0% found this document useful (0 votes)
2K views294 pages

Who Moved My Interest Rate - Leading The Reserve Bank of India Through Five Turbulent Years (PDFDrive)

Uploaded by

dev gupta
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
0% found this document useful (0 votes)
2K views294 pages

Who Moved My Interest Rate - Leading The Reserve Bank of India Through Five Turbulent Years (PDFDrive)

Uploaded by

dev gupta
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

DUVVURI

SUBBARAO

WHO MOVED MY INTEREST RATE?



Leading the Reserve Bank of India through Five Turbulent Years

PENGUIN BOOKS
Contents

Introduction

1. From Main Street to Mint Road


2. Baptism by Fire
3. Baby Step Subbarao
4. ‘When the Facts Change, I Change My Mind’
5. Inside the Chakravyuh
6. Demystifying the Reserve Bank
7. Rupee Tantrums
8. The Signal and the Noise
9. Walking Alone
10. Two More Years
11. What Does Your Promise Mean, Governor?
12. Goldfinger Governor
13. ‘Keep Your Ear Close to the Ground’
14. Sleeping at the Wheel?
15. Footloose in the World of Central Banking
16. Moving On

Author’s Note
Footnotes
4. ‘When the Facts Change, I Change My Mind’
5. Inside the Chakravyuh
6. Demystifying the Reserve Bank
7. Rupee Tantrums
9. Walking Alone
10. Two More Years
11. What Does Your Promise Mean, Governor?
12. Goldfinger Governor
13. ‘Keep Your Ear Close to the Ground’
14. Sleeping at the Wheel?
15. Footloose in the World of Central Banking
16. Moving On
Follow Penguin
Copyright
For my parents who taught me values
Introduction

‘May You Live in Interesting Times’


11 October 2008, Washington DC

It was a cold, rainy, gloomy October evening when finance ministers and central
bank governors from the G20 countries had assembled in HQ2 Conference Hall
of the international Monetary Fund (IMF) office complex in downtown
Washington DC. For sure, the ministers and governors had not travelled to
Washington for this special meeting of the G20; they were already scheduled to
be there for the annual meetings of the IMF and the World Bank over the
weekend.
The G20 meeting was a last-minute add-on, convened at short notice, to
discuss ‘the probable negative impacts of the present acute global financial
situation on world growth’. Given the uncertainty and turmoil of the preceding
few weeks following the collapse of Lehman Brothers in mid-September, the
anxiety of the finance policymakers to get together to exchange notes on what
had happened and what would likely happen was understandable.
Brazil was the chair of the G20 in 2008. I received the meeting notice on 9
October, shortly before catching the overseas flight out of Mumbai. On the
morning of the meeting, 11 October, when I was already in Washington, I got
another mail from the G20 chair asking if I could be one of the two lead speakers
in the second session of the meeting which would focus on the implications of
the current turmoil for emerging markets. The Brazilian finance minister and the
current chair of G20, Guido Mantega, much in the news in subsequent years for
his strong position on the international currency wars, was the other lead
speaker.
I was just over a month into my new job as governor of the Reserve Bank of
India but I was not new to the IMF and World Bank meetings which are held
twice a year—the spring meetings in April and the annual meetings in
September or October. As a mid-level official in the finance ministry in the late
September or October. As a mid-level official in the finance ministry in the late
’80s, it was my task to prepare briefs to the finance minister and the finance
secretary who would go for these meetings. As finance secretary myself since
early 2007, I had attended these meetings as a regular delegate. The G20 was a
later innovation but I was a little familiar with the set-up, having attended a
couple of G20 meetings earlier that year in my capacity as the finance secretary;
however, those were meetings of deputies (finance secretaries and deputy
governors). This meeting, of finance ministers and governors, was a notch higher
in the hierarchy. It was also, in the words of the convenors, ‘an extraordinary
meeting to discuss an extraordinary situation’.
I was quite irritated by this late request to be a lead speaker. I was fatigued
and jet-lagged, and my schedule for the day was clogged with meetings and
appointments with a lot of stakeholders who typically gather in Washington
during the week of these Fund–Bank meetings—possibly wanting to get a
measure of this unknown guy who had landed up as the governor of RBI. With
virtually little time and even less mind space to organize my thoughts, my first
impulse was to decline the request. But then ego came in the way. I was, by all
accounts, a greenhorn governor, unknown to most ministers and governors; yet
they chose to ask me to give the Asian perspective on what was turning out to be
a ferocious crisis. I had to take on the challenge! My experienced support staff,
efficient as they always were, cancelled a couple of appointments to slot a half
hour to tutor me for the meeting.

An Anxious G20

Since the mid-1990s, the biannual Fund–Bank meetings have also become a
high-profile venue for protests spanning a wide array of disparate causes—
repressive aid conditionalities, trade imperialism, climate change, gender
discrimination, child labour, poor governance and corruption, as well as a host of
other issues. Just as placards, slogans and hundreds of protestors from around the
world have become a standard feature of these meetings, so has tight security,
with the five or so city blocks that house the offices of the World Bank and the
IMF cordoned off and several layers of security to ensure access only to
authorized personnel. As a central bank governor, I enjoyed privileged security
clearance; even so, going in and out was always quite a hassle and I tried to stay
within the security cordon all through the business day.
within the security cordon all through the business day.
It is standard practice during these international meetings for the Indian
delegation to park themselves in the spacious office complex of India’s
executive director at the IMF which is located in the HQ1 building of the IMF.
The G20 meeting venue was in the adjacent HQ2. In other times, my inclination
would have been to walk across to the meeting but since that would involve
moving in and out of security, my staff navigated me through the basement
tunnel connecting the two buildings.
By the time I entered the meeting hall shortly before starting time, I was still
unsure about whether I could weave a coherent narrative from my jumbled
thoughts. The meeting was organized around a large quadrangular table with the
finance ministers and governors of the G20 ‘troika’ (Brazil, the current chair;
South Africa, the chair of the previous year, 2007; and UK, the chair for the
following year, 2009) seated on one side while the rest of us occupied the other
three sides. The ministers and governors sat in the front row with two deputies
per delegation in the back row. The managing director of the IMF, Dominique
Strauss-Kahn, and the president of the World Bank, Robert Zoellick, and their
support staff too were present. It was a fairly large meeting with about 125 of us
in there. The atmosphere was decidedly sombre with the usual pre-meeting
banter unusually low-key.
After a brief introduction by the chair, the meeting rolled on with Hank
Paulson, the US treasury secretary, giving an account of the hectic activity
during the week and the weekend prior to 16 September when Lehman Brothers
filed for bankruptcy, setting off tumultuous developments in the global financial
markets. Although Ben Bernanke, the chairman of the Federal Reserve, was not
listed as a lead speaker, Paulson had yielded to him. In his professorial baritone,
Bernanke gave an account of the unusual measures that the Federal Reserve had
instituted to inject liquidity into the financial markets which had gone into
seizure, and outlined the bespoke solutions they were contemplating for some of
the stressed financial institutions. The mike then passed on to Jean-Claude
Trichet, the president of the European Central Bank (ECB) who explained, in his
graceful, French-accented English, how the European banks, with large
exposures to the US sub-prime assets and their derivatives, had come under
pressure, how the contagion was spreading across Europe and what the ECB was
doing to cope with the evolving situation.
The anxiety in the room was palpable. Already a lot of hands had gone up to
The anxiety in the room was palpable. Already a lot of hands had gone up to
comment or ask questions, especially directed at the US, but the chair decided
that we should go on with the emerging-market perspective before opening up
for discussion. Minister Mantega is reasonably fluent in English, but I noticed,
after seeing him in several international meetings in later years, that he prefers to
speak in Portuguese wherein he comes off more articulate and decidedly more
forceful. Quite predictably, his comment, as the lead speaker, centred on the
paradoxical ‘safe haven’ effect—capital fleeing from emerging markets back
into the US even as the US was the epicentre of the crisis—which was
destabilizing emerging-market economies and complicating their
macroeconomic management.
My turn to speak came shortly after 7 p.m., an hour into the meeting, as the
earlier speakers had exceeded their time limits. I was going to make two points.
First, that the impact of the unfolding crisis on emerging markets had been more
severe than was understood or acknowledged internationally. The narrative that
had taken shape over the past few years that emerging markets had decoupled
from advanced economies—which is to say that even if advanced economies
went into a downturn, emerging markets would not be adversely affected
because of their robust foreign exchange reserves, resilient banks and sound
macro fundamentals—had been dented by the developments over the past few
weeks. Even though emerging-market financial institutions were not exposed to
toxic assets, the contagion had spread to them through the interconnections in
the financial system. Second, admittedly the market situation was uncertain and
unpredictable for advanced economies. But it was even more so for emerging
markets which had an additional layer of uncertainty because of not knowing the
precise channels through which the contagion would hit them. I suggested that it
was not enough that the advanced economies acted in coordination. They had to
keep us too in the loop, and on the inner track, and keep our interest in view
while shaping their policies.
The G20 delegations, except the ‘troika’, are typically seated in the alphabetic
order of countries. As it happened, the India seat happened to be close to the
door, at one edge of the rectangular table. Two minutes into my comments, the
door opened, and a man walked in quietly, but with self-assurance, trailed by
two burly grey-suited men of stern demeanour. I am sure they tried to be
unobtrusive but I was nevertheless distracted by this shuffle so close to my seat
unobtrusive but I was nevertheless distracted by this shuffle so close to my seat
and momentarily lost my flow of thought. It struck me that the ‘intruder’ looked
a lot like President Bush. But there had been no indication that he would join us.
Besides, how could the President of the United States, by far the most heavily
guarded man in the world, walk into a meeting so casually? Wouldn’t the
famous secret service have subjected the whole building to a high-profile
security quarantine before his arrival? Wouldn’t there have been security details
swarming around the premises since early afternoon?
By now, I was flustered, unsure whether I should just ignore what was
happening and continue with my comments or wait until this disturbance had
settled down. Although I was not completely sure if it was indeed Bush, by some
unconscious instinct I stood up just as he passed behind me. Quite quickly, all
the people in the room caught on and stood up too as President Bush walked past
two sides of the quadrangle to get to the troika table. I soon realized that
everyone at the meeting, including possibly Paulson and Bernanke, was
surprised by Bush’s unannounced entry.
Hastily, amid mild applause, they made space for him at the troika table, and
also found a seat beside him for Secretary Paulson. There was a minute of
whispering at the table, possibly briefing the President on what had transpired so
far and inquiring if he would like to speak. But after a very brief apology for the
interruption that he had caused, Bush requested that we continue from where we
had left off.
So here I was, barely weeks into my new position as governor, speaking not
just for India but for all emerging markets, telling the President of the US and his
team of the obligations advanced economies, particularly the US, had towards
emerging markets. I was quite satisfied with my intervention; I thought it came
out quite cogently and effectively, given my limited experience and even more
limited preparation.
President Bush then said that he had already been briefed about the US
situation, but wanted to get a first-hand account of Europe. So the ECB
president, Trichet, got an opportunity to repeat what he had said earlier.
Bush spoke after that. He spoke informally, but with self-assurance. I can’t
recall all of what he said but one point he made stayed in my mind. He reiterated
his conviction that in the American system of free enterprise, markets should be
unfettered and the federal government should intervene only when necessary. He
said he had agonized quite a lot over the previous few weeks whether the nature
said he had agonized quite a lot over the previous few weeks whether the nature
and extent of government intervention in the financial markets was the right
thing to do. But the precarious nature of the financial markets post-Lehman—
and importantly, the impact of that on the daily lives of the American people—
had led him to believe that such intervention was not only warranted but even
essential. Echoing the approach taken by Franklin D. Roosevelt in the years
following the Great Depression, he added that preserving the free market in the
long run occasionally required government intervention in the short run. Finally,
he added that he was confident that the ministers and governors gathered around
the table were more than equal to the challenge of resolving the growing market
turmoil.
Bush then looked at his watch, apologized once again for his unscheduled
appearance, apologized also that he couldn’t stay longer since he had promised
‘Laura’ that he would be back home for dinner. As he started walking back the
way he entered, all of us stood up; he exchanged a few words with Trichet, said
something to Bernanke and acknowledged a few others with a smile or a nod. As
he passed behind me, he patted my shoulder and said something to the effect that
he was impressed by what I had said and he would keep my points in view as
they moved on.

Media Interaction

The next couple of days in Washington were a blur. I was flitting from meeting
to meeting during the day. During much of the night, I was on the phone with
senior management back at the RBI headquarters in Mumbai—they were
apprising me of the situation and seeking my approval for some ‘firefighting’
actions, and I was telling them about the sense I was getting from these
international meetings on the growing crisis and seeking their clarifications on
the inputs from my meetings and interactions in Washington.
The Fund–Bank meetings traditionally attract media from all around the
world, including newspapers, magazines, wire services, network and cable TV
and radio. This time round, for obvious reasons, the media were around in
significantly larger numbers. Several of them, both from the international media
as well as the contingent that travelled from India, were chasing me. By now, I
as well as the contingent that travelled from India, were chasing me. By now, I
was acutely conscious that there was growing criticism in the media back home
that the new governor was not communicating enough. Over the past couples of
weeks, we had taken a host of measures to restore stability in the financial
markets, including pumping in liquidity, which implied reversing the tightening
monetary stance that I had inherited from governor Reddy. The media view was
that if the situation was so urgent and grave as to warrant such a slew of forceful
measures, including a regime change in monetary policy, that too outside of the
regular policy schedule, then some communication from the governor beyond
just the written statement was warranted.
It was clear to me that I had to speak soon, but I was not certain whether I
should do so from Washington or wait until I returned home. After consulting
Rakesh Mohan, deputy governor, who was also in Washington for the meetings,
and Alpana Killawala, the Reserve Bank’s competent and affable
communications chief, I decided that the balance of advantage lay in meeting the
media in Washington. Not only would it be sooner but we would also be
reaching out to the international media.
One young rookie journalist who had travelled from India was calling my staff
several times a day for an exclusive interview with me. My staff told her that I
neither had the time nor the inclination for one-on-one interactions. As time
went by, she became increasingly desperate. At some point, she called me
directly, and on the verge of tears told me that her editor had sent her all the way
to Washington on the condition that she would interview the new governor, and
if she failed, it would dent her career prospects. Even as I sympathized with her,
I could not oblige. Given all the pressures on my time, I found it difficult to
accommodate her career prospects in my priorities. When I scheduled the media
conference, I told my staff to make sure to invite her too.
At the media conference which lasted maybe about ten minutes, there were
questions seeking explanation for the actions the Reserve Bank had taken, and I
valued the opportunity of elaborating our stance. There were questions about
why India was affected by the unfolding crisis; I had a reasonable explanation
for it. The questions I found most difficult to address were those concerning the
future—how would the situation evolve and what actions would we take? These
were in the realm of speculation, there was too much uncertainty around the
world and the gloomy G20 meeting the previous evening was very fresh in my
mind. I found it hard to be definitive or forthright.
mind. I found it hard to be definitive or forthright.
As an aside, I must add that the rookie journalist has since grown into a well-
regarded and knowledgeable professional in her media house. Whenever she ran
into me in the five years that I was in the Reserve Bank, she would thank me for
her success, always leaving me feeling guilty about this undeserved gratitude.
Frankly, I was getting increasingly uncomfortable by the hour and was eager
to be back in my office. I cut short my stay by a day and took the flight back to
Mumbai.

