From UPSC perspective, the following things are important :
Prelims level : Not much.
Mains level : Paper 3- Inflation targeting by RBI, and other mandates of RBI.
The RBI’s responsibility to regulate the financial sector may have taken a back seat after the adoption of inflation targeting as the main objective. Has a fixation with inflation rate made the RBI take its eyes off the loan books of the banks?
Evolution of the role of the Central Banks
- Maintaining financial stability: The establishment of some of the world’s oldest central banks was inspired by the goal of maintaining financial stability.
- Harm to the depositors: It was recognised that when private commercial banks fail, whether due to malfeasance or misjudgement, they harm their trusting depositors.
- Harm to the entire system: But when banks fail they not only harm the depositors they can also take down with them the rest of the financial system.
- Banks lending to one another: The entire financial system also gets harmed when banks have lent to one another, which is not uncommon.
- The collapse of credit: In the crisis that ensues, there is a collapse of credit which, in turn, leads to a downturn in economic activity.
- Lender of last resort: To avoid this, the central bank was conceived of as the lender of last resort.
- Prevention of run on the banks: Lender of last resort is the one that could pre-empt a run on banks and give them time to put their books back in order.
- Regulation of banks: However, this was to be accompanied by the adoption of a tough regulatory stance.
- Whereby the central bank would stay hawk-eyed towards the activities of banks, particularly risky lending.
- Rise of neo-liberalism and change in a role: With the rise of neoliberalism, the central tenet of which is that markets should be given free play, the regulatory role of central banks took a back seat.
- Inflation control as primary role: The Central banks came to be primarily mandated with inflation control.
Inflation targeting and regulation of the financial market by RBI
- Multiple indicator approach: In India, the RBI had earlier pursued a ‘multiple indicators approach’.
- What was the multiple indicator approach: The approach involves concern for outcomes other than inflation, including even the balance of payments.
- Discouraging the approach: Developments in economic theory discouraged ‘multiple indicators approach’.
- It was argued that having economic activity as an objective of monetary policy leads to higher inflation.
- Favouring low inflation over lower unemployment: Discouraging the ‘multiple indicator approach’ encouraged low inflation over low unemployment.
- Inflation targeting as the sole objective of monetary policy: The Indian government also instituted inflation targeting as the sole objective of monetary policy.
- The fixed target for the RBI: The RBI was permitted to exceed or fall short of a targeted inflation rate of 4% by a margin of 2 percentage points.
- But have the RBI’s original mandate as a central bank been met?
- IL&FS crisis: In 2018, within three years of the adoption of inflation targeting goal, a crisis engulfed IL&FS, a non-banking financial company in the infrastructure space.
- Not a small player: It operated over 100 subsidiaries and was sitting on a debt of ₹94,000 crores.
- Effects of default: Given this, IL&FS default had a chilling effect on the investors, banks and mutual funds associated with it both directly or indirectly.
- PMC bank crisis: In 2019, a run on the Punjab and Maharashtra Co-operative Bank had to be averted by imposing withdrawal limits.
- Outright fraud in PMC case: While in the case of IL&FS, some part of the problem may have been caused by a slowing economy, outright fraud underlay the crisis at PMC Bank.
- Raghavendra Sahakara Bank case: In early 2020, curbs have had to be placed on withdrawals from the Bengaluru-based Sri Guru Raghavendra Sahakara Bank.
- Pertinent question
- Regulatory sector at the backseat? It is not too early to ask if the RBI’s responsibility to regulate the financial sector may have taken a back seat after the adoption of inflation targeting as the main objective.
- Has a fixation with inflation rate made the RBI take its eyes off the loan books of the banks?
The recent rise in inflation and shortfall of currency notes
- Inflation at 7%: At over 7%, the inflation rate in December is the highest in five years.
- Not cause of concern: This may not be the reason to panic, for the price rise could be seasonal and may well abate.
- Question on inflation targeting: But it does raise a question on the efficacy of inflation targeting as a means of inflation control.
- Reason for moderate inflation so far: If the inflation rate was within the intended range so far, that may have been due to both declining food prices and, for a phase, oil prices.
- The shortfall of notes: The central bank has a monopoly on the issue of notes.
- There is an absolute shortage of small denomination notes in the bazaars of India.
- Small-denomination notes are mostly unavailable.
While focusing on the inflation, the Central bank also needs to keep the other mandates especially the regulation of the finance sector in check.