India - Will Dr Subbarao keep the markets happy ?

The financial markets appear, by and large, to be happy with Dr Subbarao’s appointment as central bank governor. The key reason for this seems to be his previous assignment as finance secretary. The markets expect “better co-ordination” (as a fund manager put it in a television interview) between the finance ministry and the Reserve Bank in his tenure. Some foreign investment houses have, however, raised concerns about a possible dilution of the central bank’s independence.
It might help to get a couple of things straight. This is not the first time that a bureaucrat with a stint at the finance ministry has been appointed head of the central bank. His predecessor, Dr Y V Reddy, himself was an ex finance ministry-wallah. Thus, Subbarao’s appointment is not a departure from norm. Second, the RBI has two distinct functions — that of a regulator and that of monetary policy maker. Thus, “better co-ordination” could refer to a closer relationship between Mumbai and New Delhi on regulatory and other structural policy reform.
Better “co-ordination” could also mean that the RBI will accommodate the growth and revenue targets of the finance ministry much more than in the Reddy regime. I suspect that the markets are more interested in Subbarao’s monetary policy avatar. A common perception is that the governor will be more pro-growth and softer on inflation than his predecessor. Some bond traders are already betting on a halt in interest rate hikes.
I am afraid the markets’ expectation reveals an inadequate understanding of the changing role of the Indian central bank over the past decade and a half and its position in the hierarchy of economic decision making. Three things have been established in this process of change. First, when it comes to interest rates, the RBI calls the shots even if its decisions go against the wishes of North Block. This has been proved a number of times in the past few years. Second, even in the absence of a formal inflation target or a regime, inflation control has emerged as the principal mandate of the RBI. This means that the central bank’s position in the trade-off between growth and inflation, the RBI’s position is fairly clear. An immediate implication is that Subbarao will not take his foot off the monetary brake unless he is sure that lower inflation will sustain.
Third, growing central bank independence also implies a certain decoupling of the fiscal and monetary cycles. By refusing to accommodate fiscal excesses through easy monetary policy, it sends a clear message that while it cannot directly curb the budget overruns, it can make sure that the government pays for its profligacy. The kind of institutional evolution that the RBI has been going through tends to be somewhat irreversible. It would be naïve to expect an individual, whatever his professional antecedent, to either aspire to or succeed in turning the clock back.
The question then is: is it necessarily a good thing? Or could we do with more synchronisation in fiscal and monetary policy, a cozier relationship between New Delhi and Mumbai? I would argue that the growing lack of co-ordination between the finance ministry and the RBI has actually been one of the best things that happened to macro-economic policy in India. The current episode of high inflation notwithstanding, my sense is that the decline in the average level of inflation in the economy since the late nineties is because of two things: a visible “disconnect” between the RBI and North Block and a slow shift away from “multiple-target”-based monetary approach to a more blinkered focus on inflation.
India is not alone in this. It is now an established fact that greater central bank autonomy and a more aggressive anti-inflation mandate have been critical in taming inflation expectations down across the world. Major central banks like the European Central Bank and the Bank of England have a single objective — bringing inflation down to a target level. None of these central banks brooks any interference from their exchequers, nor do the exchequers try to meddle. Reams of academic work in economics are now available to explain why an independent central bank with an aggressive anti-inflation mandate is likely to ensure the “best” macroeconomic outcomes.
There is of course the issue of the new governor’s own predilections. If his public statements reflect what he believes, he seems to have the right ideological pedigree for a central bank governor. In his interactions with the press as finance secretary, he has quite categorically pointed out that despite rising concerns about an economic slowdown, it is inflation that gets top priority in policy making. He has also been clear about which policy was likely to work the best in taming price-rise — in a much-publicised interview a couple of months ago, he asserted that “monetary policy was the first line of defence against inflation”.
In short, the markets are unlikely to get the “better co-ordination” it expects. The finance ministry and Mint Street will not march to the beat of the same drum. There will be conflicting statements from the two institutions on things like exchange rates, interest rates and growth. One way to rationalise this and indeed allay some of the confusion that results from divergent rhetoric is simply to accept the fact that the two have different agendas. One of the critical roles of the finance ministry (and indeed treasuries and exchequers all over the world) is to talk up expectations about the economy and soothe frayed nerves in times of panic. The RBI, like other central banks, is in the business of talking down excess euphoria and providing a cold reality check. Once the markets accept this, they might be able to filter the sound-bytes better.
The author is chief economist, HDFC Bank. The views here are personal