‘May You Live in Interesting Times’

The Chinese have a saying: ‘May you live in interesting times.’ I can’t complain
on that account. As governor of the Reserve Bank for five years, I had more,
much more, than my share of interesting times. The crisis began days after I
assumed office and continued in some form or other all through my tenure
without even a week’s respite. The most frequently asked question of me during
those early months was about when the crisis would end. I used to joke that since
the folklore was that the new governor was responsible for inflicting the crisis on
India, it would be logical to expect it to end only when his tenure ended. For
good measure, I used to tell them when my term would end.
Many will recall that the last few months of my tenure in 2013 were marked
by the pressures on the rupee as part of the global taper tantrums. As it
happened, the rupee stabilized the week after I left the RBI. If there was one
prediction that I would have liked to be wrong on, it would have been this one
on the crisis ending with my governorship. But that was not to be my legacy!
1
From Main Street to Mint Road
Appointment as Governor

As a career civil servant, my ambition had always been to become the Cabinet
secretary to the Government of India, the highest civil service position in the
country. This was within the realm of possibility too since both age and seniority
at the top of my batch in the Indian Administrative Service (IAS) were on my
side. A lot would, of course, depend on my performance evaluation which, in the
civil service, is confidential, but I was confident that my ratings were generally
above average. But one can never be sure of one’s career trajectory in the civil
service as appointments and placements are based on a number of factors, not all
of them transparent or contestable.
I was transferred from the prime minister’s Economic Advisory Council and
posted as finance secretary to the Government of India in April 2007. By then, I
was within striking range of the cabinet secretary’s job as the position was
expected to open up well before my scheduled superannuation in August 2009.
The reason for this long preface is only to say that the job of the governor of the
Reserve Bank was not in my career calculus.
The term of Y.V. Reddy as governor of the Reserve Bank was going to end in
early September 2008. The inevitable speculation about his putative successor
started several months earlier, with economic journalists compiling their own
panels of candidates and evaluating the strengths and weaknesses, as well as the
chances of each candidate. The trick of the trade is to write authoritatively so as
to give the impression of being on the inside track. There was talk too that Y.V.
Reddy would be requested to continue for a year to allow the new government,
post-election in mid-2009, to make a choice on the successor. Occasionally, my
name too would appear on some journalist’s panel, which meant nothing beyond
inquiries from my friends and colleagues to ask if it was true, and if I had indeed
been sounded for the job by the prime minister or the finance minister.
been sounded for the job by the prime minister or the finance minister.
I found all the speculation about being a possible candidate for the governor’s
job either irritating or amusing depending on my mood. To be honest, the
question of whether I had the profile and experience to be the governor would
occasionally cross my mind. True, compared to many of my civil service
colleagues, I had long experience in public finance management, both at the state
and central government levels, if only because of accident and luck in postings.
My CV was also burnished by international experience at the World Bank for
over five years. But all this was mostly on the fiscal side—not the main focus of
central banking. Because I thought there were others who fit the bill better, I was
quite dismissive of all the kite-flying by the media.
I had known Rakesh Mohan, deputy governor in the Reserve Bank, for several
years—which in itself should not be surprising if only because there are few
people that Rakesh does not know. That acquaintance grew into a warm
friendship over the previous year because of the regular professional interaction
entailed by our respective jobs. Over this period, I had grown to respect
Rakesh’s intelligence, competence and maturity, and agreed with the widely
shared view that he was a shoo-in for the governor’s job. In an informal
conversation, Y.V. Reddy once told me that it had been a standard convention
for the government to consult the outgoing governor on the choice of his
successor, and should that convention be followed, he would certainly
recommend Rakesh’s name.
On 24 August 2008, Rakesh who was in the United States, attending the
annual Jackson Hole Conference of central banks, called me up to say that he
had got a call from the finance minister’s office asking him to come and meet
the minister in Delhi later that week. He asked me if I knew what it was about. I
didn’t, but my hunch was that P. Chidambaram was calling Rakesh to personally
convey his appointment as governor before releasing the public announcement. I
was quite pleased about this prospective development, since like Y.V. Reddy,
my choice for governor too would have been Rakesh. Besides, I had built a
comfortable professional relationship with him, which meant that we would be
able to handle the inevitable differences between the government and the RBI in
an objective and agreeable manner.

~
Interview for the Job of Governor

Finance Minister Chidambaram was usually the first one to check into North
Block, the imposing building on Rajpath that houses the ministry of finance,
every workday morning. After a few months of working with him, I realized that
this early-morning slot was the best time to touch base with him if I had to
discuss any urgent issue before the day’s schedule engulfed both of us.
So it was that on Tuesday, 26 August, I had gone to catch the finance minister
during this short morning window mainly to tell him that I would be leaving that
night for Brazil to attend the G20 Deputies meeting. As my minister,
Chidambaram had approved my foreign travel, but that was some time ago and
the exact dates of my absence from office may not have stayed in his mind. In
particular, I needed to check if he wanted me to attend to anything before I left.
My hunch was right as he went into some silent calculation when I told him
about my trip. He asked when I would be back and when that date registered on
his mind, he paused briefly and asked me if I would be interested in being
considered for the governor’s job. Frankly, I was surprised. Notwithstanding all
the media speculation, I thought that the prime minister and Chidambaram had
decided on Rakesh as the next governor. Even before I replied, he offered that I
could think about it and let him have my answer by lunchtime.
Being the governor of the Reserve Bank would, of course, be a great honour
and privilege, an exciting opportunity to steer the macroeconomic management
of the country. There was hardly any need to think through further; the decision
seemed straightforward. I immediately thanked Chidambaram for putting my
name on the shortlist and requested him to take my candidature forward. I don’t
think he was surprised by my enthusiastic response but added for good measure
that the prime minister wanted him to explicitly check with me since I was in
line to be the next Cabinet secretary.
With the big issue settled, we quickly moved into settling the logistics. He
asked me what time my flight was, which unsurprisingly for a West-bound
international flight out of India was in the middle of the night. ‘Could you then,’
he asked, ‘come to my house at 8 p.m. for a chat with Dr Rangarajan and
myself? Rakesh is coming in at 7 p.m.’ Dr C. Rangarajan is a former RBI
governor and at that time was chairman of the prime minister’s Economic
Advisory Council.
Advisory Council.
I had a heavy schedule for the day stretching late into the evening, including a
briefing session on the forthcoming G20 meeting agenda with my staff. On top
of that, I now had to make space for this interview. I called up Urmila, my wife,
and told her. Her reaction was typically nonchalant. ‘If that’s what you want, I
wish you all the best.’ Her only advice was that I call up Rakesh and level with
him on this development. I could not reach him all through the day.
Several times during the day, it did cross my mind if I was being interviewed
as a pro forma candidate just to build up the paperwork to show that the
government did indeed consider a panel of candidates before making a final
choice. That would be handy if the decision came under the scrutiny of any of
the watchdogs, including the media. But I dismissed the thought because
Chidambaram was too professional to do something like that. Besides, in the
course of the day, I was not handed any formal notice of interview; no paper trail
was being established.
By the time I showed up for the ‘interview’ at Chidambaram’s house, I was
exhausted but neither anxious nor tense. Coincidentally, the interviewers were
my former boss in the prime minister’s Economic Advisory Council,
Rangarajan, and my current boss, the finance minister—two people who could
evaluate my professional competence and personality traits even without an
interview. In the event, the interview turned out to be a relaxed, informal
discussion on a few professional topics. I can still recall a couple of issues that
came up.
Chidambaram asked if I would back the idea of a Monetary Policy Committee
(MPC) to decide on the Reserve Bank’s monetary policy, thereby replacing the
present arrangement where the governor makes the final call. Given the ongoing
debate on constituting an MPC, this was prescient. We discussed the pattern in
advanced countries, including the Federal Open Markets Committee in the US,
the MPCs of the Bank of England (BoE) and the Bank of Japan (BoJ), and even
the opaque system of the People’s Bank of China. My substantive stance was
that an MPC was the direction in which we must go but that the governor must
have a veto, at least during the transition period until the institutional structure
stabilized.
Chidambaram did not agree. His point was that the governor should see
himself as the chairman of a corporate board and try to persuade the MPC
members to his point of view. And if he failed to do that, he should defer to the
members to his point of view. And if he failed to do that, he should defer to the
majority view. I agreed with him but countered that the parallel with a corporate
board would work only if the members of the MPC did not owe any allegiance
to the government for their appointment. They might, given the institutional
structures of our system, feel pressured to push the government’s point of view
in the MPC.
Another topic we discussed at length during the interview was bank branch
delicensing. Under the regulation prevailing then, if a bank wanted to open a
new branch at some place, it had to get a specific licence for that location from
the Reserve Bank. Left to themselves, banks would prefer to expand in urban
areas where the business is attractive, and tend to neglect rural areas. The
Reserve Bank used the leverage of licensing to push banks to spread into rural
areas.
I had first-hand exposure to this issue from my field postings in the early
phases of my civil service career. We were handicapped in providing
opportunities to the poor to improve their livelihoods because there were no
banks to extend credit support. I was unfamiliar though with the pros and cons of
the issue at the policy level, since banking policy issues in the ministry of
finance were in the charge of the Department of Financial Services whereas, as
finance secretary, I was in charge of the Department of Economic Affairs.
As the discussion rolled on, we realized that all three of us were on the same
page—of balancing the efficiency of a laissez-faire regime with the equity-
enhancing licensing regime. The challenge of managing the tension was most
acute for Chidambaram who had to balance his reformist instinct to dismantle
the licensing regime with his compulsions, as a politician, to deepen bank
penetration. I would recall this conversation several times in later years as the
Reserve Bank, on my watch, moved quite a distance towards bank branch
delicensing.
It was well past 9 p.m. by the time the conversation ended. Chidambaram
walked me to the car parked in the drive of his house and wished me a safe
flight. I was touched by this gesture as few ministers would extend such courtesy
when their staff came to see them at home, but then I had always known that
Chidambaram was way more courteous than he is given credit for. Of course, he
can’t suffer fools, but that is a different matter.
At any other time, I would have rehashed the interview in my mind, thinking
through where I could have put across my views better or argued more
coherently. But just then, I was too preoccupied with more immediate concerns,
like getting ready for the journey and all the preparation I still needed to do for
the G20 meeting.
As I was driving home, I got Rakesh on the line at last and told him about my
‘interview’. He was not aware that I too had been invited to an interview, and
frankly, was quite flustered when I gave him the news. I got home, scurrying to
pack, bathe and eat, and set off for the airport. In the middle of all this, Rakesh
called back to let me know how touched he was that I levelled with him, and
both of us acknowledged, in unspoken words, that no matter what the final
decision, it would not affect our friendship. I was deeply comforted after
connecting with Rakesh, for if I had not, it would have haunted my mind all
through the trip.
My mind automatically switched off from all this as I boarded the plane for
Frankfurt on my way to Rio de Janeiro.

Appointment as Governor

As my plane landed in Delhi in the early morning of 2 September, my phone


started beeping incessantly with an unusual flood of messages. I was confused
about the congratulations since not one of them contained any clue. I called
Urmila who gave me the news of my appointment as governor and did not miss
out on complaining that the previous evening she had done nothing but field
phone calls from literally hundreds of people, many of them not even known to
us.

