Should the RBI be Independent?

The debate arises because of the new Monetary Policy Committee. It points us towards two important aspects of any central bank – Independence and accountability. So how do we resolve all these two objectives and make sure that the Central Bank is capable of tackling the issues that it faces meeting the objectives that it is supposed to meet while at the same time remaining accountable to the people.

 

urijit-patel

 

What are the major functions of RBI?

 

  • Regulating the economy or regulating other players in the economic system.
  • RBI acts as a monetary authority in India.

 

This in turn means that RBI is a complete authority as far as Monetary Policy is concerned. It not only makes the rules, not only implements them but also monitors them. Whereas if we think in terms of the political structure of India ,formulation is done by legislature, implementation is done by the executive and monitoring is done by the judiciary, whereas here RBI is doing all three functions.

 

What is the objective of Monetary Policy itself?

 

  • Maintaining price stability
  • Ensuring adequate flow of money
  • Credit to required areas.
  • It acts as a regulator and supervisor of financial system

 

This is what RBI tries to achieve through its Monetary Policy. Maintaining the overall stable level primarily through controlling the interest rates and all this is done so as to maintain public confidence in the system. So, RBI puts some rules to the banks to follow so that banks maintain the trust of the public. It manages the FEMA, Foreign Exchange Management Act, so as to facilitate foreign trade to develop Indian trade as well as to maintain rupee stability in the foreign exchange market as well. RBI is also the issuer of currency because it is controlling the money supply in the country, so it issues currency and also destroys currency. Specific to a developing country RBI also has a development role in which it tries to promote what the Government is trying to do with the development agenda. It also has some major banking functions such as being a banker to the Government, being a banker to other banks and even being a lender of last resort in the economy.

 

What are the goals of the RBI?

 

RBI governor also consults with important bodies like FICCI CRISIL etc. so as to get a good understanding of the sentiments in the business sector of the country. In addition to all this RBI also publishes the annual report on the official website for public discussion and for transparency. So a good amount of transparency is being maintained in the current system itself. Now this structure of the RBI makes it one of the most independent agencies of the Government. It is comparable to Supreme Court in terms of independence that it commands. However RBI governor is appointed by the Government of India so that is one notch below in terms of independence. It is also one of the most independent Central banks in the entire world.

Now there are two different viewpoints about the RBI. One is that RBI has too much power and should be controlled more by democratically elected Government. So one viewpoint is we have to control RBI’s power so that democratically elected Government has power over RBI, or power over the Monetary Policy making. Another viewpoint is RBI should remain independence or else politicians including the Parliament and the Prime Minister’s office could order the RBI to boost money supply, increase credit etc. just before an election.  Government could misuse Monetary Policy for its own purposes because of that RBI has to remain as a separate institution. That is another viewpoint.

So what is the case for Central Bank independence? The first is that RBI avoids inflationary spending by the government. The government might spend more to meet its own political agenda, such as, spending more before an election so that people have a perception that the country is improving etc. So government can sell this by forcing the banks to buy bonds so that the government can spend more. This is banned because this can lead to inflation very fast. So one reason an independent organization is good is that this kind of problems can be avoided. And we can avoid the use of Monetary Policy for political goals.

So we cannot lower interest rates before an election so as to win an election. We can only lower the interest rates when we feel that the inflation is low enough to allow that. Otherwise, the election will in turn cause inflation. The election cycle used to be matching with the inflation cycle but independent RBI can control this kind of mismatches. If the government is given power over Monetary Policy, governments have a tendency, automatic tendency to misuse that power.

 

What is the case against central bank independence? 

 

The biggest reason is that central bank is not directly accountable to the voters. What the voters want and what the bank does might be slightly at odds. So RBI might sometimes be implementing monetary policy against the wishes of the electorate. For example, there could be a stack inflation situation in which economy is not growing. At the same time unemployment is high as well and RBI cannot reduce interest rates. Instead it has to hike interest rate because inflation is high. Now the electorate might not appreciate that. People might start feeling why should the RBI have this power, why can’t we decide, why can’t our government decide? So those kind of questions can come. Also government might sometime blame RBI for not allowing India to develop etc. So in these situations this accountability issue becomes a problem.

