Why should RBI be independent?

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Why should RBI be independent?

Last month with the news of Govt. invoking Sec 7 the question on the autonomy of RBI was raised. Now with the resignation of governor Urjit Patel and the appointment of Mr. Shaktikanta Das, the control of the government over RBI is again in talks. In our earlier post “Govt. invokes Sec. 7: Is RBI independent?” we read about the disagreements or the factors that led to the conflict between government and RBI. Though constitutionally or legally, the central bank is an autonomous structure, many times government intervention in say appointments or approving decisions at Board meetings, etc can cause damage to the independence of the central bank and to the economy at large. In this post let us understand in general, why the central bank of any country should be independent? 

Functions and structure

A central bank performs the following important functions for the country:

  • Controlling the money supply;
  • Ensuring financial stability,
  • Regulating the financial sector and banks,
  • Regulating the Forex market and exchange rates,
  • Regulating credit and set the interest rates on borrowing and lending money, and more importantly,
  • Keeping inflation in check

To perform these complex and technical functions, the proper structure of the central bank is important. Globally, a central bank is an institution separate from the government. In other words, the central bank generally does not work as a department of the government rather it is created as a separate institution with a separate legislature. And to perform its critical and complex tasks, the bank is manned by field experts like economists, bankers etc. These officials are not elected but are selected by the government. This process ensures that the central banks will be allowed to exercise their powers independently.

An independent central bank can take its decisions for macroeconomic stability without considering political windfalls. Hence, the autonomy of the central bank is essential for ensuring stable and sustainable growth in any economy.

Short term v/s Long-term goals

As Dr. Viral Acharya (Dy. Governor) mentioned while delivering a speech that the Government’s horizon of decision-making is like a T20 cricket match whereas a central bank plays a Test match.

In other words, any government’s horizon is relatively very short-tenured.  There are multiple considerations like upcoming elections of any sort. Sometimes, delivering on proclaimed manifestos of the past creates urgency. At times, manifestos cannot be delivered upon and populist alternatives are arranged with immediacy. Sometimes, wars had to be waged, financed, and won at all costs.

Central Bank, on the other hand, has horizons of decision-making much longer than the government. The criticality of managing economic i.e. financial as well as inflationary health depends on the Central Bank. This economic health strives on the policies or frameworks created considering medium to long-term vision.

Many times, the government can be tempted to make short-term decisions for political good. A short-term, hasty decision can cause larger harm to the economy in long run. Hence, it’s of utmost importance to keep the Central Bank as an independent function, separate from the government’s control.

Tail Risks

The central bank manages money creation, credit creation, inflation, forex, and financial stability. Many of these involve potential front-loaded benefits to the economy but there is always a possibility of back-loaded costs from financial excess or instability.

To give an example, Allowing free foreign capital flows into the economy can ease the financing pressures due to investments coming into the country. However, this has some “tail risks”. Sudden stopping of flows can trigger a collapse of the exchange rate with an adverse economic outlook in the future. Similarly, a lowering of interest rates can increase credit creation in short term. But, excessive lowering of rates can lead to bad quality loans and financial crisis in the long term.

Hence, it is important to weigh the risks in the long-term against the rewards in near future and to achieve this, the autonomy of RBI is a must.

Is there any need for the government to control RBI?

Sometimes, the decisions taken by the central bank can be considered wrong or fail. In such cases, it can be argued that government control on the decisions should be mandated.

However, as Dr. Acharya says in his speech, that RBI can, of course, make mistakes, and is generally held publicly accountable through parliamentary scrutiny and transparency norms. This way, the institutional arrangement of independence, transparency, and accountability to the public not only balance but also strengthen the central bank’s autonomy. However, direct intervention and interference by the government in the operational mandate of the central bank negate its functional autonomy.

Argentinian Example

Not just in India, but Central banks are under attack by politicians in many countries after the 2008 recession, like Russia, South Africa, Thailand, Turkey, etc. In December 2009, the Argentinian government set up a fund to finance public debt maturing that year. This involved the transfer of $6.6 billion of the central bank reserves to the national treasury and it was claimed that the central bank had excess reserves. By the beginning of January 2010, a New York judge, had frozen the Argentine central bank’s account held at the Federal Reserve Bank of New York, following claims of investors that the central bank was no longer an autonomous agency but under the thumb of the country’s executive branch. An Argentina analyst at Goldman Sachs noted on February 7, 2010: “Using central bank reserves to pay government obligations is not a positive development and the concept of excess reserves is certainly open to debate. It weakens the balance sheet of the central bank and provides the wrong incentive to the government, as it weakens the incentive to control the rapid expansion of spending and to promote some consolidation of fiscal accounts in 2010.

(Reference: RBI Website)

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About CA Janhavi Phadnis 73 Articles
Chartered Accountant and financial consultant. She has worked with corporates for 14 years with expertise in Forex-Treasury, Accounting, and Corporate Tax. She can be contacted at info.financepost@gmail.com

1 Comment

  1. this article is so good ,I am thinking that RBI should be independent because all the currency manufactured by the RBI so that’s why i am saying if it will dependent on any other origination i will lead to create more note leads to inflation.

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