I would be the twenty-second governor of the Reserve Bank in its seventy-three-


year history—the eleventh bureaucrat to don the governor’s mantle. Finance
secretaries had become governors in the past too, but I would be the first finance
sectary to go directly from the North Block to Mint Street without a gap in
between. I would also be the first governor of the Reserve Bank born after
Independence.
The news was expectedly all over the TV and print media over the next couple
of days, instantly turning me from an unknown unknown to a known unknown.
of days, instantly turning me from an unknown unknown to a known unknown.
There was coverage of my background and career trajectory, and also extensive
commentary on my reform credentials and policy biases.
In over one year as finance secretary, I had occasion to make a few statements
on inflation, financial sector reforms and capital-account liberalization. At the
time I made these comments, they passed off as relatively innocuous items, but
now analysts, columnists and economic journalists were digging them up to
evaluate my potential policy stance as the prospective governor.
Opinion and commentary were varied. Some said I would continue with Y.V.
Reddy’s hawkish monetary-policy stance, while others said that I would be more
biased towards growth and would be of a more dovish disposition. Some said I
would accelerate the financial market reforms laid out in the Percy Mistry,
Deepak Parikh and Raghuram Rajan committee reports, and some others thought
I would be more cautious in moving forward with reforms. Similarly, there was
much speculation about my stance on exchange rate issues and balance of
payments. There were questions about whether, as governor, I would fulfil my
dharma of countering fiscal profligacy for which I was—some said—‘at least
partly responsible’. All of this amused me since this was at best informed
speculation passing off as authoritative commentary. The biggest takeaway for
me from all this was that there was a lot riding on the governor’s policy stance
and world view.
And there was advice aplenty, predictably from both ends of the ideological
spectrum: slay inflation with all the policy force at the Reserve Bank’s command
vs recognize the paramount importance of supporting growth at a time of
business-cycle downturn; leave the exchange rate to the dynamics of the market
vs you can’t afford to abandon the exchange rate to the vagaries of the market;
open up the capital account with blitzkrieg reforms vs beware of the pitfalls of
hasty capital-account liberalization; invite foreign banks with open arms vs keep
in mind the sorry experience of other emerging markets which had embraced
foreign banks prematurely; implement financial sector reforms with alacrity vs
focus on the macroeconomy and let reforms wait.
There was the expected and predictable debate on the advisability of
appointing civil servants as governors. Some thought that tried-and-tested civil
servants can bring fresh thinking into what is considered to be an insular
institution: an outsider like me would add value to the Reserve Bank and shake
the institution out of its ‘status quo’. The opposing view was that I did not have
any central banking experience and this would be a handicap in providing
leadership to the RBI.
There was quite a bit of commentary on what a direct transition from North
Block to Mint Street would entail. Y.V. Reddy, my predecessor, had a
formidable reputation for standing his ground with the government. The
commentariat said that my familiarity with, and sympathy for, the government’s
point of view would help repair that strained relationship between the ministry of
finance and the Reserve Bank. Others thought that my allegiance to the ministry
of finance would make me more pliable and I would dilute the independence of
the Reserve Bank. Some even suggested that I was being dispatched to
implement the government’s agenda from within the Reserve Bank.
The media commentary was par for the course and a pointer to the
expectations and demands of the job I was getting into. The only bit that
troubled me was doubts about my credentials and the suspicion that I would
compromise the autonomy of the Reserve Bank. I was aware too that the only
way I could counter those doubts and suspicions, and establish my credibility,
was by demonstrating my professional integrity in all that I said and did, which
would inevitably take time. I had no option but to be patient.
My immediate concern, where I did not have the luxury of time, was to
establish my credentials with my staff in the Reserve Bank, as their trust and
support would be critical to my performance and effectiveness. More than any
other constituency, I had to convince them as soon as possible that all my
decisions as governor would be informed by nothing but larger public interest.
This would be a daunting addition to my already long list of formidable
challenges on the way forward.

Transition from Delhi to Mumbai

I had barely two days to prepare—physically, mentally and emotionally—for


this most unexpected turn in my career. I met the finance minister and thanked
him for selecting me for this responsible and prestigious position. I called on the
prime minister and the conversation went along predictable lines about how he
reposed confidence in me and of all the challenges that the government and the
Reserve Bank had to jointly address. The prime minster also encouraged me to
Reserve Bank had to jointly address. The prime minster also encouraged me to
brief him on the macroeconomic situation regularly, and added for good
measure, ‘I will always make time for you.’ As I look back, I can say that the
prime minister stood by his word. Not only did he always give me time no
matter how pressing his schedule or the preoccupations on his mind, but he also
seemed to enjoy those meetings.
There was also a strange irony in my appointment as governor. I say this more
from hearsay and my own inferences rather than any hard evidence. A year and a
half earlier when I was being considered for the position of finance secretary,
Chidambaram did not know me and was understandably circumspect about
taking me into his team. I gathered that Prime Minister Manmohan Singh, who
was acquainted with me from my earlier posting in the ministry of finance in the
early ’90s, had to nudge him into it. And now when it came to my appointment
as governor, I understand it was Chidambaram who was more actively
sponsoring my candidature and it was the prime minister who had to be nudged.
I was touched by the farewell given to me by my colleagues and staff in the
DEA. The DEA attracts some of the best civil service talent in the country, and
over the previous year and a half, I had built valuable professional relationships
and personal friendships. Together, we had launched many initiatives and
several were still works in progress. They were proud that one of their own was
going as governor, and I was sad to break these bonds, and apprehensive about
jumping from the comfort and familiarity of the known to the fear and
uncertainty of the unknown.
In the middle of the logistic nightmare of the transition that I was muddling
through, Y.V. Reddy, who was also from the IAS, called me up from Mumbai to
advise that I should seek voluntary retirement from the IAS before assuming
office as governor. At the time, I was fifty-nine and still a year away from
superannuation. Reddy’s logic was that I should unequivocally be covered by the
code of conduct prescribed for the governor which may be at variance with the
IAS code of conduct. When I checked, I was informed by the ‘rules people’ not
to bother since I would be deemed to have retired from the IAS as soon as I
assumed office as governor. Never in the thirty-five years of my IAS career did I
imagine that I would sever links with the civil service, which nurtured and
defined me all through my adult life, so nonchalantly.
On 5 September 2008, I took an early-morning Air India flight from Delhi to
Mumbai, a two-hour journey that would mark by far the most significant
Mumbai, a two-hour journey that would mark by far the most significant
transition of my career. Even as I was drained—physically, mentally and
emotionally—I couldn’t keep my mind away from the potential challenges and
concerns about how I might perform as the governor of the Reserve Bank of
India.
2
Baptism by Fire
Battling the Global Financial Crisis

When I assumed office as governor on 5 September 2008, the dominant concern


of the Reserve Bank was decidedly the persistently high inflation. In fact, the
only thing I could think of saying when I was ushered in front of the media for a
sound bite minutes after signing on as the governor, was that reining in inflation
and anchoring inflation expectations would be my top priority. Little did I know
that my top priority would change in such a dramatic way in less than a
fortnight.
The advance tremors of the global financial crisis started going off in the
week following my joining the Reserve Bank, sending tectonic shocks across
financial markets around the world. Every day there was news of some storied
financial institution crumbling under pressure. In the space of just a few days,
Fannie Mae and Freddie Mac went into conservatorship; Merrill Lynch had
vanished; Washington Mutual was closed down by the regulators; Wachovia was
sinking, and AIG was on the brink of a meltdown. Finally, on 16 September, the
big bang—Lehman Brothers collapsed, plunging the global financial sector into
a near-death experience.
Quite unsuspecting of the oncoming tumult, my staff had scheduled a series of
briefing meetings for me over the first two weeks to ‘induct’ the new governor
into the world and work of the Reserve Bank. The shock and awe following the
collapse of Lehman Brothers denied me the luxury of learning systematically
and at my own pace. It was baptism by fire.

Reserve Bank’s Immediate Response

The Reserve Bank swung into a crisis-management mode with energy,


intelligence and briskness. I was impressed by the rich expertise and mature
intelligence and briskness. I was impressed by the rich expertise and mature
understanding of the senior management of the Reserve Bank, which was clearly
evident in the way they advised me on where pressures might erupt and what our
priorities should be. Within hours of Lehman Brothers filing for bankruptcy, we
had issued a press release, saying: ‘The Reserve Bank is keeping a close watch
on the developments in the financial markets and is in touch with banks and
other market participants to manage in an orderly manner any fall-out of these
developments on the Indian financial markets.’ With characteristic alacrity, the
Reserve Bank ring-fenced the operations of both the Lehman subsidiaries in
India—Lehman Brothers Capital Pvt. Ltd, a non-banking financial company
(NBFC), and Lehman Brothers Fixed Income Securities Pvt. Ltd, a primary
dealer—restricting their operations and prohibiting them from making foreign
remittances.
Around the world, fear and panic gripped financial markets; virtually every
big-name institution was engulfed by rumours of imminent collapse. Trust had
dried up, banks were hoarding liquidity, and trading came to a near-complete
stop. We anticipated panic in our financial markets too, mainly because of the
fear of the unknown. The standard first aid a central bank administers when
markets are unnerved is to shore up liquidity. So was the case in India, as on that
very day, we instituted a slew of measures to ease liquidity both in the money
and forex markets.

The Contagion
Over the following days and weeks, the global financial markets remained on the
boil, and markets at home reeled under the onslaught of the global tremors as the
contagion spread through three channels—the finance channel, the real economy
channel, and importantly, as happens in all financial crises, the confidence
channel.
The contagion through the finance channel was, by far, the most perceptible as
external developments fed on our domestic vulnerabilities through complex and
pernicious feedback loops. All our financial markets—equity market, bond
market, money market, credit market and forex market—were rattled by the
global developments.
The benchmark equity index, the Sensex, collapsed by over a quarter from
13,518 on 16 September to 9647 by end December 2008. The call rate in the
13,518 on 16 September to 9647 by end December 2008. The call rate in the
money market zoomed by over 5 percentage points from 13.1 per cent on 16
September to a high of 18.5 per cent on 10 October, reflecting market fear and
uncertainty. A complex, cascading knock-on impact played out, squeezing the
money and credit markets. Edged out of foreign markets, corporates started
turning to domestic banks for their credit needs even as the banks themselves
were in the midst of a huge funding uncertainty. Simultaneously, corporates also
started withdrawing their investments from domestic money market mutual
funds; money market mutual funds, in turn, started withdrawing their
investments from NBFCs; and NBFCs, reeling under the funding pressure,
turned to banks, exacerbating, in the process, the stress on banks which were
already struggling to cope with the additional credit demand from the corporates.
The forex market pressure reflected two main developments. First, foreign
institutional investors (FIIs), who had put billions of dollars into our equity and
debt markets in the pre-crisis years, started withdrawing their investments as part
of the global deleveraging process. Second, as external financing dried up,
Indian corporates raised funds locally and began converting those into foreign
currency to meet their external obligations. The exchange rate plunged as a
result, falling from ₹46.63 to a dollar on 16 September, to a low of ₹50.52 on 2
December 2008, despite the Reserve Bank’s almost regular intervention in the
forex market.
Since forex intervention by the Reserve Bank when the rupee is under
downward pressure involves selling dollars for rupees, an incidental by-product
of our forex-market intervention was that we were squeezing rupees out of the
system, and thereby exacerbating the pressure on domestic liquidity. On the
balance of payments front, we were also worried about a potential sharp drop in
remittances from non-resident Indians (NRIs) located in advanced economies
which were sinking into deeper recession and in the Gulf countries which were
wobbling from a steep drop in oil prices.
The contagion of the crisis through the real channel, which manifested mainly
in the form of a slump in demand for exports, was more prolonged and painful.
The United States, the European Union and the Middle East, which together
accounted for three quarters of India’s foreign trade, were in a synchronized
downturn. Not just goods export, but even services export growth started
slowing as overseas financial services firms—traditionally large users of
outsourcing services—were downsizing.
outsourcing services—were downsizing.
Beyond the finance and real economy channels, the crisis spread through the
confidence channel. For sure, even at the height of the crisis, Indian financial
markets continued to function in a fairly orderly manner; also, our banks
continued to lend. However, the tightened global liquidity situation in the period
immediately following the Lehman collapse came on top of a turn in the
domestic credit cycle which heightened risk aversion, making banks wary and
cautious about lending.

Crisis Management

In terms of crisis management, our strategy in the Reserve Bank was to focus on
the finance and real economy channels on the calculation that if we kept the
domestic financial markets functioning normally and ensured that the liquidity
stress did not set off solvency cascades, confidence would automatically return
to the financial markets. This translated into targeting three objectives: first,
make the system flush with rupee liquidity; second, augment foreign-exchange
liquidity; and third, drive a policy framework aimed at keeping credit delivery
on track and arresting moderation in growth.
It is standard practice for central banks to impound a prescribed proportion of
commercial banks’ net time and demand liabilities (NDTL), called ‘reserve
requirement’, as an instrument of monetary policy; but this also doubles as a
safety deposit that a bank can draw upon to meet any sudden and unexpected
liquidity crunch. In India, we call this the ‘cash reserve ratio’ (CRR). In addition
to the CRR, the Reserve Bank also requires commercial banks to invest a
minimum proportion of their NDTL, called the ‘statutory liquidity ratio’ (SLR),
in government securities. We were anxious that banks should not pull back on
credit flow which meant that we had to put more money in their hands. To do so,
we reduced both the CRR and the SLR. To further encourage flow of credit to
what we thought were stressed sectors, we extended regulatory forbearance to
banks by relaxing the risk weights and provisioning norms governing bank loans
to the stressed sectors. This meant I was partly reversing the countercyclical
measures instituted by my predecessor, Y.V. Reddy, to restrain risky lending
during the ‘subprime’ years.
On the forex side, we had to offset the pull-out by the FIIs by encouraging
inflows of other types. Towards this end, we raised the cap on the interest rate
that banks could offer to foreign-currency deposits by NRIs, substantially
relaxed the norms for external commercial borrowing by corporates and allowed
NBFCs and housing finance companies to access foreign borrowing. To mitigate
the dent on export prospects, we extended the period of pre-shipment and post-
shipment credit, and expanded the refinance facility for exports.
I announced the first interest rate cut on 20 October 2008, just a month after
the Lehman collapse, reducing the policy repo rate—the rate at which
commercial banks borrow overnight from the Reserve Bank—from 9 per cent to
8 per cent. The significance of this move becomes clear if you note that Y.V.
Reddy had actually raised the rate as late as July in response to rising inflation.
And here I was, reversing the policy stance and cutting the rate in less than three
months’ time, signalling that financial stability had overtaken inflation as the
overriding concern. True, we had cut the CRR and SLR in the past month, and
these were technically monetary-easing measures. But given the extraordinary
financial market situation, they were interpreted by the markets, and correctly so,
as pure liquidity-easing measures without a link to the monetary policy stance. A
rate cut, on the other hand, was a decisive shift in the policy regime.
Within the Reserve Bank itself, opinion within the top management was
divided on the rate cut. The majority view among my top advisers was that a rate
cut was uncalled for and that we could ride out the crisis without a change in the
monetary policy regime. However, I agreed with and accepted the minority view
that the uncertainty and unpredictability in the markets was choking credit flow
and that more than the rate cut itself, the fact that we were reversing the
monetary policy regime would send a strong signal to the markets about the
Reserve Bank’s resolve to preserve financial stability, restore market confidence
and improve credit flow.
The markets generally welcomed the rate cut, and analysts endorsed it as
being consistent with our earlier liquidity-easing measures. But there was
criticism in certain quarters both for its timing—just four days before a
scheduled policy review—and for the way we nuanced the policy rationale by
emphasizing financial stability more than growth and inflation.
I could see where the critics were coming from but could not agree with them.
Sure, making a major policy shift just four days before a scheduled policy
review was an unusual decision, but then we were handling an unusual situation,
review was an unusual decision, but then we were handling an unusual situation,
and my honest judgement was that waiting for another four days would be costly
at a time when the markets were gripped by uncertainty and fear about
developments in advanced economies. Besides, we also calculated that in the
prevailing global context, the signalling impact of an unscheduled policy
announcement would be substantial. Similarly, the relative de-emphasis on
growth and inflation concerns in explaining the policy rationale was deliberate
inasmuch as the motive for the unscheduled and hurried action derived from
preserving financial stability.
Why did our critics not see it the way we did? There is always an information
asymmetry between a regulator and the regulated institutions, and even more so
between a central bank and the external world of analysts and markets. In the
prevailing situation, there was more than the usual share of it. From within the
Reserve Bank, we were getting a lot of information on the inside track. Also, my
exposure to the Washington IMF and G20 meetings had given me a keener, if
also a more disturbing, perception of the uncertainty and turmoil in the global
economy and finance, an appreciation that differed from that of our external
interlocutors.

