Opinion | Why the RBI Act, a British-era relic, is responsible for central bank-govt friction

Amol Agrawal

The Reserve Bank of India Governor Urjit Patel resigned, ending another chapter of friction between the central bank and the government. Patel in his resignation statement expressed gratitude to colleagues and directors of the RBI board, which is interesting and ended it saying 'wish them all the best for the future'. But what exactly is this future?

In the last four tenures of RBI governors, we have seen how the friction between RBI and the government have become institutionalised. Right from YV Reddy to Patel, this has been the common theme. With each passing episode, the points of frictions have become more and wider.

It started with FII inflows and rate increases in Reddy’s tenure. Subbarao fought over attempts to undermine RBI autonomy in the Financial Stability and Development Council. Raghuram Rajan battled the government over taking away the governor’s veto rights in the proposed Monetary Policy Committee and the setting up of a debt management office. Patel has had to deal with the RBI board taking centre stage, setting up a new payments regulator, overcapitalisation of RBI and so on.

It is as if there is a clause in the Reserve Bank of India Act, 1934 or a vow taken by the governor, which says something like ‘on being appointed, it is the duty of the RBI governor to fight with the Finance Ministry and these fights become bitter as elections approach’.

Clearly, the need of the hour is to minimise these frictions in an amicable fashion. Some frictions are welcome and will always be there given the differences in their objectives, but this open confrontation and resignations are best avoided. It takes years to build institutional credibility and reputation and very little time to lose it.

The central problem in these issues is governance at RBI, because the opacity in the RBI Act does not give enough protection to these appointed individuals. The Act has several loopholes which need to be plugged. For instance, Section 11 of the Act which deals with removal from and vacation of office, simply says: “The central government may remove from office the governor, or a deputy governor or any other director or any member of a local board.” Thus, authorities can remove officials without any conditions, which encourages all kinds of unhealthy speculation.

Section 7 of the RBI Act has become the bone of contention in this recent fight. We still do not know whether Section 7 was invoked or not, but it gives the government enormous powers to control the central bank. The earlier scuffles were mainly between the finance minister and the RBI governor, but this time the board has emerged as the third party. This is because Section 7 allows the government to impose certain decisions on RBI which are 'necessary in the public interest' and in this case, all powers are 'entrusted to a central board of directors'. Focus on 'a central board' as it seems some of the directors (perhaps closer to the government) can be appointed and given the powers. This implies one need not fire the governor and just Section 7 will do the job. There is a reason why it has not been invoked so far.

Likewise, it is amazing to note that the Act does not specify who is chair of the RBI board of directors. It is assumed to be the governor, but it is not specified. We all know how economists assume all kinds of things, but this time the blame lies with the lawyers. In case of frictions, hierarchy matters and assumptions don’t hold water. It is possible that this could have undermined Patel’s position as he was trying to battle the government on several points of friction.

It is interesting to look at experiences of other central banks, especially around the developed world, where it is not as easy to undermine central bank autonomy as it is in the case of emerging economies. There is the US Federal Reserve where the President appoints the board of governors who are responsible for everything from general management to monetary policy.

The European Central Bank, formed by a treaty among the countries in the eurozone, is closest to full independence. It has a governing council (GC), which comprises central bank governors of eurozone countries and a six-member executive board (EB). The EB is responsible for monetary policy and in turn is appointed by the European Parliament and GC.

Then, we have central banks such as Canada and Sweden where the finance minister appoints a board, which in turn appoints the executive (governors and deputy governors) who are responsible for monetary and financial policies. Thus, there is an additional cushion of the board protecting the central bank executives from high-handed government action.

RBI’s governance still partly resembles that of the Bank of England, as the former was modelled largely on the latter and remains that way. The chancellor appoints the court of directors (five executive and up to nine non-executive directors) whose chair is a non-executive member and the central bank has created separate committees for both monetary policy and financial stability.

Thus, governance designs differ widely and there is neither a unique nor an ideal model. These board structures have developed based on their own monetary history and later changes. What it points to is that we need to think and debate critically about these issues. This is perhaps even more important as the world is getting polarised with rising nationalistic political movements. In such times, the question of whether governments can compromise central bank autonomy and whether there are any checks in the central bank Act is of paramount importance.

Much of central banking literature is focused on the need to have monetary policy rules and targets, ignoring this vital governance aspect of central banks. One example of this is the fact that India’s Financial Sector Legislative Reforms Commission suggested overhauling the RBI board as well as prescribing inflation targets to be achieved by the MPC. However, we only cared for the second and completely ignored the first. We are facing the consequences of this omission and hopefully both we and other central banks will learn from this experience.

Amol Agrawal is faculty with Ahmedabad University. Views are personal

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