RBI reform and the triad of independence, accountability and transparency

Independence

Some people say that the draft Indian Financial Code envisages reducing the independence of the RBI. This could not be further from the truth because at present, the RBI has no independence. This is easy to tell by reading the RBI Act. Here is the relevant extract:

7. Management.

(1) The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.

(2) Subject to any such directions, the general superintendence and direction of the affairs and business of the Bank shall be entrusted to a Central Board of Directors which may exercise all powers and do all acts and things which
may be exercised or done by the Bank.

Note that the directions from the Central Government are not even reported into the public domain. Directions can be threatened or given in secret. There is no limitation to the subject on which directions can be given. The government can give a direction to RBI that air conditioners must be switched off, claiming that this is `in the public interest'.

How does RBI fare on independence in an international comparison? In a recent paper, Central Bank Transparency and Independence : Updates and New Measures by Dincer and Eichengreen, RBI appears at the bottom of the list of the world's central banks on independence. Not only are we bad in absolute terms (as shown in the extract from the RBI Act above), we are bad in relative terms, when compared with other central banks of the world.

The Indian Financial Code does enormous new work to establish the notions of independence at numerous levels. Along with this, of course, go an array of accountability mechanisms. There are deep connections between the three themes of accountability, transparency and independence. It is not possible for a central bank to break any of the three legs of this stool. This is a big step away from the old RBI ethos of no accountability, low transparency and no independence.

Transparency

It is well known that RBI fares poorly in international comparisons of transparency. The working paper above gives updated data on this and there is no progress to report in the last five years.

RBI statement failed to reduce uncertainty

Today RBI said they will:

- reduce the marginal standing facility (MSF) rate by 75 basis points from 10.25 per cent to 9.5 per cent with immediate effect;

- reduce the minimum daily maintenance of the cash reserve ratio (CRR) from 99 per cent of the requirement to 95 per cent effective from the fortnight beginning September 21, 2013, while keeping the CRR unchanged at 4.0 per cent; and

- increase the policy repo rate under the liquidity adjustment
facility (LAF) by 25 basis points from 7.25 per cent to 7.5 per cent
with immediate effect.

You did not understand that? Neither did I.

The challenge

The heart of successful monetary policy is a coherent monetary policy framework. There should be clarity on objectives, instruments and operating procedure.

RBI has failed as a central bank because it lacks clarity on all three. As a consequence, India has experienced sustained macroeconomic instability: look at this long time-series of CPI inflation:

Other than the 1999-2006 period, where we roughly achieved the goal of y-o-y CPI inflation from 4 to 5 per cent, there has been failure all through.

One factor which is holding back high growth in India today is the immense uncertainty about the future. What will happen to inflation and interest rates? Nobody knows, and this hurts confidence. There is a short-sighted view which suggests we should tolerate high inflation. But low inflation is a growth fundamental.

Matters have been made worse by the recent fight about the rupee [link, link]. An array of harmful measures were taken, which have muddied the waters considerably. The RBI operating procedure was shattered by these moves.

India now has the silliest monetary policy framework in the world where the central bank engages in monetary policy through changes in 8 numbers: (1) The repo rate (2) The MSF / Bank rate (3) CRR (4) Reverse repo rate (5) LAF window cap (6) MSF window cap (7) Minimum CRR to be maintained (8) SLR. In addition, they also mess with capital controls. A variety of objectives are in the fray including WPI, CPI, GDP growth, the exchange rate, exchange rate volatility, and then some. So RBI is supposed to chase 6 objectives using 9 instruments.

Raghuram Rajan did an excellent Day 1 speech (on the day he was appointed as Governor). All of us
were optimistic about what might arise in his work on monetary policy. What is required is clarifying objectives, instruments and the operating procedure.

What we needed to say

Today's speech needed to say:

1. RBI now has an unruly menagerie of objectives and instruments.
   
2. This situation has generated heightened uncertainty which is hurting the economy.
   
3. We got into this tangled mess because of the fear of QE withdrawal and the currency fight of recent months.
   
4. We recognise that this is a mess.
   
5. Now that this fear has subsided, we will clean things up.
   
6. We do not care about the exchange rate. The prime objective of monetary policy is low and stable CPI inflation.
   
7. We recognise that a central bank with discretion but not rules is impotent. MIT and Yale teach Kydland and Prescott.
   
8. We will replace this mess by a framework.
   

Today's announcements

In my reckoning, today's monetary policy statement has failed to clarify objectives, instruments and operating procedure.