Global Coordination and Consultation

There was no let-up in the financial market uncertainty and global economic
convulsions up until December 2008. The international media ran saturated
coverage of the crisis, and reams were being written on its diagnosis and
prognosis; analysts were busy critiquing policy responses and offering their own
advice on what should and should not be done by policymakers. This advice
spanned a wide spectrum of issues—stabilizing the markets, arresting the
economic downturn, coordinated fiscal stimulus, infusing capital into banks,
disciplining shadow banks, punishing guilty banks and bankers, and
international cooperation, just to name a few. As someone said, in an otherwise
no-growth world, the only growth to be seen during this period was in the output
by economists, analysts and financial sector commentators.
The crisis tested the leadership mettle of central bank governors. Even big-
name governors were struggling to cope with the challenge of the biggest
financial crisis since the Great Depression. For me, there was additional pressure
as I was called upon to perform on the big stage even before I had time to
as I was called upon to perform on the big stage even before I had time to
establish my credentials and before the market had time to size me up. I was
aware that the markets were struggling to interpret my actions and words. And
what with all the speculation surrounding my appointment about whether I
would act at the government’s bidding, I also had to endure intense scrutiny for
acting independently.
If advanced economy central banks were shaken by the ferocity and
unpredictability of the crisis, for us in emerging markets, it was a double
whammy since we had to factor in not only the uncertainty of the global market
developments, but also the uncertainty of how the policy responses of advanced
economies would impact our economies and our markets.
Understandably, there was greater interaction among central bank governors
during the crisis than during normal times. Recall that in my intervention in the
G20 meeting in October 2008, I had urged the advanced economies to keep the
emerging-market central banks in the loop on financial market developments as
they view them as also on their proposed policy responses. Either because of
that, or more likely quite apart from that, there was regular briefing to some of
us in the emerging markets—China, India, Brazil, Argentina, Mexico, Turkey,
South Africa—by the US Treasury, the Federal Reserve and the European
Central Bank (ECB). These would typically happen on a conference call but on
occasion also be one-on-one.
Even more useful in this anxious period—when fear mounted, prices plunged
and markets froze—were the Bank for International Settlements (BIS) bimonthly
meetings of governors in Basel, which provided a forum for both structured and
informal exchange of views among the governors. Given the centrality of
America to the origin of the crisis and to its resolution, the highlight of these
meetings invariably was the briefing by Bernanke, the Fed chairman. But there
would also be a lot of interest in what Zhou Xiaochuan, the governor of the
People’s Bank of China, had to say—a sign not just of China’s growing clout in
the global economy, but also of how important China’s prospects were to
leading the world out of the Great Recession. There used to be active interest on
the situation in India too, in part because we are a large economy and how India
fared mattered to the world economy; moreover, some of the macroeconomic
developments in India were contrarian to the global trends.

Unconventional Monetary Policy


Unconventional Monetary Policy

Advanced economy central banks were stretched in terms of policy response to


the crisis. The standard and conventional instrument available to central banks is
the policy interest rate. Once they have brought that down to zero and find that
the markets are still choked, what else can they do? They wade into
unconventional policy, which is what they did by embarking on quantitative
easing (QE)—large-scale asset purchases to flood the system with liquidity with
the aim of repairing broken financial markets and stimulating their economies.
An interesting question was whether we, in the Reserve Bank, too were
required to resort to unconventional measures. True, our policy rate, at 3.25 per
cent, the lowest we had reached in the crisis, was still way above zero, but given
our inflation rate, this was virtually the zero lower bound for us with not much
room for further cuts. However, given the stress, and even more so a perception
of stress, in segments of the financial markets, we too instituted our own version
of unconventional measures. We opened a rupee–dollar swap facility for Indian
banks to help them meet any shortfall in foreign funding requirement; we
expanded the lendable resources available to apex financial institutors like the
Small Industries Development Bank of India (SIDBI), the Export–Import Bank
of India (Exim) and the National Housing Bank (NHB) so as to expand the flow
of credit to productive sectors. We established dedicated lines of credit for
augmenting the liquidity of NBFCs and mutual funds to provide them the cash
they needed to pay off their investors.
We didn’t exactly throw the rulebook out the window, but had to be quite
inventive in invoking little-used provisions to stitch up bespoke solutions.

As the global markets remained on the brink all through the last quarter of 2008,
there would be constant news from all around the world of banks failing, and
pictures in the media of long lines of people outside banks waiting to empty out
their savings and investments for fear that their bank was going bust. That
nervousness would occasionally have a knock-on impact on India with ominous
stories appearing in our media about a run on the branches of some banks in
some city or some large NBFC collapsing. In the event, and to our great relief,
these turned out to be false alarms.
these turned out to be false alarms.
Compounding our anxiety in those dreary months were the dastardly terrorist
attacks in Mumbai on 26 November 2008. Mumbai shut down, but the world
around us did not. Even as the security forces were battling the terrorists, and the
police were engaged in arresting fear and panic from spreading, some of us, the
senior management of the Reserve Bank and essential staff, were back in the
office ensuring that we were in readiness to react and respond to both domestic
and external developments. Brainstorming meetings on the eighteenth floor of
the Reserve Bank central office in the Fort area of Mumbai, even as we could
look out of the window and see the onion dome of the iconic Taj Mahal Palace
hotel in Colaba belching out smoke, will forever remain etched in my memory as
a reminder of that gloomy period.
We were anxious that there should be no contagion from the terrorist attack to
the financial system. The payment and settlement system, which enables
settlement of financial transactions, is the plumbing of the financial system. If it
breaks down, it would cripple the financial sector, bring commercial activity to a
standstill and sap public confidence. The potential for panic was frightening. A
lot of experts, in fact, claim that during the early weeks of the global financial
crisis when markets were seized with deep anxiety and fear, what prevented a
total collapse was that even as everything around was breaking down, the global
payment systems held up. Quite understandably, this was our top concern in the
wake of the terrorist attack. That we were able to recommence the two large
payment and settlement systems—the Real Time Gross Settlement (RTGS),
National Electronic Funds Transfer (NEFT)—on 27 November, just a day after
the attack, is a tribute to the commitment of the Reserve Bank staff and a
testimonial to the robustness of our technological systems.
Chidambaram was on the phone several times asking when we could reopen
the markets. He was particular that we must demonstrate to the world that India
would not be cowed down by terrorists and that our financial markets were too
resilient to be hit by anyone. I consulted Chandu Bhave, chairman of the
Securities and Exchange Board of India (SEBI), which regulates the equity
markets. We agreed that we must open our markets as soon as possible and do so
simultaneously. By 28 November, within two days of the attack, we reopened
government securities, foreign exchange, money and stock markets, and clearing
houses returned to normal functioning. I must admit that Chidambaram’s
pressure was the motive force behind our sense of urgency and alacrity.
pressure was the motive force behind our sense of urgency and alacrity.

By December 2008, I had brought down the policy rate from 9 per cent to 5 per
cent, in effect reversing in just three months the policy rate hike that took five
years on the way up. In fact, I cut rates so regularly during this period that I was
rapidly coming to be seen as a trigger-happy governor. At the launch of Rakesh
Mohan’s book in Delhi in February 2009, I alluded to my predicament with one
of my famous hair jokes. This is what I said:
‘The other day, when I was in Hyderabad, I went to my regular barber for a
haircut. In the inevitable barber–client conversation, it was our practice to talk
about his children, my children, local politics and Bollywood. But this time
round he was seeing me for the first time after I became governor. Even as he
was preparing to apply scissors to my hair, he asked, “When are you going to cut
interest rates?” I was exasperated by even my barber not giving me any respite
from interest rates. Clearly wanting to take my mind off stressful issues, I tried
to divert the topic. But he seemed bent on dispensing wisdom and persisted with
the banter on interest rates. I got irritated and snapped at him, “What do you
know about interest rates and how does it matter to you at all? Why don’t you
just leave me alone?” He smiled and said, “I don’t know much about interest
rates, but I do know that if I talk about them, your hair will rise and it will be
easier to cut it.”’

Government and the Reserve Bank during the Crisis

In mid-October 2008, even as the Reserve Bank was dousing the system with
rupee and forex liquidity, Finance Minister Chidambaram had suo moto
constituted a committee on liquidity management, with Finance Secretary Arun
Ramanathan as the chairman. The Reserve Bank was asked to nominate a
representative on the committee. I was annoyed and upset by this decision.
Chidambaram had clearly overstepped into the RBI turf as liquidity management
is a quintessential central bank function. Not only did he not consult me, but he
had not even informed me of this before the notification was issued. Coming as
it did amidst a lot of suspicion in those early weeks of my tenure that I was a
government lackey sent to the Reserve Bank to act at the government’s bidding,
the constitution of this committee only reinforced the view.
I called up Chidambaram and let him know in unequivocal terms that his
action was totally inappropriate, and requested firmly that he dissolve the
committee. His argument was that when liquidity management was such a
central concern, getting advice from external market participants would help us
understand and respond to the ground reality in the market faster and better. I
granted that, but if he wanted external experience to be tapped, he could have
advised me informally to constitute such a committee rather than taking the
Reserve Bank for granted. The call ended with my telling him that the Reserve
Bank would not participate in the committee. This skirmish with Chidambaram,
who I believed pushed my candidature for the governor’s job, so early in my
tenure upset me a lot. Little did I know that this set the tone for what would be
an uneasy relationship between us in the last year of my term.

The prime minister also held several informal discussions during these months
and his office was invariably kind enough to schedule these meetings to suit my
convenience. Most of these would be informal, involving just the finance
minister and me, and occasionally, the finance secretary; a few times, the
chairman of the Economic Advisory Council, Rangarajan, and Planning
Commission Deputy Chairman Montek Singh Ahluwalia were also present. I
was aware that such frequent meetings at the prime minister’s level were unusual
and were occasioned entirely by the crisis.
In general, Chidambaram believed that the crisis demanded more aggressive
easing both on the policy rate and liquidity than I was comfortable with. At these
meetings, he would try and pin me down to specific actions and time frame. I
would go as far as indicating the general direction in which I would go but
refused to get committed to any specifics. There were no overt arguments
between us, but it was clear that Chidambaram was annoyed that I was not
moving as aggressively as he would have liked me to. Our relationship remained
frosty.
There was one particular meeting sometime in late November 2008, larger and
more formal than usual, chaired by the prime minister and also involving a
dozen Cabinet ministers and secretaries to the government. The agenda was to
dozen Cabinet ministers and secretaries to the government. The agenda was to
discuss the government’s response to the crisis, and I too was invited. By then,
Chidambaram had moved from finance to home ministry, a transfer occasioned
by the terrorist attacks in Mumbai, but he was also invited to the meeting to get
the benefit of his advice.
The meeting kept clear of monetary or regulatory issues, but several ministers
and secretaries took advantage of my presence and the pressure of the crisis to
ask that the Reserve Bank open money spigots for all sorts of sectors and
schemes, much of which had no relevance to fighting the crisis. I was amused by
this attempt to use the crisis as a cover to get the Reserve Bank to relax its norms
and support proposals that it had consistently resisted.
In some sense, this was vigorous democracy at play and, in fact, mirrored
what was happening in another big democracy, the US. There were headline
media reports on how US lawmakers were playing pork-barrel politics while
debating their President’s fiscal package in the Congress. They were tearing
apart the package to include their own pet schemes to serve narrow constituency
interests as a precondition for their support, never mind that all the pork
barrelling may have compromised the basic thrust of the scheme of boosting
consumer demand.
I had to say no to almost all of these proposals even as I found it difficult to
disagree with friends and colleagues who were all well intentioned, but not
necessarily well informed on what the Reserve Bank can or cannot do. When the
meeting concluded well past 10 p.m., and all of us stood up waiting for the prime
minister to leave, I recall the prime minister coming around to me, silently
patting me on the back and then exiting. Vini Mahajan, joint secretary in the
prime minister’s office, one of my friends and well-wishers, told me as we were
all walking out of the meeting that such demonstrative behaviour on the part of
the prime minister was uncharacteristic and uncommon. I was deeply touched by
the prime minister’s gesture, which I realized was both an act of commiseration
with my plight and an endorsement of my firm stand.

