RBI wants to break free of budgetary shackles

RESERVE BANK OF INDIA'S REPORT ON CURRENCY AND FINANCE 2003-04

The Reserve Bank of India's Report on Currency and Finance for 2003-04 has made a strong pitch for independence of a central bank. It said that the monetary policy should be independent and free from budgetary compulsions of governments to stabilise inflationary expectations.

The inflationary consequences of the fiscal dominance of monetary policy has brought into sharp focus the need to reduce fiscal imbalances. This has also naturally raised the issue of the nature of monetary and fiscal coordination, it pointed out.

A key issue in this context is whether the coordination should be rule-based or discretionary. Frameworks based on clear mandates and rules are usually considered preferable to ad hoc discretionary coordination, which could be clouded by problems of implementation and incentive distortions caused by electoral cycles, it said.

The report said budget deficits turn out to be especially inflationary when the central bank is not independent and the financial markets are not developed enough to contain inflationary expectations. The very existence of large fiscal deficits puts continuous pressure on inflationary expectations.

A recent view has argued that fiscal imbalances lead to an increase in inflation and it is the money supply which adjusts subsequently to higher prices.

Uncertainty and imperfect information about the current state of the economy as well as future outlook make it difficult to agree and implement a case-by-case discretionary approach to coordination.

On all these grounds, there is an explicit preference for frameworks based on clear mandates/rules. In most countries, these take two forms: central bank independence and fiscal responsibility legislation, the report pointed out.

A well-developed domestic debt market can help government raise their borrowing requirements locally. This will avoid automatic monetisation and pitfalls associated with any overseas borrowings.

If the government borrowing requirements are high, this could exert upward pressure on domestic interest rates. The development of domestic government securities markets needs to be supported by fiscal discipline so as to provide a more enduring solution, the report said.

This has also resulted in a widespread consensus in favour of central bank independence, backed by some form of fiscal discipline. Such clear-cut rules are an essential pre-requisites to contain inflation and stabilise inflation expectations.

Monetary authorities are now also required to pay greater attention to external developments. Swings in trade flows and, especially capital flows are quite common and these impart a high degree of volatility to exchange rates. Even in an environment of price stability, the 1990s witnesses episodes of financial instability.

The presumption that price stability ensures financial stability is thus not true, at least in the short-run, the report noted.

Ensuring orderly conditions in financial markets and maintenance of systemic financial stability has, thus, emerged as an important objective of monetary policy, the report said.