Friday, July 24, 2015

Reforms in Reverse Gear

Almost two decades ago, when I was studying at IIM Lucknow - I became aware of one big mistake in Economic policy of India during the Indiraji/Rajeev Gandhi era. Maintaining Governments control over the Monetary system of India. My generation is a witness to the Economic reforms under the stewardship of Dr. Manmohan singh over these two decades.

A key tenet of these reforms, an independent RBI seems to be going into the reverse gear now. Recently the Govt. announced a draft policy called the Indian Financial Policy that seems to severely restrict the autonomy of the RBI. Here is why this should not happen

 If anything we must learn from history and not repeat past errors. Indira Gandhi was an admirable leader and yet she was so wrong in creating a tight fisted control of the Government on the Indian Monetary system. She was the person behind nationalisation of the banks. What followed was decades of fiscal and monetary profligacy. Two terms that we learnt and used a lot back then were "Monetisation of Fiscal Deficit" and "Double digit inflation".

Even to an amateur in economics like me, it was easy to establish the connect. The Government of the day ran high fiscal deficit - ostensibly in the name of development - and as the system goes the fiscal deficit actually built due to non-development expenses like irrelevant subsidies, political dole outs and loss making PSUs. One of the major routes to finance this high fiscal deficit was to print more notes (monetisation) and hence increased liquidity in the system which led to runaway inflation resulting in falling value of Rupee, which in those days the RBI (read the Govt.) will maintain at artificially high levels through draconian laws like FERA and by not allowing Rupee convertibility.

Obviously it resulted in exports losing competitive edge while imports becoming very attractive. They then needed to be managed by high tarrifs, import duties and quantitative restrictions. This was a major reason (mind you not the only reason) for the economic mess we were in 1991 (for those who do not know - we were at the edge of defaulting on our payments because of a hugely deteriorated Balance of Payment (BOP) situation).

We gradually clawed back to normalcy and then quite remarkably into a high growth scenario of close to 9% GDP growth rate and modest inflation rates of 3-4% for close to a decade. This was possible because of far reaching reforms taken by subequesnt Governments both UPA and NDA. The key architect of this recovery was Dr. Manmohan Singh, first as the FM and then as the PM.

A lot of this economic mess in those days was ascribed to we having an RBI which was considered a slave of the Government. The RBI Governor in those days was expected to toe the line of the Government. Dr. Manmhan sigh who had served earlier as the RBI Governor too understood the importance of an autonomus central bank in managing the moetary policy effectively. This was ofcourse vindicated by the largely autonomous central banks of almost all developed nations at the time (which remains largely true till date).

As a result some of the key reforms focussed on a more autonomous and stronger RBI. Fiscal Responsibility Bill was passed that committed to a maximum limit of monetisation of fiscal deficit. Monetary policy was largely left to the RBI governor and it was decided that beyond the limit of monetisation Govt. will finance its fiscal deficit through Market operations. All these helped ensure debate on key areas of reforms and policy. Healthy disagreements between the FM and the RBI Governors have often resulted in rethinking and reevaluating of options. Many believe with some strong basis that India managed to cruise through the 2009-10 Global Financial meltdown triggered by the sub-prime crisis in the US, quite admirably largely due to prudent policies on the part of the RBI (and also due to fairly expert management by the FM/PM/planning Commision head of the fiscal economy).

So what is alarming about the draft Indian Financial Policy issued by the Finance Ministry? It seems to be undoing this body of work done over close to three decades. The draft suggests formation of a "Monetary Policy Committee" that would decide key rates of the Monetary Policies. What is interesting, is that out of seven members in the committee four are proposed to be those appointed by the Central Government and only two to be appointed by the RBI. This effectively means that the RBI Governor has effectively lost control on decisions related to key monetary policy parameter. An earlier draft allowed for a veto with the RBI Governor in case he/she disagreed with the commitee's decision - this draft does not allow even that safeguard against an overzealous FM.

Further, The revised IFC is also silent on the setting up of a Debt Agency Advisory Council that was proposed in the earlier draft to advise the Public Debt Management Agency. The revised draft has also toned down the FSAT and removed the provision empowering it to review regulations. This in short means we are not to expect any reforms towards strengthening the monetary/banking system of the country anytime soon.

Now I am not saying that we are anywhere near the economic mess of 1991 and yet it would not take more than a decade at today's pace to be there - if we do  not learn from our past mistakes. Whatever be your criticism of the Manmohan Singh government - one credit he must get. His government created strong institutions that were allowed to work autonomously - and each one of them helped/is helping transform the sector. Eg. SEBI, TRAI, IRDA, UID etc. Limiting their autonomy would be counter productive in the medium term.

Most well meaning Indians should express view on such an important piece of legislation that threatens to take us back tens of years on a piece of reform that has actually worked. In fact we need a Government that that takes these reforms further by expediting the formation of Debt Management Agency which is a crying need of PSU banks that are already reeling under the increased levels of NPAs. The Government can do so much to ensure a strong India and facilitate Economic recoery - taking away institutional autonoy from key functions is the last thing they should target. Is someone listening.