17th January 2020 : The Hindu Editorials Notes : Mains Sure Shot
Question – Is limiting the role of the RBI to only inflation targeting a good move or has it failed on multiple counts? Discuss.(250 words)
Context – The rising inflation and the role of the RBI.
Why do we need Central Banks?
- The establishment of some of the world’s oldest central banks was inspired by the goal of maintaining financial stability because when private commercial banks fail, whether due to malfeasance or misjudgment, they not only harm their trusting depositors, they can also take down with them the rest of the financial system.
- How? – it is because banks lend to one another (inter-bank lending – The interbank lending market is a market in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate.).
- Now when one bank fails, there is a collapse of credit which, in turn, leads to a downturn in economic activity.
- To avoid this, the central bank was conceived of as the lender of last resort, one that could pre-empt a run on banks and give them time to put their books back in order.
How would the central banks do this?
- By the adoption of a tough regulatory stance, whereby the central bank would stay hawk-eyed towards the ‘all’ the activities of banks, particularly risky lending i.e. adopting a multiple indicator approach.
Impact of neoliberalism: policy from 2016 onwards:
- But with the rise of neoliberalism, the central idea of which is that markets should be given free play, the regulatory role of central banks took a back seat.
- The banks primarily became concerned with inflation control.
- Even though before neoliberalism also the banks were looking after inflation control, but they were at the same time concerned with financial stability and the level of economic activity.
- Now the banks role became more to manage inflation rather than financial stability and economic activity.
An overview of development in the role of RBI as a regulator:
- Monetary policy decisions by central banks can have far-reaching implications for the economy, investors, savers and borrowers. Between1980 to 1998, RBI adopted operating method of monetary policy ‘monetary targeting with feedbacks’. This method has been later altered pursuant to liberalization of financial markets and opening up of the economy and short-term deviation in the relationship between money, output and prices.
- From 1998-99 till February 2015, RBI was following Multiple Indicator Approach (MIA), in which a number of macroeconomic and financial variables are considered while deciding the monetary policy rather than a single M3 aggregate as in the past. Under MIA, Central Bank’s rate decisions were taken based on variables like interest rates, rate of return in different markets, foreign trade, Capital flows, inflation, growth, employment, banking stability and the need for a stable exchange rate etc. The multiple indicator approach provided necessary flexibility to RBI to respond to changes in domestic and international economic and financial market conditions. However, in spite of considering other variables, under MIA, the growth in broad money (M3) continues to be used as an important indicator of monetary policy.
- The expert committee headed by Dr. Urjit Patel recommended revising the monetary policy framework, and it came up with its report in January 2014. It suggested that RBI abandon the ‘multiple indicator approach’ and make inflation targeting the primary objective of its monetary policy. The reason given for this was that according to one theory of economics – having economic activity as an objective of monetary policy leads to higher inflation.
- The Reserve Bank of India (RBI) officially adopted inflation targeting (IT) as a monetary policy strategy in February 2015. Inflation targeting has steadily gained popularity with increasing number countries adopting the frame work. So inflation targeting became the sole objective of RBI’s monetary policy.
As a result:
- The RBI was permitted to exceed or fall short of a targeted inflation rate of 4% by a margin of 2 percentage points. This was hailed by the government as the adoption of the ‘modern monetary policy framework’ by India, and came into effect from the year 2016-17.
Has this shift in RBI’s role been successful? Has a fixation with inflation rate made the RBI take its eyes off the loan books of the banks?
- In 2018, within three years of the adoption of inflation targeting goal, a crisis engulfed IL&FS, a non-banking financial company in the infrastructure space. It defaulted on several of its obligations, including repayment of bank loans and the redemption of commercial paper.
- The IL&FS was not just another ‘shadow bank’; it operated over 100 subsidiaries and was sitting on debt of ₹94,000 crore. Given this, its default had a chilling effect on the investors, banks and mutual funds associated with it both directly or indirectly. Since then, in 2019, a run on the Punjab and Maharashtra Co-operative Bank had to be averted by imposing withdrawal limits. It was discovered that fictitious accounts, reportedly over 21,000 of them, had been created so that the books would tally, even as deposits were siphoned off as loans to the promoters.
- While in the case of IL&FS, some part of the problem may have been caused by a slowing economy, outright fraud underlay the crisis at PMC Bank. And now, in early 2020, curbs have had to be placed on withdrawals from the Bengaluru-based Sri Guru Raghavendra Sahakara Bank.
- Even if it is too early to declare that financial instability prevails in India, it is not too early to ask if the RBI’s responsibility to regulate the financial sector may have taken a back seat after adoption of inflation targeting as the main objective.
- Also, it is not as if the RBI is doing spectacularly on the inflation targeting front either. At over 7%, the inflation rate in December is the highest in five years. This may not be reason to panic, for the price rise could be seasonal and may well abate, but it does raise a question on the efficacy of inflation targeting as a means of inflation control. Inflation led by rising prices of food stuff cannot quickly or easily be contained by the mode of control underlying inflation targeting. It requires enhancing supplies which, in turn, would mean raising imports in the short run.
- Be that as it may, the extent of failure of inflation targeting right now is substantial indeed; the inflation rate has exceeded the permissible range of error by 65%. This must give pause as to how much the shift to the ‘modern monetary policy framework’ has delivered.
- The government needs to take a fresh look at whether limiting the role of the RBI to only inflation targeting is yielding desired outcomes or not. If not there is no harm in readopting the multiple indicator approach.