The monetary system is for an economy, what the cardiovascular system is for the human body. Therefore, if there is any truth in Darwin’s theory, then naturally, the former must keep pace with the latter’s evolution. Metaphorically, a cheetah cannot survive with the cardiovascular system of a tortoise.
The fact is that the India for which the Reserve Bank of India (RBI) was originally designed does not exist anymore, and the central bank must adapt itself to newer requirements, or risk being overburdened and fatally choking the economy. Taking this argument forward, a central bank must build a monetary system in its own image. But first, the central bank itself must be built in the image of its government’s priorities. Historically, just like any central bank, the RBI is also a product of its masters and the associated policy environment. Since 1935, the RBI has been a microcosm of Indian politics and oriented itself to serve political hunches.
Indian central banking 1.0
The RBI as we know it today, began to take shape with the passing of the Banking Regulations Act, 1949, when a centralized policy towards commercial banking was initiated. As the then Prime Minister Nehru adopted the strategy of resource optimization, under what is known as the Nehruvian Consensus, the RBI was touted as a centralized agency to rein in the banking sector. The idea here was to make Indian banks the primary financiers of development. The job of commercial banks was to therefore monetize government debt via public savings, and this was clearly delineated, even more so post-1969 nationalizations. At the time, this was perhaps the only way to protect India from the clutches of foreign debt.
Consequently, the function of the RBI was to modulate interest rates to mobilize public savings. In other words, the RBI was designed to be a functionary of the government for resource mobilization and for that kind of role, its posture was obviously authoritative. Therefore, it can be argued that the RBI became the ‘centralized monolith’ as a product of successive ruling governments and their set priorities. This in turn resulted in the RBI evolving into an overbearing institution, instead of an active participant within the monetary system.
Indian central banking 2.0
Today, however, the economy is at a distant place. Given this understanding, the present government must initiate a process, allowing the RBI to not only transform itself into a decentralized, plugged-in central bank but also transform the entire monetary architecture, in the process. In today’s context, India is no longer in a consolidation phase, rather it is in a divergence phase, and monetary architecture must exhibit the economy’s needs.
Time and again, key macro data reminds us that India remains a diverse economy, with significant regional disparities and developmental priorities. A one-size-fits-all approach is not applicable today, and central banking must reflect this. The fact of the matter is that the economic needs of Karnataka and Bihar differ profoundly.
Shallow corporate debt market
It is always the unforeseen events that force a system to re-evaluate itself, and it was not until the Covid-19 pandemic that things were found out of place. In its professed role as a financier to the government and defender of the system, the RBI has always kept itself isolated from India’s corporate debt market. Accordingly, the entire monetary system has evolved around government securities, so much so that ‘high-quality liquid assets’ of commercial banks are fully composed of these securities.
This comes at the cost of corporate issued securities, and results in making India one of the shallowest secondary markets, among peers. It was not until Indian mutual funds, the primary holders of such securities faced considerable redemption pressures, that the policymakers took notice, and a special window was created as a rescue operation. The learning here was that India’s new economy had a thriving private sector, radiating unprecedented sophistication and utilizing diverse sources of financing. In fact, the evolving corporate debt market is worth over $500 billion, and the system can no longer afford to stifle this segment.
Way forward
Unfortunately, with its existing dispensation, the central bank finds it risky to include such securities as system-wide collaterals. Hence, the idea is that in a reformed reserve bank system, since central banking will be decentralized, the risks will not only be evenly spread across the four reserve banks but also among commercial banks. This in turn is because central banking will then begin to reflect the experience of commercial banks while interacting with the market.
At the same time, with higher levels of integration, the reserve banks can gradually bring their combined balance sheet to the global standard of 30 percent of GDP. In today’s terms, this can unleash an incremental $400 billion as additional holding capacity, which can then be utilized to hold not only corporate debt (as a market stabilizing mechanism) but also municipal and additional government securities. Initially, this may result in incremental debt overhang and inflationary tendencies, but over the longer term, may help in reducing the cost of debt servicing through system efficiencies, innovations, and deeper capital markets.
Globally, most major central banks dedicate a portion of their balance sheets to alternative securities. Over 30 percent of the US Fed balance sheet, for example, is comprised of corporate and municipal debt, valued at over $2.5 trillion. The ECB and the Bank of Japan have dedicated 5 percent and 6 percent of their respective balance sheets to corporate debt. Indeed, a significant system-wide sophistication has been achieved by such countries, and the resultant capital abundance has been a major enabler of economic property.
Therefore, if India too seeks the prosperity of its citizens, which is in fact natural, the country’s monetarists must look within, critically, and reflect prevailing realities. It’s high time that adequate cognizance is diverted towards this end. A sense of urgency is however entailed. Arguably, an overburdened, clogged cardiovascular system invariably leads to a heart attack.
(This is the second of a series looking into reforms required at the RBI to make it more effective in a changing India. Read part one here.)
Karan Mehrishi is an economist, specialising in monetary economics and fixed income. Views are personal, and do not represent the stand of this publication.
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