Criticism against the Reserve Bank

There was broad endorsement in the media of the Reserve Bank’s policy
There was broad endorsement in the media of the Reserve Bank’s policy
response to the crisis although there were some outliers—some saying that the
Reserve Bank was doing too much by way of crisis management and others
saying that we were doing too little.
In all of this, there were two strands of criticism from the commentariat during
those early months which had disturbed me. The first was that I was
compromising the Reserve Bank’s already fragile autonomy by allowing the
government to dictate policy, confirming what some people suspected at the time
of my appointment. The second criticism was that the Reserve Bank remained
largely uncommunicative even as it was hyperactive on the policy front. The
general refrain was that the Reserve Bank’s silence was jarring, especially when
set against the flurry of comments from almost everyone in Delhi—whether on
the inside track or not—about what should be done and what would be done by
way of policy response to the crisis.
There was not much I could do about the criticism on diluting the Reserve
Bank’s autonomy, not in the short-term anyway. The crisis was a black swan
event, and everywhere around the world, governments, central banks and
regulators were acting in concert and synchronizing their policy responses. What
we were doing in India was no different from the global practice during those
anxious and turbulent times. But my credentials were suspect because of my
background as finance secretary and so lent credence to this criticism.
I was more sensitive to the criticism on the ‘eloquent silence’ of the Reserve
Bank. This was by no means deliberate. In normal course, it would take at least a
couple of months for the media to take a measure of a new governor, for both
sides to get to know each other and for a protocol of communication to get
established. The crisis did not allow us the time to go through this familiarization
process at the normal pace. In part because of the lack of familiarity, I tended to
neglect the communication dimension of my job in those early months.
The criticism was a welcome call for corrective action. My first response was
to establish a practice of a media conference following every major crisis-
response package by the Reserve Bank.
The first of this series of media conferences was on 28 October 2008,
following the first quarterly policy review on my watch. I was not a novice in
dealing with the press; I had in the past taken questions from reporters as finance
secretary, and also given brief interviews. But facing a media conference as
governor was an altogether different proposition since so much seemed to hang
on what you said and how you said it. I had gone through answers to possible
questions with the staff but I was still nervous. After all, this wasn’t any old
time; we were going through a period of acute anxiety and uncertainty, and the
media was struggling to interpret my actions and understand my personality. I
knew they would be more probing than usual, but would they also be
adversarial?
As I entered the conference room with the four deputy governors in tow at 3
p.m., a strange calm suddenly descended upon me. The conference didn’t
exactly go as per script; in fact, no media conference does. But I never felt
cornered or lost. I believe I gave cogent and reasoned replies to all the questions,
including why I had to resort to an unscheduled policy action, that too one as
significant as a regime change in monetary policy, just four days ahead of a
scheduled policy review. One question that came up several times and in several
formulations was whether the government was driving the Reserve Bank’s
agenda. Beyond a simple denial, I chose not to join issue since any elaboration
would have seemed defensive and unconvincing. Time alone should establish
my credibility.
The press conference lasted an hour, longer than the typical thirty–forty-five
minutes of post-policy conferences under my predecessor, Governor Reddy. It
seemed a success on several fronts. The explanation of the rationale for the slew
of crisis-response measures gave the media an appreciation of the context in
which we were operating; the media got a full, good look at me, enough to size
up the new governor; and at a personal level for me, it drove away the fear of the
unknown. Most importantly, it set the tone for a very constructive and happy
relationship that I enjoyed with the media through my five-year term.
The criticism that I was ceding control of the Reserve Bank’s crisis response
to the government was weighing on my mind, but as I said, there was nothing
much I could do to reverse what I thought was an ill-informed view. Time alone
would have to neutralize that.
My bigger concern though was whether I was, even at this very beginning of
my tenure, losing credibility with my own staff in the Reserve Bank. What if
they too became prejudiced by all the talk of my inability or unwillingness to
protect the Reserve Bank’s turf? Instead of looking up to me for my professional
competence and intellectual integrity, they would be looking at me with
competence and intellectual integrity, they would be looking at me with
suspicion, and worse, distrust. This would hurt my reputation in many ways, but
even more importantly, it would compromise my effectiveness, something that
the Reserve Bank could not afford, least of all in a crisis situation like this.
Hopping from job to job and organization to organization is standard fare in
an IAS officer’s career trajectory. With thirty-five years of civil-servant
experience under my belt, I was quite aware that the default relationship between
a new boss and the organization that he comes into laterally is of distrust and
suspicion. The new boss has to work hard early on in his tenure to tear down
those barriers and establish his credentials to earn the respect of his staff. But
here I was, forced to perform at peak level, under high-profile visibility even
before the large majority of the senior staff of the Reserve Bank, let alone the
thousands of subordinate staff, got to know me. Besides, here I was interacting
with the government much more actively than the Reserve Bank staff had been
used to seeing. Would they give me the benefit of the doubt and evaluate my
actions in the context of the crisis? Or would they write me off as someone who
couldn’t stand up to pressure from the government?
The senior officers’ retreat of the Reserve Bank in late November 2008
presented a much-needed opportunity for me to open up with the senior
management and speak to them candidly about my concerns and anxieties, and
also about my positions vis-à-vis the government. This retreat is a standard
feature on the Reserve Bank’s annual calendar when all the senior staff, from the
governor down to the chief general manager, maybe about one hundred in all, go
offsite for a couple of days to learn, understand, bond and rejuvenate.
I spoke without any notes which—as the Reserve Bank’s staff would learn as
they got to know me better—was very uncharacteristic of me. I also spoke
without any specific narrative in my mind. I levelled with them on the process
leading to my appointment, on the complexity of the crisis, and my journey up
the learning curve. I drew their attention to what was happening everywhere
around the world—governments and central banks were coordinating as never
before to fight the crisis. What was happening in India, I told them, was in tune
with that pattern. It was only the special circumstances surrounding me—my
background in the government and my relative ‘unknownness’—that were
fuelling these misperceptions. While I could live with the negative press, I could
not live with an institution that was suspicious of me. As I concluded, I
requested them to help transmit this message to the entire staff of the Reserve
requested them to help transmit this message to the entire staff of the Reserve
Bank, not all of whom were able to fully appreciate the unusual circumstances
brought on by the crisis.

The criticism on both strands—inadequate communication and not acting


independently—waned and eventually disappeared as the calendar turned to
2009. The broad thrust of the media evaluation of the first 100 days of my
governorship in December 2008 was that I had handled a very turbulent period
with intelligence, professional integrity and exemplary calm. Even more
gratifying was the one-year evaluation of my governorship in the media in
September 2009 where the broad consensus was that the Reserve Bank under my
‘mature and reassuring’ leadership was bold, swift and imaginative in its
response to the crisis and that, in an uncertain time, I brought clarity and candour
to the central bank.
What was most comforting to me was that some of the very same
commentators who had earlier criticized me for surrendering to Delhi’s
instructions had now written that I meant business, didn’t bend under pressure
and steered the Reserve Bank with calm determination and quiet confidence
during a time of great tumult. Writing in the Business Standard of 1 February
2010, Sanjaya Baru said: ‘[Subbarao’s] leadership at the central bank through
the difficult months of 2009 has, without doubt, been exemplary. As he led his
four deputy governors into the boardroom last Friday, he exuded the kind of
confidence that only being in charge and in control gives.’
Universal endorsement is perhaps too much to expect in a public policy job.
Even in the midst of this wide appreciation, some analysts were more grudging
and said that even if I may have passed the test as a crisis manager, that success
didn’t say anything about my competence in the bread-and-butter business of
central banking—fighting inflation—and that the real test for me was yet to
begin. As later developments would show, this summing-up was prophetic.

The Governor’s Bungalow

Even as I was completely preoccupied with the crisis, I also had to complete the
transition from Delhi to Mumbai.
transition from Delhi to Mumbai.
The Tilak Lane house that I was occupying as finance secretary had to be
vacated within three months of leaving the job or else the Central Public Works
Department (CPWD) would charge me a penal rent. That itself was no problem
as Urmila too had got a transfer to Mumbai as chief vigilance officer of Air
India. I could hardly devote any time to the winding up, packing and shipping,
but Urmila managed that with the ever-efficient logistic support from the Delhi
office of the Reserve Bank.
There are many perks attached to the governor’s job; among them, the
colonial-era governor’s bungalow on the posh Carmichael Road, since renamed
M.L. Dahanukar Marg, is possibly the most valued. The location of the
bungalow is itself symbolic of the sharp contrasts that are so characteristic of
Mumbai. Along the road are the homes of some of the richest corporate leaders
of the country with snazzy houses and flashy cars, and just down the cliff, a
slum, one of hundreds in Mumbai, sheltering migrants from villages across the
country who come in pursuit of a livelihood to this ‘maximum city’ of hope,
enterprise and opportunity.
Y.V. Reddy had vacated the bungalow within a couple of days of handing
over to me but I continued to stay in the Reserve Bank guest house on Nepean
Sea Road as the bank’s maintenance staff asked for a couple of weeks to
undertake some long-pending repairs and restoration. Even as the staff got to the
job with alacrity, the two weeks turned into two months as the governor’s
bungalow is a heritage building, and any alteration or replacement, from floor
tiles to woodwork to wall colour, requires the clearance of the Bombay Natural
History Society (BNHS). In the event, some chipped floor tiles remained, as our
engineers could not produce a replacement ‘colonial era tile’ which could pass
muster with the BNHS. I am not complaining though, as the BNHS surveillance
ensures that the bungalow maintains its period-piece decorum and gentle charm.
Living in the bungalow was a happy and comfortable experience. What I liked
most of all was its spaciousness and generous proportions. The irony of living in
such a large house when it was just the two of us, as we had lived in matchbox-
like government housing in Delhi when our two sons were of the running and
jumping age, was not lost on Urmila and me.
I must confess that we—Urmila and I—never really got around to doing full
justice to that magnificent habitation, caught up as we were in our respective
jobs which involved extensive travel too. But we did try to grab every
jobs which involved extensive travel too. But we did try to grab every
opportunity possible to invite family and friends over so that these ‘outsiders’
could enjoy to the full the short time they got to spend in these splendid, sylvan
surroundings.
We were conscious that the place was on loan to us for the period of our stay
and wanted to share it to the fullest. And so it was that, on more than one
occasion, we made it available for the celebration of Diwali by the Carmichael
Road Walkers’ Association—the lights, fireworks and delicious Diwali food
contributing to evenings filled with joy, cheer and bonhomie. On another
occasion, towards the end of my tenure, we hosted the Asia Society for an
evening of ‘exploring the heritage’ of the bungalow. An expert they brought
along conducted a tour of the bungalow for us, explaining the history of the
architectural design and the ancestry of every piece of furniture and furnishing. I
knew I was an ignoramus on heritage issues; even so, the realization that I was
so much of a boor that I had remained indifferent to the rich heritage of the
surroundings I had inhabited for nearly five years left me shamed.
In terms of actual time spent in and on the bungalow, I must confess to having
been an indifferent, if not a poor, householder. But when I open my ‘inward
eye’, I recall many a moment spent enjoying the ‘atmosphere’ of it, revelling in
the open spaces, the fresh air wafting in through the many large windows, the
cacophony of birds that converged on the lawn for a last diatribe before they
settled down to another night in the snug foliage. I close my eyes and see the
heavy bunches of jackfruit which every season bent the branches of the tree that
peeped in at our bedroom window.
In particular, I remember 2010, a year of battering rains in Mumbai when, on
occasional Sunday mornings, I would sneak downstairs and stretch out on the
leather couch tucked into the semicircular alcove opposite the main staircase,
ostensibly to do some serious reading. But the soothing strains of the
interminable rain, the luxury of having someone else attend to the opening and
closing of windows and doors as the deluge revived or abated, sent me into an
almost comatose state far removed from the ‘fever and fret’ of real life. I must,
however, confess that every such occasion was invariably vitiated by twinges of
guilt at the thought of millions of Mumbai slum dwellers under leaky roofs for
whom the rain meant the loss of daily earning, and hungry children.

On the Learning Curve


On the Learning Curve

Needless to say, the ‘Baptism by Fire’ was a crash course for me in central
banking, and a rewarding one too. What would have taken me months, if not
years, to learn in ‘peace time’, I got to learn in a few weeks. The brainstorming
sessions, extending over several hours and often stretching late into the evening,
were an opportunity to learn, cutting across the standard departmental silos and
vertical hierarchies. These sessions were also an opportunity to bond with my
senior staff and build personal and professional relationships that would prove
very valuable as I led the Reserve Bank in the months and years ahead.
I must add here that I was tremendously impressed by the agility, creativity
and intelligence demonstrated by the staff of the Reserve Bank in addressing the
surprises and uncertainties thrown up by these unusual circumstances. Every so
often I would pick up some stray bit of information from a casual conversation
with an outsider or from a newspaper I read or TV report I watched at home in
the night, on which Reserve Bank action might be warranted. I would worry the
whole night if our staff were aware of it and were preparing for it. In just a few
weeks, I realized that I need not have worried. The Reserve Bank staff were
almost always on top of most developments and quite clear about what
developments required response and what did not. Deputy governors Rakesh
Mohan, V. Leeladhar, Shyamala Gopinath and Usha Thorat, as well as their
teams, were a tremendous source of support and reassurance to me during this
critical period.
Sure, the crisis was a testing time for us in the Reserve Bank. There were
tensions and apprehensions. There was anxiety about the known unknowns and
fear of the unknown unknowns. But the crisis also brought out the best in the
Reserve Bank.