 

This article was written by Paulami Paul (PGDM, Batch 22, XIME-B)

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The Man Who Broke The Bank of England

People in Finance are generally stereotyped as evil masterminds. If there was ever an individual who fully embodied this stereotype, it would have to be the famous English high-profile currency speculator. Meet George Soros, who is notoriously titled “The Man Who Broke The Bank of England“.

 

ex-soros-portfolio-manager-claims-george-soros-owes-him-1952389829
(Source: GeorgeSoros)

 

So, how did Soros “break” the Bank of England, the English Central Bank? For this, you need to have a first-hand understanding of how the European Exchange Rate Mechanism (ERM) works. Before the introduction of Euro as a currency, the English Pound traded against several European currencies under the purview of the ERM. The ERM basically promised a fixed rate of the English Pound against several European currencies (To put it in technical terms, The Pound was ‘pegged’ to many European currencues). That is to say, regardless of how bad the economic conditions were at home, the value of the home currency would remain about the same – the Bank of England promised this. And so, every other currency under the ERM had their exchange rates fixed (pegged) against several other ERM currencies. The elaborate and perplexing system of ERM is of little interest to anyone these days.

 

However, many speculators predicted that the Pound being in the ERM was not sustainable and that it would lead to a financial crisis. At the center of this huge outcry was George Soros. Known for his ability to take massive amounts of risk, Soros called a spade a spade. Under his advise, many private fund houses started selling the Pound to ‘anyone who would buy’ and started accumulating other stable currencies – the majority being the U. S. Dollar. If you’re wondering why he would advise this – remember that Soros predicted that the Pound will fall. This meant that a single Dollar note would fetch him more Pounds in the future than today. On top of this, Soros and his accompanying private funds shorted the Pound.

 

John Major, the then Prime Minister of England, did not like this one bit. He did everything in his power to prove Soros and his followers wrong. He asked the Bank of England to raise the policy interest rates to as much as 10 percent. He also authorized an unprecedented accumulation of the English Pound that was being sold by Soros and his private funds. These steps were aimed at maintaining the exchange rate of the Pound vis-a-vis the other European currencies under the ERM system. But soon, the Bank of England noticed that they were running out of Foreign Currency Reserves to purchase the Pound back. Meanwhile, Soros kept on selling and shorting more and more Pounds. Meaning, they stood to make massive amounts of money provided the Pound fell (On the flipside, they also stood to make massive losses if the Pound, in fact, did not fall or worse, rose instead).

 

But soon, the Bank of England gave up. The Pound crashed. The day this happened would later be named the “Black Wesnesday“. The losses estimated would pile up to £3.3 Billion. Soros would personally make £1 Billion out of the deal. Shortly afterwards, the Bank of England pulled the Pound out of the ERM system and promised to stabilize it in phases.

 

How-soros-broke-the-bank-of-England
(Source: ForexIllustrated)

 

Later, the Bank of England bitterly blamed George Soros for turning the tide against the market and making individual profits at the cost of massive public losses.George Soros himself felt he did not deserve his infamous title. Says Soros in his book ‘Soros on Soros: Staying Ahead of the Curve‘, “If I had gone against the market, instead of guessing where the market going, my action would not have for example led to the collapse of the pound sterling. Although I believe the man who caused the bankruptcy of the Bank of England was not really me. Market was the one who did it. I guess where the market was going and was an important element of it because I gave him momentum. But I did not cause the bankruptcy of the Bank of England.”

 

Supporters of Soros claim that the Bank of England broke itself – and simply needed a decoy to pin the crisis on. Critics of Soros accuse that the speculator took a position and then manipulated the market participants using his expertise and knowledge, thus manufacturing profits out of thin air. This is now termed in the investment circles as “the Soros effect“.

 

So, is George Soros, and all Finance people in general, inherently evil? George Soros himself provides an interesting answer: “I was a Human Being before I became a Businessman“.

 

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)