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The Independence of the Central Bank (Raghuram G. Rajan Governor - September 3 2016 - at St. Stephen s College New Delhi)

The Independence of the Central Bank (Raghuram G. Rajan, Governor - September 3, 2016 - at St. Stephen s College, New Delhi) - News and Press Release - Dated:- 5-9-2016 - Good afternoon. It is great to be invited to speak at St. Stephen's College. In 1980, I toyed with the idea of joining my best friends in applying for admission to the BA in Economics here. Because I had worked so hard for the IIT exam, however, I succumbed to the sunk cost fallacy and studied Electrical Engineering. I don .....

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tainty. This will then lead in to my arguments about why we need an independent central bank. To set the stage, think back to the summer of 2013. After Chairman Bernanke hinted that the United States might end quantitative easing, capital started flowing out of emerging markets, especially those deemed to have weak macroeconomic fundamentals. India, with high fiscal deficits, high current account deficits, and near double digit inflation, was deemed one of the Fragile Five countries. The rupee p .....

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cing them that India was still an attractive place to invest in, despite the then paralyzed economic reforms. Furthermore, they had to believe that the rupee would retain its value going forward. So I went from room to room asking RBI staff what they were working on, and what ideas for financial sector reform they were prepared to contemplate. We packaged our ideas into a reform program over the medium term that could change the narrative on India, especially given the fiscal reforms the governm .....

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establish that we were not heading towards crisis. The easiest way to demonstrate that was to show we could raise plenty of foreign exchange. My thought turned to an iffy scheme that had been presented to me in North Block. Essentially, bankers had told us they would bring plenty of dollars in as FCNR(B) 3 year deposits, which they would convert to rupees and invest in India. In return, they wanted a cheap rate at which they could convert rupees back into dollars 3 years hence. So long as the Re .....

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s of confidence worsened. I too became more favourable after thinking carefully about it. First, I weighed the balance of risks. If we did not move the rupee back to fundamental value, every 1 rupee rise in the dollar-rupee rate would costs us ₹ 40,000 crores more in import costs. Assuming the rupee was undervalued by ₹ 3 for a couple of years, this would mean a loss of lakhs of crores to national income. In contrast, even if the scheme was wildly successful in attracting inflows, th .....

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ia, and the rupee continued appreciating between the point when the money came in and the point we covered our liabilities to the bankers in forward markets, it would cost us significantly less. In fact, we might even make money on the deal. But what if the rupee plunged after the dollars flowed in? There were no certainties here. The bottom line was that the scheme was a measured risk, with a probability that the RBI would lose money, a certainty that the bankers would make money, but also a re .....

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illion, more than any of us anticipated. But more important, confidence picked up, the rupee continued strengthening beyond when the money came in, partly because the global investor mood as well as Indian electoral projections also changed, and we covered our forward swaps cheaply. We are fully covered for outflows today and have made money on the deal. The rupee has been one of the most stable emerging market currencies since then. Of course, in hindsight it seems like it was the obvious thing .....

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risks in the face of uncertainty. Clearly, we do not want to be in the position we were in August 2013 ever again. Macroeconomic stability is of paramount importance for India. Equally clearly, drawing from this experience, the central bank must have the resources, the knowledge, and the professionalism to act when the situation warrants. In the rest of this talk, I want to explain why this means India needs a strong and independent RBI to ensure macroeconomic stability. Then I will discuss what .....

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ssion, however, exposes the central bank to criticism. If we try and bring down inflation, interest rates will remain higher than borrowers desire. If inflation comes down, the currency will depreciate less than some exporters desire. If we push the banks to clean up, banks may be less tolerant towards habitual non-payers. Whatever we do, someone will object. The RBI then becomes the favorite scapegoat for underperformance - if exports are not picking up, it is because interest rates are too hig .....

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objective the government has set for us. Once again, this means higher interest rates. Just look at Brazil or Russia to understand you cannot have a significantly depreciated exchange rate and lower interest rates at the same time if you want stable growth! First Year Economics: There is no free lunch. RBI Dividend Policy A fundamental lesson in economics is there is no free lunch. This can be seen in the matter of the RBI dividend: Some commentators seem to suggest that public sector banks coul .....