Across large sections of the public, including among educated and informed
people, there was dismay that the contagion of the global financial crisis had
spread to India. One of my big challenges in that first year was not only to
respond to the crisis at the policy level, but also to explain to the public why we
were, in fact, hit by the crisis.
In order to understand the public dismay, it is necessary to throw our mind
In order to understand the public dismay, it is necessary to throw our mind
back to the heady days of 2008 before the Lehman collapse. Recall that India
was on the verge of being christened the next miracle economy of the world.
Growth was surging at more than 9 per cent; the fiscal deficit was on the mend;
the rupee was appreciating and asset prices were rising. There were inflation
pressures but the general perception was that our inflation was a problem of
success, a sign of rising incomes and shared prosperity, rather than a symptom of
failure. Most importantly, we thought we had ‘decoupled’—that even if
advanced economies went into a downturn, emerging-market economies would
not be affected because of their improved macroeconomic management, robust
external reserves and sound banking sectors. But there was no decoupling, after
all.
So why did India get hit by the crisis? The reason we were hit was that, by
2008, India was more integrated into the global economy than we consciously
recognized. India’s two-way trade (merchandise exports plus imports), as a
proportion to the gross domestic product (GDP), more than doubled over the
past decade: from about 20 per cent in 1998–99, the year of the Asian crisis, to
over 40 per cent in 2008–09, the year of the global crisis.
If our trade integration was deep, our financial integration was even deeper. A
measure of financial integration is the ratio of external transactions (gross two-
way current account plus gross capital account flows) to the GDP. This ratio had
more than doubled, rising from 43 per cent in 1998–99 to 111 per cent in 2008–
09, evidencing the depth of India’s financial integration. What this integration
meant was that if global financial and economic conditions went into turmoil,
India could not expect to remain an oasis of calm.
I thought it was my responsibility to disseminate this message in the larger
public domain. I did so at every possible opportunity, especially while speaking
to students. But as I asserted this, I also had to be prepared for a logical follow-
up question. If India had to suffer global convulsions because of integrating into
the world economy, wouldn’t we be better off withdrawing from globalization?
The important point is that globalization is a double-edged sword; it offers
immense opportunities but also poses ruthless challenges. Nothing illustrated
this more strikingly than the global financial crisis.
Recall that in the years before the crisis—during the Great Moderation
spanning roughly twenty years till 2008—the world saw steady growth in
advanced economies and accelerating growth in emerging and developing
economies, and low and stable inflation all around. More than anything else, this
was a consequence of globalization—in particular, a dramatic expansion in
global trade coinciding with a period of tremendous boost to world production
and productivity as a result of India and China joining the world labour markets.
If the Great Moderation was the positive side of globalization, the financial
crisis of 2008–09 was its negative side. That a financial bubble in a
quintessentially non-tradable sector like housing snowballed into a global
financial crisis, taking a devastating toll on global growth and welfare, is a
demonstration of the ferociousness of the forces of globalization.
It would be tempting, based on the experience of the crisis, to believe that
India and also other emerging-market economies would be better off reverting to
insularity. That would be like throwing away the baby with the bathwater,
clearly a misguided response. Globalization comes with benefits and costs. Our
response should be not to withdraw from the global economy but to learn to
manage globalization in ways that will maximize its benefits and minimize its
costs.

Lessons from the Crisis

As someone said, this crisis was too valuable to waste. I, for one, learnt many
lessons on crisis management and leadership.
By far the most important lesson I learnt is that the primary focus of a central
bank during a crisis has to be on restoring confidence in the markets, and what
this requires is swift, bold and decisive action. This is not as obvious as it sounds
because central banks are typically given to agonizing over every move they
make out of anxiety that failure of their actions to deliver the intended impact
will hurt their creditability and their policy effectiveness down the line. There is
a lot to be said for such deliberative action in normal times. In crisis times
though, it is important for them to take more chances without being too mindful
of whether all of their actions are going to be fully effective or even mildly
successful. After all, crisis management is a percentage game and you do what
you think has the best chance of reversing the momentum. Oftentimes, it is the
fact of the action rather than the precise nature of the action that bolsters
confidence.
confidence.
Take the Reserve Bank’s measure I wrote about earlier of instituting exclusive
lines of credit for augmenting the liquidity of NBFCs and mutual funds (MFs)
which came under redemption pressure. It is simply unthinkable that the Reserve
Bank would have done anything like this in normal times. In the event of a
liquidity constraint in normal times, the standard response of the Reserve Bank
would be to ease liquidity in the overall system and leave it to the banks to
determine how to use that additional liquidity. But here, we were targeting
monetary policy at a particular class of financial institutions—the MFs and
NBFCs—a decidedly unconventional action.
This departure from standard protocol pushed some of our senior staff beyond
their comfort zones. Their reservations ranged from: ‘this is not how monetary
policy is done’ to ‘this will make the Reserve Bank vulnerable to pressures to
bail out other sectors’. After hearing them out, I made the call to go ahead.
Market participants applauded the new facility and saw it as the Reserve Bank’s
willingness to embrace unorthodox measures to address specific areas of
pressure in the system. In the event, these facilities were not significantly tapped.
In normal times, that would have been seen as a failure of policy. From the crisis
perspective though, it was a success inasmuch as the very existence of the
central bank backstop restored confidence in the NBFCs and MFs, and smoothed
pressures in the financial system.
Similarly, the cut in the repo rate of one full percentage point that I effected in
October 2008 was a non-standard action from the perspective of a central bank
used to cutting the interest rate by a maximum of half a percentage point (50
basis points in the jargon) when it wanted to signal strong action. Of course, we
deliberated the advisability of going into uncharted waters and how it might set
expectations for the future. For example, in the future, the market may discount a
50 basis-point cut as too tame. But considering the uncertain and unpredictable
global environment and the imperative to improve the flow of credit in a stressed
situation, I bit the bullet again and decided on a full percentage-point cut.
Managing the tension between short-term pay-offs and longer-term
consequences is a constant struggle in all central bank policy choices as indeed it
is in all public policy decisions. This balance between horizons shifts in crisis
times, as dousing the fires becomes an overriding priority even if some of the
actions taken to do that may have some longer-term costs. For example, in 2008,
we saw massive infusion of liquidity as the best bet for preserving the financial
we saw massive infusion of liquidity as the best bet for preserving the financial
stability of our markets. Indeed, in uncharted waters, erring on the side of
caution meant providing the system with more liquidity than considered
adequate. This strategy was effective in the short-term, but with hindsight, we
know that excess liquidity may have reinforced inflation pressures down the line.
But remember, we were making a judgement call in real time. Analysts who are
criticizing us are doing so with the benefit of hindsight.
The QE, launched by the US Federal Reserve, presents a more high-profile
example of the dilemma of balancing short-term compulsions against potential
longer-term threats. The Fed’s immediate concern was to repair broken financial
markets for which QE was seen as the best policy option. But there was always
the risk of the excess liquidity leading to the mispricing of risk and threatening
financial stability. And now that the fire is out, QE is also being criticized for
accentuating inequality and for taxing prudent savers in order to bail out reckless
borrowers. It is unlikely that these concerns would have escaped the Fed
policymakers as they embraced QE. By taking the plunge though, they
presumably calculated that the immediate concerns of stabilizing the markets
and stimulating demand outweighed the longer-term threats.
A second lesson to be drawn from the crisis pertains to communication. Mere
words can have a miraculous effect in a crisis. For example, it is now widely
held that the unconventional monetary policy of the Fed would not have been
effective if it were not accompanied by the repeated assurance that the ultra-easy
monetary stance would be maintained over an ‘extended period of time’.
At home too, I realized that once I gave up my early reticence and took to
active communication, it did a lot to restoring market confidence. I got feedback,
for example, that even as we took a host of measures all through October–
December 2008, there was always a lingering anxiety in the market that the
Reserve Bank had not come out of the inflation-control mindset, was clearly
uncomfortable with all the monetary easing under way and would clamp down at
the earliest. If those expectations got anchored, it would have undermined the
effectiveness of all the unconventional measures we were instituting. I took the
opportunity of the media conference on 6 December 2008 to emphasize that
inflation had fallen sharply owing to a crash in oil prices as well as demand
recession at home. My intent was to regain control of the narrative and credibly
convey to the markets that inflation had receded as an immediate concern and
that they were misguided in thinking that the rollback of the accommodative
that they were misguided in thinking that the rollback of the accommodative
stance was around the corner. The reassurance comforted investors enough for
them to make long-term plans.
Reassuring markets is half the battle but there is also a dilemma there for
central banks. How much do they reveal and what do they hold back? There is
typically an information asymmetry between central banks and the markets.
Central banks, by virtue of being financial sector regulators, have inside
information on evolving developments. If they level with the markets on all they
know, they risk triggering avoidable anxiety which could turn into panic. On the
other hand, if they hold back information, they risk denying the market
participants valuable time to make the necessary adjustment to the expected
market developments. This is a fine line that central banks have to tread
carefully.
Let me illustrate this with an example. The Reserve Bank had maintained all
through the crisis months that the Indian financial sector was safe and sound.
This was certainly true and the intent behind this assertion was to send a
message of reassurance. But there was a concern too about whether such an
unequivocal message was also spreading an unwarranted sense of complacency
in the market and leading financial sector institutions to relax their guard. Was it
not the responsibility of the Reserve Bank to keep the markets prepared for any
unexpected development by mixing reassurance with caution?
Similarly, in those early months of the crisis, as the rupee was falling
consequent on capital flight, a frequent question to me was whether we had
enough reserves to defend the exchange rate. Even as you reassure the market
that you do indeed have enough reserves to stem excess volatility, you do not
want your reassurance to be interpreted as a commitment to defend a specific
level of the exchange rate. That would be a moral hazard; assured of a stable
exchange rate, they would pile on too much risk. This was a fine line that I had
to tread carefully.
Another lesson we learnt is that even in a global crisis, central banks have to
adapt their responses to domestic conditions. I am saying this because all
through the crisis months, whenever another central bank, especially an
advanced economy central bank, announced any measure, there was immediate
pressure that the Reserve Bank too should institute a similar measure. Such
straightforward copying of measures of other central banks without first
straightforward copying of measures of other central banks without first
examining their appropriateness for the domestic situation can often do more
harm than good. Let me illustrate.
During the depth of the crisis, fearing a run on their banks, the UK authorities
had extended deposit insurance across board to all deposits in the UK banking
system. Immediately, there were commentators asking that the Reserve Bank too
must embrace such an all-out measure. If we had actually done that, the results
would have been counterproductive if not outright harmful. First, the available
premium would not have been able to support such a blanket insurance, and the
markets were aware of that. If we had glossed over that and announced a blanket
cover anyway, that action would have clearly lacked credibility. Besides, any
such move would be at odds with what we had been asserting—that our banks
and our financial systems were safe and sound. The inconsistency between our
walk and talk would have confused the markets; instead of reassuring them, any
blanket insurance of the UK type would have scared the public and sown seeds
of doubt about the safety of their bank deposits, potentially triggering a run on
some vulnerable banks.
Finally, an important lesson from the crisis relates to the imperative of the
government and the regulators speaking and acting in unison. It is possible to
argue that public disclosure of differences within closed doors of policymaking
could actually be helpful in enhancing public understanding on how policy
might evolve in the future. For example, a 6–6 vote conveys a different message
from a 12–0 vote. During crisis times, though, sending mixed signals to fragile
markets can do huge damage. On the other hand, the demonstration of unity of
purpose would reassure markets and yield great synergies.
I recall one occasion when the government, the Reserve Bank and SEBI timed
their policies to be released shortly before 11 a.m. when the prime minister was
scheduled to make a statement on the crisis in the Lok Sabha. That coordinated
move—which, for us, was a complicated piece of theatre—was criticized on two
counts: first, that the government was trampling on the autonomy of the
regulators, and second, on why the Reserve Bank had resorted to a market-
moving policy announcement during market hours. This criticism was clearly ill-
informed.
The experience of the crisis from around the world, and our own experience
too, showed that coordination could be managed without compromising
regulatory autonomy. Merely synchronizing policy announcements for
regulatory autonomy. Merely synchronizing policy announcements for
exploiting the synergistic impact need not necessarily imply that regulators were
being forced into actions that they did not own.
Regarding the criticism on the timing, the decision to release the statement
during market hours was deliberate. It is true that the standard practice of the
Reserve Bank is to release unscheduled policy announcements after market
hours to prevent any knee-jerk reactions. There have been exceptions to this
general rule but the effort generally is to minimize such exceptions. In this
instance, we decided to deviate from the standard practice to time the
announcement with the prime minister’s Lok Sabha statement. In the event, I
believe, the synchronization had a greater impact than if we had announced the
measures at the close of business the previous evening.

Spring Shoots

By the time of the London G20 meeting in April 2009, there was much talk of
spring shoots in the advanced world and credible recovery in emerging markets,
and a growing view that maybe, with concerted and coordinated action,
governments and central banks had managed to extinguish the embers sooner
than we had originally thought. Alas, that turned out to be a false hope as the
global financial crisis morphed into the eurozone sovereign debt crisis that
would continue to agitate the global economy and financial markets for several
years thereafter.
At home in India though, attention started turning to exit policies and
strategies. However, given that the eurozone crisis was in full bloom, we could
not take crisis management off our radar and out of our mind space.
At a personal level, the turning point in the crisis was also a turning point in
my motive force, as a fear of failure had given way to a desire for success.
3
Baby Step Subbarao
Combating Inflation

India recovered from the crisis by the middle of 2009, sooner than most other
emerging economies, but we barely had a chance to celebrate as inflation too
caught up with us. The beginning of this episode of inflation, which would
preoccupy my mind space for over two years, was actually quite dramatic
because inflation, as measured by the wholesale price index (WPI), actually
went negative for a few months in 2009. For us in India, conditioned to think of
high inflation as evil, it is disorienting to view deflation as evil too. The reality,
though, is that deflation can hurt growth and welfare as deeply as inflation,
indeed oftentimes even more so. It was not surprising, therefore, that some
analysts even started to talk about this deflation pushing India into a deeper
recession.
That anxiety was clearly misplaced. This was by no means a bad deflation
caused by falling output and jobs, but a good one caused by falling global input
prices. In the event, the deflation also turned out to be transient as prices started
rising rapidly thereafter and inflation remained in the 9–10 per cent range in
2009–11; it started declining only gradually in 2012.
To appreciate the severity of inflation during this period, you only need to
note that the average WPI inflation during the three-year period 2010–12 was
8.7 per cent, significantly higher than the average inflation of 5.4 per cent during
the entire previous decade (2001–10). Bringing inflation down by raising interest
rates understandably became my foremost priority and remained so for much of
my term. This anti-inflation policy stance, called ‘monetary tightening’ in
technical jargon, invariably attracts criticism, often ill-informed, that the high-
interest-rate policy of the Reserve Bank is choking growth by inhibiting
consumption and investment. My concurrent challenge therefore was to
evangelize that any growth obtained in an environment of high inflation would
evangelize that any growth obtained in an environment of high inflation would
be transient and that low and steady inflation is a prerequisite for sustained
growth.