As I read the statement, I could not understand whether this was a tightening or an easing. I spoke with veterans on the bond market and they were also fumbling. By the evening, it looked like the 91 day T-bill rate (one important summary statistic about the money market) had gone down by 20 bps, but the overnight interest rate swap (another important summary statistic about the money market) had gone up by 15 bps. Only late in the evening, I started thinking that it is an easing. The short end of the yield curve has gone down by 20 to 40 basis points.

Some say that there is method in this madness, that an enormously complicated scheme is in motion which will make the world a nice place. But if a layman like me cannot understand the strategy that is now in motion, the fault lies in the statement.

Lack of clarity on objectives

The statement says that exchange rate volatility continues to be an objective at RBI: The timing and direction of further actions on exceptional measures will be contingent upon exchange market stability, and can be two-way. Further actions need not be announced only on policy dates.. I think this is a mistake. The only piece of sound macro policy in India today is the floating exchange rate. When RBI pursues exchange rate objectives (in whatever form), this leads to trouble.

And, this immediately begs the question: What is your objective? Are you targeting a specific exchange rate? Do you consider INR/USD volatility of over 15% annualised to be too high or too low? What statistical procedure will you use to measure volatility? The moment you try to answer these questions, you realise that the exchange rate is a bad objective. And, until the objectives are precisely stated, there is no monetary policy framework (RBI can hit the economy at random dates with random actions because they have committed themselves to nothing). There is also a loss of accountability which is the breeding ground for failure.

There is talk about both WPI and CPI. So the old confusion about the target continues. No serious economist thinks the WPI is a price index, so this talk reduces respect. There was talk about a WPI target of 6\%. This suggests all is well, for WPI inflation is already there.

Messy outlook

Another disappointing thing that was made clear in the press conference was that capital controls will continue to be used. This is a mistake. In India, capital controls are not an effective tool for macroeconomic policy. Each attempt at doing this is going to roil the markets.

Far from saying that the messy defence of the rupee will be rapidly unwound, we are left worried that over the coming three years, in which QE will unwind, we will continue to have a messy framework.

Conclusion

Compare and contrast the press conference by Bernanke -- link -- which is a masterpiece of clarity, against what we got from RBI today -- link.

The statement should have aimed to clarify objectives, instruments, and operating procedures. It has just intensified the muddle. And since the muddle -- the lack of confidence in the macro framework -- is India's primary problem, it just made India's problems worse.

NPS: The day after

All of us are delighted that the PFRDA Bill was passed, even though PFRDA will only have a brief life given that the Indian Financial Code is in the pipeline. The original design of the NPS is perfect: individual accounts, portability across employers, centralised recordkeeping, procurement of fund managers through auctions, index funds. The NPS that has been hacked together as a transitional measure has accumulated numerous flaws when compared with this vision.

When the PFRDA Act was passed, I had written a post titled Implications of the Pensions Act. In addition, we have a few good opinion pieces in the Indian newspapers:

• Uma Shashikant in the Economic Times.
• Dhirendra Kumar in the Economic Times: One, Two.
• Deepti Bhaskaran in Mint.

That Parliament has enacted the PFRDA Act is not the end of the story of NPS. It is a beginning. We have a B grade NPS in hand, with a large number of accounts. Now that the law is done, it's time to go make a A grade NPS.

11th Conference of the Macro/Finance Group

All the materials are up on the website.

Implications of bringing commodity futures into the Ministry of Finance

Essentially everywhere in the world, we see unification of trading in all kinds of products -- spot or derivatives, equities or currencies or fixed income or commodities etc., OTC or exchange. It makes too much sense to reap economies of scale and economies of scope, both in the private sector and in the work of regulation and supervision. The arrangement in India, where the Forward Contracts Regulation Act (1952) envisages the Forward Markets Commission that is a part of the Department of Consumer Affairs, is a silly one.

Everything we have learned about how to run the equity market is valuable for commodity futures:

• The regulatory governance process at SEBI including authority to issue regulations, enforcement process, appeals at SAT, etc.
• Governance problems of Infrastructure Institutions with three-way separation between shareholders, managers and trading members.
• Netting by novation at the clearing corporation.
• Not having `badla' trading.

It is likely that the Ministry of Finance would not give an exemption to any exchange from regulation. A lot of what we saw in this field in the last decade would not have arisen if commodity futures had been placed with SEBI and MoF. But then, we have had dubious finance ministers and one should not be too confident. The price of sound governance is eternal vigilance.

Merging FMC into SEBI began as controversial ideas:

• One markets regulator or three? in the Business Standard, 1997.
• An interview in the Financial Express, 1998.
• Rethink financial intermediation in the Business Standard, 1998.