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lities, we buy financial assets from the market. We do not pay interest on our liabilities. However the financial assets we hold, typically domestic and foreign government bonds, do pay interest. So we generate a large net interest income simply because we pay nothing on virtually all our liabilities. Our total costs, largely for currency printing and banker commissions, amount to only about 1/7th of our total net interest income. So we earn a large surplus profit because of the RBI s role as th .....

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the Taper Tantrum, no bank questioned our ability to deliver on the FCNR(B) swaps, even though the liability could have been tens of thousands of crores. Based on sophisticated risk analysis by the RBI s staff, the Board has decided in the last three years that the RBI s equity position, currently around 10 lakh crores, is enough for the purpose. It therefore has paid out the entire surplus generated to the Government, amounting to about ₹ 66,000 crores each in the last two years, without .....

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worthiness of the RBI, there is a more fundamental economic reason why a special dividend would not help the Government with its budgetary constraints. Here s why: Much of the surplus we make comes from the interest we get on government assets or from the capital gains we make off other market participants. When we pay this to the government as dividends, we are putting back into the system the money we made from it - there is no additional money printing or reserve creation involved.2 But when .....

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n we budgeted). Of course, the Government can use the special dividend to spend, reducing its public borrowing by that amount. But the RBI will have to sell bonds of exactly that amount to the public in order to stick to its target for money creation. The overall net sale of Government bonds by the Government and the RBI combined to the public (that is, the effective public sector borrowing requirement) will not change. But the entire objective of financing Government spending with a special RBI .....

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There are no creative ways of extracting more money from the RBI - there is no free lunch! Instead, the Government should acknowledge its substantial equity position in the RBI and subtract it from its outstanding debt when it announces its net debt position. That would satisfy all concerned without monetary damage. If what I have said just now seems complicated, it is, but it is also the correct economic reasoning. Similar detailed rationales lead us to turn down demands to cut interest rates i .....

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alized person, even ones with substantial economics training, to grasp quickly. Of course, we still must explain to the best of our ability but we also need to create a structure where the public trusts the central bank to do the right thing. This then is why we need a trusted independent central bank. Central Bank Independence In this environment, where the central bank has to occasionally stand firm against the highest echelons of central and state government, recall the words of my predecesso .....

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actions. Outline Responsibilities of the RBI When the responsibilities of the RBI are fuzzy, its actions can continuously be questioned. Instead, if the constitutional authorities outline a framework for the responsibilities of the RBI, it can take actions consistent with those responsibilities and be held to outcomes. The inflation objectives recently set for the RBI by the Government are an example of what is needed. Critics can lambast the RBI if it fails continuously to meet the objectives, .....

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I s role in macroeconomic stability is, however, still fuzzy. While RBI clearly has responsibility for the safety and soundness of credit institutions and the stability of the external account, there are some areas that are hazier. For example, with an inflation focused framework, the RBI s ability to be accommodative depends on fiscal prudence from the center and states. How much should the RBI warn on fiscal profligacy, including the building up of contingent liabilities, and when should such .....

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by entities that do not have the technical understanding, will only hamper decision making. Instead, the government-appointed RBI Board, which includes ex-officio government officials as well as government appointees, should continue to play its key oversight role. In this regard, all important RBI decisions including budgets, licenses, regulation, and supervision are now either approved by the Board or one of its sub-committees. Vacancies in the RBI Board, which have remained unfilled for many .....

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f RBI Governor There is a reason why Central Bank Governors sit at the table along with the Finance Ministers in G-20 meetings. It is that the Central Bank Governor, unlike other regulators or government secretaries, has command over significant policy levers and has to occasionally disagree with the most powerful people in the country. It is dangerous to have a de facto powerful position with low de jure status. Today, the RBI Governor has the salary of the Cabinet Secretary. He or she is appoi .....

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explicitly setting the Governor s rank commensurate with her position as the most important technocrat in charge of economic policy in the country. Communication I do not fool myself into thinking that reporters and TV cameras follow me around everywhere because I am a magnetic speaker. They follow RBI Governors around because they may offer market-moving information on policy. Fortunately, I have escaped unintentionally saying anything that moves markets. At the same time, while different RBI G .....

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ndeed, communication is as much about educating as it is about informing. For instance, even as I explained to entrepreneurs and retail borrowers why interest rates were not falling faster, I had to use the price of dosas to explain to pensioners why they were actually better off earning lower nominal but higher real interest rates. Public understanding can help ease the way for reforms, as well as increase support for policies. The RBI Governor therefore has to explain again and again. Occasion .....

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