Exit from Crisis-driven Easy Policy

Over much of the previous year, 2008–09, we had run an easy monetary policy
—low interest rates and ample liquidity—to mitigate the impact of the crisis on
the economy. Rolling back that accommodation was always on the cards but the
rapid pick-up in inflation meant that we had to do so sooner than we had
originally thought. We were also aware that in contrast to the policy path on our
way into the crisis, when being swift, even radical, was more important than the
precise contours of the measure, in reversing our way out of the crisis,
meticulous calibration had to be a critical part of the strategy.
Our dilemma was similar to the one that confronted the US Federal Reserve as
it agonized over reversing its ultra-easy monetary policy. To be sure, the Federal
Reserve had invested a lot of thought into embarking on the extraordinary
monetary accommodation needed to fight the collapse of confidence in the
financial markets in the wake of the Lehman meltdown. Given the ferocity of the
crisis and the urgency of dousing fires, the broader decision to bring the interest
rate down to the zero lower bound and undertake QE became much more critical
than the precise contours of the policy. Just contrast this with the feverish debate
and high drama that surrounded the taper and the eventual halt to the asset-
purchase programme in 2014 as well as the interest rate ‘lift off’ in 2015, when
so much seemed to hang on whether the markets were, in fact, prepared for these
most expected ‘surprises’.

In the Reserve Bank, we started preparing the market for the so-called exit from
the crisis-driven measures starting the second half of 2009. We had a rough road
map too: we would begin with unwinding the unconventional policies, then
move on to withdrawing the liquidity measures and finally, tighten the policy
interest rate consistent with the inflation trend. Even as our plans were driven
largely by our domestic developments, such as rising output and inflation, which
were quite contrarian to the global trends, I was conscious that we had to keep an
were quite contrarian to the global trends, I was conscious that we had to keep an
eye on external developments which continued to be uncertain and
unpredictable. It was also clear to me that we had to navigate the reverse path
very carefully; interest rates had gone to historically low levels during the crisis
and an abrupt reversal would disrupt the recovery.
There was active media speculation on our exit path, and quite unsurprisingly
it turned into an FAQ for me. The media would actively quiz me on the
considerations that will go into the glide path of the exit. It so happened that I
had just recently finished reading Gurcharan Das’s much-acclaimed book, The
Difficulty of Being Good, and the tales of Mahabharata were fresh in my mind.
So, in one media conference, without any prior contemplation, I found myself
likening the Reserve Bank’s situation with regard to ‘exit’ to that of Abhimanyu
who knew how to break into the Chakravyuh, the battle formation of the
Kauravas but, because of Krishna’s cosmic design, never got to learn how to
break out of it. This wasn’t the answer to the question but the media was
nevertheless happy writing stories about whether I would, like Abhimanyu, get
trapped in the Chakravyuh, or, like Arjuna, make a successful exit.
We stayed with our road map by withdrawing the unconventional measures in
October 2009, and while doing so, had explicitly signalled that this would
constitute the first phase of our ‘exit’. We followed up by raising the CRR in the
January 2010 policy meeting. Thereafter, we had to deviate from the road map,
not so much in sequencing but in timing, as inflation started rising rapidly
because of supply-side pressures. It became clear that interest rates had to be
raised soon and we thought it inadvisable to wait until the next policy meeting in
April 2010. We raised the repo rate through an ad hoc policy announcement in
mid-March 2010. Starting from that point up until October 2011, in a space of
just eighteen months, I took the effective policy rate up from 3.25 per cent to 8.5
per cent, raising it a total of thirteen times, a record by a long stretch.
How rapidly and by how much we raised rates were critical to reining in
inflation and inflation expectations. We raised rates by 50 basis points (0.5 per
cent) on occasion, but much of the time the increase was in steps of 25 basis
points, earning me the moniker of Baby Step Subbarao. Many analysts thought
this baby-step approach to be too timid and too inadequate in the face of such
stubborn inflation, and some of them started to ask whether the governor would
ever grow up and take an adult step. But I am getting ahead of myself in telling
that story.
that story.

Drivers of Inflation

The key to monetary policy calibration lies in understanding the drivers of


inflation. We would talk about this a lot within the Reserve Bank and it would
also be the focus of much of our dissemination effort during this admittedly
difficult period. In the internal brainstorming sessions, the discussion would be
more in-depth, analytical and multidimensional. My challenge was to absorb all
of that technical analysis and communicate our understanding of the problem
and our response to the public domain in simple language.
Several factors—some of them cyclical but many of them structural—stoked
inflation and kept it elevated during this period. Every time I met him, the prime
minister would ask me why inflation was so unrelenting. I would tell him that
our inflation was, of course, a problem, but it was a problem of success. The
government’s affirmative action programmes led by the employment guarantee
under the Mahatma Gandhi National Rural Employment Guarantee Act
(MGNREGA) pushed up wages without raising the underlying productivity
while the expanded subsidy schemes, combined with improved delivery systems,
had contributed to raising rural incomes at a record pace. A result of this rapid
growth in incomes was a spurt in demand for consumption goods which, in the
absence of commensurate increase in production, put upward pressure on prices.
But as they say, there are no free lunches. The government’s apparent success
on one side was also its failure on another front. It was spending way beyond its
means by borrowing in the market. Since the total pool of money available in the
market for borrowing is limited, the more the government borrows, the less there
is for the private sector. And if the private sector did not borrow and invest, we
would not be able to expand the productive capacity of the economy to meet the
growing demand for goods and services. It would have been some consolation if
the government, even if it borrowed way too much, spent the borrowed money
on building capital or infrastructure, which would then add to the productive
capacity of the economy; but they were spending it on consumption which was
only driving up inflation.
The reason for this rather long exposition is to say that in telling the inflation
story to the prime minister, I would give him both the positive and negative sides
of it. As an economist, he understood my arguments, but as a politician, he felt
of it. As an economist, he understood my arguments, but as a politician, he felt
helpless. Most of the time, all I would get by way of a reply would be a wry
smile.

Criticism of Baby Steps

There was criticism of my monetary policy stance, ironically from opposite


directions—by the hawks for being too dovish and by the doves for being too
hawkish. The hawks argued that we were too soft on inflation, that we were late
in recognizing the inflation pressures, and even after recognizing the problem,
we remained behind the curve. The baby-step tightening that defined my anti-
inflation strategy, according to them, was a timid and hesitant response. The
drip-drip effect of repeated baby steps, the argument went, did not give the sense
of overwhelming power being directed to fight inflation head-on.
From the other side of the spectrum, the doves’ charge was that raising
interest rates as I was doing was a futile exercise since our inflation was fuelled
largely by food and other supply shocks over which monetary policy has little
impact. Our actions, they contended, would not tame inflation; they would only
end up stifling growth. ‘Is this man killing India’s growth?’ was the dramatic
title of a feature in the Economic Times of 17 September 2011.
Let me respond to this criticism from both ends of the spectrum.
To those who say we were behind the curve and failed to close the monetary
spigots in good time, my simple response is to recall the context of the years
2010 and 2011. The world economy was still in recession and the much-heralded
spring shoots turned out to be a false dawn. The eurozone crisis was pounding
global markets; confidence all around was fragile, and markets remained testy.
And as we learnt from the experience of the post-Lehman developments, India
remained vulnerable to adverse external developments, especially as the
eurozone kept the global financial sector on tenterhooks by moving from one
‘five minutes to midnight solution’ to another. Our ‘baby steps’ were therefore a
delicate balancing act between preserving stability on the one hand and
restraining inflation on the other.
With the benefit of hindsight, of course, I must admit in all honesty that the
economy would have been better served if our monetary tightening had started
sooner and had been faster and stronger. Why do I say that? I say that because
we now know that we had a classic V-shaped recovery from the crisis, that
we now know that we had a classic V-shaped recovery from the crisis, that
growth had not dipped in the Lehman crisis year to as low as had been feared,
and that growth in the subsequent two years was stronger than earlier thought.
But remember, all this is hindsight, whereas we were making policy in real time,
operating within the universe of knowledge at that time.
Let me now respond to the doves—inclusive of senior officials and advisers in
the government—who argued that the Reserve Bank was too hawkish in its
inflation stance.
First, I do not agree with the argument that the Reserve Bank failed to control
inflation and only ended up stifling growth. WPI inflation had come down from
double digits to below 5 per cent (April–May 2013); core inflation had declined
to around 2 per cent (June–July 2013). Yes, growth had moderated, but to
attribute all of that moderation to tight monetary policy would be inaccurate,
unfair and, more importantly, misleading, as a policy lesson. India’s economic
activity slowed owing to a host of supply-side constraints and governance
failures which were clearly beyond the purview of the Reserve Bank. If the
Reserve Bank’s policy rate was the only factor inhibiting growth, growth should
have responded to our rate cuts of 125 basis points between April 2012 and May
2013, CRR cuts of 200 basis points and open market operations (OMOs) of ₹1.5
trillion in 2012–13.
Admittedly, monetary tightening did have some negative impact on growth.
But this was only to be expected. After all, the objective of monetary tightening
is to compress aggregate demand, and some sacrifice of growth is programmed
into it. But this sacrifice is only in the short-term; there need be no sacrifice in
the medium term. Indeed, low and steady inflation is a necessary precondition
for sustained growth. Any growth sacrifice in the short-term would be more than
offset by sustained medium-term growth.
What about the criticism that monetary policy is an ineffective tool against
supply shocks? This is an ageless and timeless issue. I was not the first governor
to have had to respond to this, and I know I won’t be the last. My response
should come as no surprise. In a $1500 per capita economy—where food is a
large fraction of the expenditure basket—food inflation quickly spills into wage
inflation, and therefore into core inflation. Indeed, this transmission was
institutionalized in the rural areas where MGNREGA wages were formally
indexed to inflation. Besides, when food has such a dominant share in the
indexed to inflation. Besides, when food has such a dominant share in the
expenditure basket, sustained food inflation is bound to ignite inflationary
expectations.
As it turned out, both these phenomena did play out—wages and inflation
expectations began to rise. More generally, this was all against a context of
consumption-led growth, large fiscal deficits, and increased implementation
bottlenecks. If ever there was a potent cocktail for core inflation to rise, this was
it. And it did—rising from under 3 per cent at the start of 2010 to almost 8 per
cent by the end of the next year. It is against this backdrop that our anti-
inflationary stance in 2010 and 2011 needs to be evaluated.

Data Deficiencies and Monetary Policy

This may be an appropriate point to comment on how the Reserve Bank’s


monetary policy calibration goes astray because of data deficiencies. As I said
before, the Reserve Bank operates within the universe of knowledge available in
real time, and that universe is largely shaped by data. If the data are reliable and
available in good time, policy response can be accurate and confident. But the
Reserve Bank is oftentimes wrong-footed because of the questionable quality of
data.
For example, our data on employment and wages, crucial to judging the health
and dynamism of the economy, do not inspire confidence. Data on the index of
industrial production (IIP), which gives an indication of the momentum of the
industrial sector, are so volatile that no meaningful or reliable inference can be
drawn. Data on the services sector activity, which has a share as high as 60 per
cent in the GDP, are scanty.
The poor quality of data is compounded by frequent and significant revisions,
especially in data relating to output and inflation which are at the heart of
monetary policy. As governor Y.V. Reddy put it with his characteristic wit,
everywhere around the world, the future is uncertain; in India, even the past is
uncertain. It is this data uncertainty under which the Reserve Bank has to make
policy; it does not have the luxury of waiting until the past becomes crystal
clear.
I have already written about how our baby-step approach to fighting inflation
was in part informed by data which were telling us that recovery was still fragile.
In the event, subsequent revisions to output data showed that growth in 2009–10
In the event, subsequent revisions to output data showed that growth in 2009–10
was, in fact, more than a full percentage point higher than the original number. It
is a fair conjecture that the tightening cycle to rein in inflation would have been
steeper had we known that output growth was significantly better than we knew
in real time. Another instance of data wrong-footing us was the indication of a
significant drop in inflation which prompted me to cut the repo rate by 50 basis
points in April 2012. But that inflation number was retrospectively revised
upwards; it turned out that inflation had not declined as sharply as we were given
to understand in real time.
Flawed data was also the culprit behind the ‘stagflation’ puzzle we had
encountered in 2012 when growth moderated steeply from 8.9 per cent in 2010–
11 to 6.9 per cent in 2011–12 even as inflation remained elevated. Many analysts
had put me in the dock to explain why inflation had not softened even in the face
of such a sharp decline in growth and whether the Reserve Bank’s tight
monetary policy was actually pushing India down the quagmire of stagflation—a
frightening combination of low growth and high inflation similar to the US
experience in the late 1970s.
The Reserve Bank denied suggestions of stagflation but that was more an
assertion than a persuasive reply. The only conjecture we could offer was that
potential growth, which is difficult to measure, had possibly declined more
steeply during the crisis years; as a consequence, even at a very moderate rate of
output expansion, we were experiencing fairly high inflation. And even as the
issue of stagflation was important and needed to be probed, the whole debate
remained ill-informed because of unreliable data.
It now turns out that there was no puzzle, after all. Subsequent data revisions
tell us that growth had not slowed as sharply as indicated by real-time data,
which explains both the presence of high inflation and absence of any
stagflation. If, in fact, the Reserve Bank had fallen victim to the groupthink,
acquiesced in the stagflation theory and responded accordingly, the
macroeconomic implications of the policy error would have been very costly.
The Reserve Bank, under my leadership, had come under frequent criticism
for consistently getting its forecasts of growth and inflation wrong. Could we
have done better? One straightforward option would have been not to make any
forecast at all. Someone, it was perhaps Groucho Marx, said, never make a
forecast, especially about the future! Alas, not putting out forecasts is not an
option available to the Reserve Bank.
option available to the Reserve Bank.
I wish there was a single or a simple explanation for getting forecasts wrong.
An important reason, of course, was data flaws that I have spoken about as also
the large and unanticipated spikes in global oil and other commodity prices.
These forecasts are based on time series models, and if the data in the series are
inaccurate, the forecast could go wrong. Arguably, flawed data were not unique
to my period. But what was unique to my period was the trend shifts in growth
and inflation. The structural models that we use lose their predictive capability
around these turning points. They tend to under-predict when the trend shifts
upwards, as happened in the case of inflation, and over-predict when the
opposite happens, as happened in the case of growth. It was these turning points
in the perverse direction that led our forecasts astray.
The Reserve Bank’s analysts and modellers are among the best in the business
and are impressively innovative in scenario-building to forecast the future path
of the economy. But there are some developments, global and domestic, that
escape all analysts, not just the Reserve Bank economists. Take the global oil
price scenario. Whoever could see the upward price spike in late 2010, and
equally, who could see the reverse shock in 2014? The only difference is that the
shock in 2010 was an ugly one that hurt our economy and the Reserve Bank got
the rap; the shock in 2014 was a happy one, at any rate for a massive oil importer
like India, and the forecast error went largely unnoticed!