Then it turned into a government committee process:

• On 14 May 2003, a committee was setup headed by Wajahat Habibullah, who was secretary of the Department of Consumer Affairs. Key persons who shaped this work were S. Narayan, who was Secretary at the Department of Economic Affairs, and Ashok Lahiri, who was Chief Economic Advisor.
• Percy Mistry's committee said: Redraft the legal foundations for organised financial trading, so as to unify all organised financial trading under SEBI regulation. This would include currencies, equities, sovereign and corporate bonds, and commodity derivatives.
• Raghuram Rajan's report said: all organized financial trading, spanning currencies, fixed income, equities, commodity futures, exotics (such as weather and decision markets), and spanning all trading venues and forms of trading should come under a single regulator, the SEBI.
• The draft Indian Financial Code has a general and sector neutral treatment of financial regulation where all organised financial trading is the work of the Unified Financial Authority.

In 2003 and 2004, we were well on our way on getting this done. However, once the UPA government came to power in May 2004, and Sharad Pawar became the minister in charge of Consumer Affairs, it became infeasible to shrink his turf. By that time, substantial commercial interests had developed which wanted to preserve the existing arrangement, with regulatory capture of FMC.

More generally, one of the most harmful instincts of bureaucrats and citizens in India is the notion that the boundaries of government agencies are somehow sacred. There is much resistance to changing the role and function of a government agency. But every employee of government exists to serve the people of India, and we need to continually change the block diagram of government so as to best cater to the fast changing requirements of the economy.

Now we have a crisis on our hands, and policy makers have resurrected the project. While there is a news item, the details are not yet visible. The first step would be a small change in the allocation of business rules, through which the subject of commodity futures trading would shift from the Department of Consumer Affairs to the Ministry of Finance. The big step would be to repeal the FC(R)A and modify securities law appropriately; until this is done, the gains would be limited. The draft Indian Financial Code is a natural source of ideas on how this drafting should be done.

In the short term, the FMC would become a part of the Ministry of Finance. Important decisions at FMC would go up to the Ministry of Finance and ultimately the Minister of Finance for approval. The knowledge on organised financial trading at the Ministry of Finance will give us improved decisions under the existing law. We may expect considerable porting of regulations and public administration practice from SEBI into FMC.

This seems to be a season for old policy projects working out. First the Pensions Act, and now this. Nothing like adversity to make India deliver.

Interesting readings

An editorial in the Business Standard on getting away from gerontocracy.

An editorial in the Indian Express on the next steps on pensions and the next steps on legislation.

Anil Padmanabhan in Mint about the people in India who would like for India to remain focused on poverty. I would add one more interest group in this: Development economics.

The burqa joins the league of cape and cowl by Mahvesh Murad.

N. Sundaresha Subramanian in the Business Standard reports on the parties of India which have the biggest criminal footprint.

One of the first sensible things in the field of higher education policy in India: Building the Links Between Funding and Quality in Higher Education: India's Challenge by Lindsay Daugherty, Trey Miller, Rafiq Dossani, Megan Clifford, Rand Corporation. Also see.

Trampling on the individual in India: Here's something for us in India to envy: the response of the Polish Prime Minister to proposals to censor the Internet: We shall not block access to legal content regardless of whether or not it appeases us aesthetically or ethically.
And here is another: a story of a dentist who tried to interfere with the online freedom of speech of customers.
Compare and contrast with what our Supreme Court just said to mouthshut.

Ila Patnaik: What Raghuram Rajan needs to do and Gearing up for the slow withdrawal of QE.

Mihir Sharma in the Business Standard on the consequences of exchange rate depreciation.

The trouble with our banks by Shankar Sharma and Devina Mehra in the Business Standard.

Editorial in the Indian Express.

Trouble for treaties by N. Sundaresha Subramanian in the Business Standard, about the kind of firms who showed up in the Private Treaties portfolio.

Anusha Soni in the Business Standard about capacity constraints in the government that are hindering the field of infrastructure.

When rent-seekers and startups collide by Steve Blank: A useful set of insights into the field of payments in India.

Noah Smith on the Economics Ph.D.: why and how. Also see: a set of concerns, and the beautiful books.

Those who fail to remember our past will be forced to relive it. See this post. I wrote something a while ago which draws on a similar idea.

Raghuram Rajan's day 1 statement

Everyone should read it.

Implications of the Pensions Act

In 1998, the Ministry of Social Justice and Empowerment setup `Project OASIS', led by Surendra Dave, to engage in deep thinking about pension reforms. The report, which was submitted on 11 January 2000, envisaged an individual account defined-contribution system with central recordkeeping, and recruitment of fund managers by an auction which asked for the lowest fees+expenses.

