There are four elements of the report card that we would write in December 2014. How much has year-on-year CPI inflation declined? Did the exchange rate hijack monetary policy? Has the bond-currency-derivatives nexus started thriving, with liquidity and market efficiency? Has substantial implementation of the Indian Financial Code taken place?
The choices that will be made will have momentous consequences. It is possible to obtain huge progress, or collapse into abject failure, on all four fronts.
The first priority is that of dealing with stubborn high inflation. The informal target of policy makers consists of achieving year-on-year CPI inflation between 4 to 5 percent. From February 2006 onwards, in every single month, the upper bound of this target has been violated. At the same time, it is not possible to bring inflation down quickly. The tool at RBI's disposal—the short-term interest rate—influences the economy in a limited way, as the financial system is flabby. RBI must never take its eye off the ball but we can only expect limited progress in 2014.
2. Monetary Policy
The world economy is healing, and some moves by the US Fed are likely in reversing unconventional monetary policy. These moves will reverberate in financial markets worldwide. There will be fervent pleas to RBI to manage the exchange rate by people who have neglected to do their own currency risk management. As the messy rupee defense of 2013 showed, getting sidetracked by the exchange rate is costly. All exchange rate policy is monetary policy, and the pursuit of an exchange rate objective comes at the cost of the prime objective of monetary policy: To deliver low and stable inflation.
3. Bond-Currency-Derivatives Nexus
RBI finds it hard to deliver low and stable inflation because the financial system is flabby. Thanks to a weak bond-currency-derivatives nexus, RBI is unable to influence the economy through changes in the short-term interest rate. It is ironic that RBI has pursued a strategy of damaging this nexus that results in its own impotence on its first responsibility—low and stable inflation. A long list of policy mistakes need to be reversed to achieve a liquid bond market and a currency market and derivatives on these. One year from now, all these can be solved problems.
4. Indian Financial Code
RBI is a badly structured organisation. There is a lack of clarity on the legislative, executive and judicial functions, and on establishing an organisation that will pursue these objectives in ways that are grounded in wise public administration. The draft Indian Financial Code has brought clarity about how financial agencies should be organised, and the market failures that they should pursue. The process of implementing the code has begun, and substantial adoption can take place over the year at RBI.
Ajay Shah is a professor at the National Institute of Public Finance and Policy
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(This story appears in the 10 January, 2014 issue of Forbes India. To visit our Archives, click here.)
The draft Indian Financial Code written by the Financial Sector Legislative Reforms Commission(FSLRC) which defined the objectives of the Reserve Bank of India(RBI) asunder, practically ignored the evolution of RBI and the present Indian context of financial sector regulatory environment: (a) formulate and implement monetary policy; and (b) carry on other activities of a central bank, including – (i) to issue currency of India; (ii) to transact certain business of the Central Government and the State Government, as contained in section 348 and section 349 respec- 10 tively; and (iii) to act as banker to banking service providers. The FSLRC would have perceived things differently, if it had recalled the preamble of the RBI Act, 1934 which read asunder: “…And whereas in the present disorganization of the monetary systems of the world it is not possible to determine what will be suitable as a permanent basis for the Indian monetary system; But whereas it is expedient to make temporary provision on the basis of the existing monetary system, and to leave the question of the monetary standard best suited to India to be considered when the international monetary position has become sufficiently clear and stable to make it possible to frame permanent measures; It is hereby enacted as follows: -” Beyond some cut and paste, because of changes in the institutional structure in the financial sector or external policy compulsions, the RBI Act has not yet been subjected to the comprehensive review, envisaged in its preamble. Still, it may not be administratively expedient or even desirable to dismantle or truncate RBI as proposed by FSLRC now. Efforts should be made to improve the existing structure and mandate. As legislative procedure and government action in the present scenario would be slow, it would be desirable for RBI itself to make an internal assessment of its responsibilities in regard to monetary policy vis a vis various other additional responsibilities such as developmental role, institution-building and management of public debt thrust on it by history.on Jan 5, 2014