In order to obtain the full gains in the shortest time, we must also emphasise early implementation of the non-legislative recommendations, and creation of the requisite institutional architecture.

Back up to Ajay Shah's 2015 media page
Back up to Ajay Shah's home page