This was a futuristic vision at the time, as a lot of the surrounding infrastructure had not fallen into place. In socialist India, it was quite novel to propose that households would build their own assets to take care of themselves in old age. However, the idea rapidly got widespread acceptance. More and more people started looking at the maladies around them and said that if only we had the NPS, these problems would not arise.

NPS was ahead of its time in being mistrustful of mutual funds and insurance companies. The great scandals of mutual funds and ULIPs lay in the future. Issues of consumer protection were not widely understood in 1998. But the key calls made in the NPS have proved to be the right ones: of delivering a solution that is good for the lifetime financial planning of households while giving financial firms wafer-thin margins. Apart from index funds, the NPS is essentially the only piece of Indian finance that is accessible to the average household that I trust. Thinking on consumer protection has progressed enormously in the following years, first at IFMR and then in FSLRC. Yet, the NPS designed in 2000 fares well in satisfying the consumer protection principles of the draft Indian Financial Code of 2013.

In December 2002, NPS was adopted by the NDA government as the mandatory pension system for all new recruits after 1 January 2004. All this was re-opened by the UPA government when it took charge in May 2004, and they chose to stay on course.

From May 2004 to September 2013, we were unable to make progress on the proper legal foundations. But the NPS was built and executed through a network of contracts and rules, planned out by one of India's best lawyers (P. Chidambaram), which is legally sound. All civil servants recruited after 1/1/2004 have been placed into the NPS, and by now this is shaping up to be substantial numbers. NPS has also started gradually going into the unorganised sector, with the assistance of co-contribution.

The wheels grind slow, but they grind true. I wish all this had happened faster, but it is good that it happened. The key implication of this decision by Parliament is that the NPS cannot be shut down by a future administration. To find out more, I suggest :

• Concepts of the NPS and their rationale: Indian pension reform: A sustainable and scalable approach by Ajay Shah, Chapter 7 in `Managing globalisation: Lessons from China and India', edited by David A. Kelly, Ramkishen S. Rajan and Gillian H. L. Goh, World Scientific, 2006.
• A story of how the NPS came about: India's pension reforms: A case study in complex institutional change by Surendra Dave, page 149--170 in `Documenting reforms: Case studies from India', edited by S. Narayan, Macmillan India, 2006.
• A recent look at developments in implementing the civil service pension: Civil service and Military Pensions in India by Renuka Sane and Ajay Shah. Chapter 4 in `Reforming Pensions for Civil and Military Servants', edited by Noriyuki Takayama, Maruzen Publishing, 2011.

This story is interesting not just from the immensely important problem of ageing, but also as a case study in how we achieve far-reaching change in India. I disagree with the pessimists who limit their ambitions to minor tinkering changes. We in India must constantly question the foundations; almost everything about the Indian State is broken and needs to be redone from scratch.

There has been a sea change in thinking about financial law in India thanks to the work of the Financial Sector Legislative Reforms Commission.  In 2001 and 2002 we did not know how to draft law. The PFRDA Act reflects the old ways of drafting law and will not look good to modern eyes.

Looking into the future, the story now runs on five tracks:

1. Making the civil servants NPS work properly as originally envisaged. At present it does not.
2. NPS has forked into two systems: one for the unorganised sector and another for civil servants. These need to be merged into one single system with full portability.
3. Achieving large-scale participation and sustained contribution for the unorganised sector -- while not sacrificing the heart of the NPS which is wafer thin charges. All too often, we get an urge to do to the NPS what was done to mutual funds and insurance companies.
4. Using this institutional capacity to solve the problems of EPFO.
5. We will need to adapt the PFRDA Act and the draft Indian Financial Code so as to achieve the following framework: (a) NPS would become a pension system run at the instance of the government, (b) It would be regulated by the machinery of the Indian Financial Code, (c) PFRDA would get merged into the proposed Unified Financial Authority (UFA). It is more important to be correct than to be consistent.

A season for bad ideas

One feature of each period of turbulence is that we get an upsurge of out of the box thinking. While it is always good to think out of the box, these innovative ideas must also make sense. If I were a teacher of economics, I would use these in class as demos of how not to do economics:

• Coordinated intervention by emerging markets. Andy Mukherjee nails this one.
• Devesh Kapur and Arvind Subramanian want an import tariff -- that they term a `third best measure' -- to do things that exchange rate depreciation does better.
• Veerappa Moily says we should close down petrol pumps at night so as to reduce consumption of petrol.
• Swaminathan S. Anklesaria Aiyar thinks there is a second Asian Financial Crisis in store. But Asia has substantially moved away from exchange rate rigidity. He says depreciation is recessionary. No, depreciations are expansionary. He implies that depreciation is a problem in India today as corporations have large unhedged foreign currency borrowing. The existing evidence does not support this.
• Jamal Mecklai on temple gold. It is satire.