Differences with the Government on Monetary Policy

There was constant and decidedly unhelpful friction between the ministry of
finance, under both Pranab Mukherjee and later Chidambaram, and the Reserve
Bank on what the government saw as the Reserve Bank’s unduly hawkish stance
on interest rates, totally unmindful of growth concerns. The distilled version of
their argument went as follows. All the government’s efforts to kick-start the
supply response in the economy were being stymied by the high-interest regime
of the Reserve Bank. If only the Reserve Bank relaxed on the interest rate,
investment would take off and launch the economy into a virtuous cycle of
increasing growth and declining inflation.
When Chidambaram was asked in a media interaction in July 2013 why he
was frustrated with the Reserve Bank when all it was doing was pursuing its
mandate of price stability, he admitted that the Reserve Bank’s mandate was
mandate of price stability, he admitted that the Reserve Bank’s mandate was
indeed price stability but that ‘mandate must be understood as part of a larger
mandate of promoting growth’. The clear implication was that the Reserve Bank
was mistaken in interpreting its mandate.
I believe both Pranab Mukherjee and Chidambaram had erred in seeing the
Reserve Bank as being fixated on inflation, unmindful of growth concerns. On
the contrary, the Reserve Bank interprets its mandate exactly as Chidambaram
had said, although not as he implied. The Reserve Bank was targeting price
stability precisely because it is a necessary condition for sustained growth.
The argument is slightly technical but I will try to communicate this as simply
as possible. Textbook economics tell us about the famous ‘Phillips curve’, put
forward by the New Zealand economist William Phillips in 1958, which shows a
historical inverse relationship between unemployment and inflation in every
economy. Stated simply, lower unemployment in an economy correlates with
higher inflation. Subsequent research led by Milton Friedman showed that the
inverse relationship is true only in the short run; in the long run, you cannot
reduce unemployment by simply tolerating higher inflation.
If we transpose the Phillips curve research to the Indian context, the inference
that follows is that there could possibly be a trade-off between growth and
inflation in the short-term. In other words, it might be possible to grease the
wheels of growth by acquiescing in higher inflation; but such growth is bound to
be fickle. In the long run though, higher inflation takes a heavy toll on growth. If
we want sustained growth, low and steady inflation is a necessary prerequisite. It
was this understanding based on historical evidence and empirical research that
underpinned the Reserve Bank’s interpretation of its mandate.
The burden of my argument both in the public domain as well as internally to
the government was that the Reserve Bank was running a tight monetary policy
not because it did not care for growth but because it did care for growth. But the
government remained unpersuaded or chose to be unpersuaded.
In order to defend his position vis-à-vis the Reserve Bank and possibly to
sound a conciliatory note, in a media conference in July 2013, Chidambaram had
generalized this divide between governments and central banks by saying that
‘governments are for growth and central banks are for price stability’. This
stereotyping was misinformed not only with reference to India but even from a
broader experience.
broader experience.
In fact, no central bank in the world, not even an inflation-targeting central
bank is, or indeed can afford to be, insensitive to growth concerns. Take the case
of the Bank of England which is statutorily mandated to target inflation. If the
BoE fails to deliver on the inflation target, it is required by law to write to the
chancellor of the exchequer explaining the reason for its failure. Given this strict
discipline, you’d think that the BoE would prioritize inflation management over
all else if only to avoid the stigma of having to explain its failure to the
government. Not so. Even the BoE takes cognizance of growth and employment
concerns in its policy calculus as evidenced by this excerpt from an explanatory
letter dated January 2008 from the governor of the BoE to the chancellor: ‘If the
Bank rate was set to bring inflation back to the [2 per cent] target, there would
be unnecessary volatility [that is fall] in output and employment.’
The issue is more straightforward in the case of the US Federal Reserve. It
cannot focus exclusively on inflation as it has, by law, a twin mandate, requiring
it to balance price stability with maximum employment. Take the case of Japan
which went through a high-decibel debate on the mandate of the Bank of Japan
in January 2013 shortly after Prime Minister Shinzo Abe had returned to office.
Given the quagmire of deflation that Japan had sunk into, we would have
thought that the government would mandate the BoJ to raise inflation to the
target level to the exclusion of all other concerns. But even in the midst of such
compelling circumstances, the BoJ was required, while pursuing its inflation
target ‘to ascertain risk to sustainable economic growth’. All these examples
clearly demonstrate that central banks everywhere interpret their price stability
objective in the context of growth, contrary to Chidambaram’s stereotyping.

Although the high-interest-rate regime would be the main area of difference


between the government and the Reserve Bank, there were other issues that
stoked the friction even deeper.
One such issue which was almost always a point of contention in my pre-
policy meeting with the finance minister was the estimate for growth that the
Reserve Bank would be putting out in its policy document. The government’s
pet peeve was that the Reserve Bank was being too cynical in its forecasts.
Either the secretary of economic affairs or the chief economic adviser (CEA)
Either the secretary of economic affairs or the chief economic adviser (CEA)
would contest our estimate with their assumptions and estimates which I thought
was par for the course. What used to irritate me, though, was that almost
seamlessly the discussion would move from objective arguments to subjective
considerations, with one of the senior officers suggesting that the Reserve Bank
must project a higher growth rate and a lower inflation rate in order to share
responsibility with the government for ‘shoring up sentiment’. Finance Secretary
Arvind Mayaram went to the extent of saying in one meeting that ‘whereas
everywhere else in the world, governments and central banks are cooperating,
here in India the Reserve Bank is being very recalcitrant’.
I was invariably discomfited and annoyed by these objections and
insinuations. I was also often dismayed that the ministry of finance would seek a
higher estimate for growth while simultaneously arguing for a softer stance on
interest rate without seeing the obvious inconsistency between these two
demands. I used to take a consistent and firm position that the Reserve Bank
cannot deviate from its best professional judgement just to doctor public
sentiment. Our projections have to be consistent with our policy stance, and
tinkering with estimates for growth and inflation would erode the credibility of
the Reserve Bank.
Another constant source of friction used to be the position taken by the
Reserve Bank on the government’s fiscal stance. The government’s large fiscal
deficit was one of the prime drivers of inflation, and its inability to roll back
expenditure undermined the Reserve Bank’s anti-inflation stance. There was no
way the Reserve Bank could tell a credible inflation story without pointing this
out. The finance ministry used to be irritated by the Reserve Bank making an
issue out of its fiscal stance, and Pranab Mukherjee was always miffed about it;
he clearly showed it even though he never said anything. But for me, skirting
around this issue was neither appropriate nor advisable.
It was my standard practice to apprise the prime minister too of our statement
on the government’s fiscal stance. He understood the economic logic but always
seemed uncomfortable with the Reserve Bank pointing it out. He never
intervened directly with me, but in early 2012, he told Rangarajan, the chairman
of his Economic Advisory Council and my former boss when I was secretary to
the council, to convey to me that he did not expect Subbarao, ‘who was finance
secretary in the government and understood its political compulsions’ to take
such a strident stand on the fiscal stance. I certainly had sympathy for this point
such a strident stand on the fiscal stance. I certainly had sympathy for this point
of view but was unwilling and unable to show any accommodation.

Curiously, the eurozone sovereign debt crisis and the debate it triggered on fiscal
austerity provided fresh ammunition to the government to contend that fiscal
deficits were not as bad as they were projected to be. Although this debate did
not play out much in the public space, it turned out to be a contentious issue
between the ministry of finance and the Reserve Bank, and warrants telling if
only to illustrate the pitfalls of transposing arguments from one context to
another without checking about applicability.
As the PIGS (Portugal, Ireland, Greece and Spain) in the eurozone were
struggling with sovereign debt sustainability issues in 2010 and 2011, a common
conditionality imposed on them by the IMF-led bailout programmes was fiscal
austerity—drastic reduction in public spending in order to bring government’s
books of account into balance. There was recognition that this might hurt growth
but the understanding was that the negative impact on growth would only be in
the short-term. In the medium term, the argument went, growth would pick up
since the austerity programme would enable more efficient private investment to
replace the less efficient government spending.
Then, in 2012, the IMF came out with an influential and somewhat
controversial study, showing that the fiscal multipliers in the eurozone countries
were indeed higher than originally projected, implying that the negative growth
impact of the fiscal austerity imposed on PIGS would be higher than the figures
built into the bailout programmes. In plain English, this was a plea for softening
the fiscal austerity conditionality so as to reduce the hardship on the public.
Some senior officials in the ministry of finance caught on to the new IMF
research and argued that like in the eurozone, in India too, the adverse
consequences of fiscal deficits were being exaggerated and that the Reserve
Bank was being misguided in taking a negative view on the government’s fiscal
adjustment path.
I was dismayed by this effort to extend the eurozone arguments to India
without reckoning with India’s altogether different macro parameters. Our fiscal
adjustment road map was by no means aggressive; besides, the IMF research
applied to countries with a demand recession and a negative output gap,
certainly not to a country like India where a cocktail of sizzling demand and
strained capacity was stoking inflation pressures. My standard response to the
ministry of finance was that whereas the debate in Europe could be fiscal
austerity versus growth, for us in India, it has been and will continue to be fiscal
austerity for growth.
My discussion of the differences with the government on fiscal issues will not
be complete without a reference to the fiscal dominance of monetary policy—a
situation in which a central bank’s monetary policy is forced to accommodate its
government’s fiscal stance. In some sense, this has always been the case in India
with the Reserve Bank’s degrees of freedom in monetary policy curtailed by the
government’s expansionary fiscal stance.
The Reserve Bank’s constant refrain was that it was left to do all the heavy
lifting to manage the tension between growth and inflation while the government
took the easy way out with its loose fiscal stance. Given this scenario, some
analysts would quiz me, in informal discussions, on why the Reserve Bank just
does not force the government into fiscal discipline by unilaterally easing on the
monetary side. The resultant inflation pressures, the argument went, would force
the government to restrain its ‘borrow and spend’ policy. That would make a
good coffee-house argument but is highly impractical and strictly inadvisable in
the real world. Public policy simply cannot be made through an adversarial
stance.
The only redeeming feature in all of this is that fiscal dominance of monetary
policy is neither new nor unique to India. It has a long history going back over
seventy years and manifests in many countries and many situations, including in
advanced economies. Let me cite some recent examples.
In the thick of the eurozone crisis, the European Central Bank had to stretch
its mandate in order to buy treasury bonds of stressed countries to soften their
debt pressures—a clear case of subordinating monetary policy to fiscal
compulsions. In the United States, the Fed became hostage to the fiscal stance of
the government when in the autumn of 2013, it was forced to defer the much-
publicized taper of quantitative easing in view of the political impasse over debt
sequestration. The tussle was even sharper and more public in Japan when Prime
Minister Abe tried to push the Bank of Japan into quantitative easing, overruling
Governor Masaaki Shirakawa’s argument that monetary easing without support
Governor Masaaki Shirakawa’s argument that monetary easing without support
from fiscal consolidation would be ineffective, if also risky.

Equity Considerations in Monetary Policy

The narrative of our growth–inflation debate is also shaped by what I call the
‘decibel capacity’. The trade and industry sector, typically a borrower of money,
prioritizes growth over inflation, and lobbies for a softer interest-rate regime. I
believe this is a legitimate lobby comprising constituencies which contribute to
growth, and its demand deserves every consideration by the Reserve Bank.
At the same time, the Reserve Bank cannot afford to forget that there is a
much larger group that prioritizes lower inflation over faster growth. This is the
large majority of the public comprising several millions of low-and middle-
income households who are hurt by rising prices and want the Reserve Bank to
maintain stable prices. Inflation, we must note, is a regressive tax; the poorer you
are, the more you are hurt by rising prices.
But here is the thing. The business sector is organized, has a platform for
voicing its demand and even has an opportunity to present its point of view to
the governor in the pre-policy consultation meeting. On the other hand, the large
majority of the public that is hurting under inflation is scattered and
unorganized, has no avenue to voice its concern and does not have the privilege
of a pre-policy meeting with the governor. I always believed that this asymmetry
placed an obligation on the Reserve Bank to bend over backwards to listen to the
voices of silence.
One comforting factor is that this tension of balancing the interests of a vocal
minority with those of a silent majority is not unique to the Reserve Bank—all
central banks face this dilemma. Alan Greenspan, the former chairman of the US
Federal Reserve, said in an interview following the publication of his latest
book, The Map and the Territory: ‘In the eighteen and a half years I was there, I
got a huge number of letters or notes or whatever, urging us to lower interest
rates. On the side of getting letters which say you’ve got to tighten [raise rates],
it was a zero. So it is a huge political, regulatory asymmetry.’ (‘What Alan
Greenspan Learned Till 2008’: interview to Justin Fox)
This concern for the less privileged raises a larger debate about whether
central banks should at all reckon with the distributional consequences of their
monetary policy. In other words, should central banks worry about how their
monetary policy. In other words, should central banks worry about how their
policy might affect the poor vis-à-vis the rich or remain strictly agnostic? I raise
this issue because some analysts said that I was distorting the debate by looking
at inflation from an equity perspective instead of treating it as any other macro
variable.
This is not just a poor-country issue. Even in rich countries, there is a
contentious debate under way, especially in the context of the heightened
concern about growing inequalities, on whether central banks should concern
themselves with how their policies affected the rich vis-à-vis how they affected
the poor. Take QE by the Federal Reserve. A principal objective of QE is to
raise the prices of assets so that the wealth effect would induce more spending,
and thereby stimulate the economy. Some left-leaning economists have criticized
the Fed for acting like a ‘reverse Robin Hood’ since it is the rich who hold a
disproportionate share of the assets whose prices are being primed by QE. Bob
Corker, a senator, accused Bernanke of ‘throwing senior citizens under the bus’
by keeping interest rates low.
This argument that QE has adverse distributional consequences has
expectedly been countered on several grounds. Most importantly, it has been
argued that the tools available to the Fed are best suited to raising the level of
national prosperity which is generally neutral in its distributional consequence as
much as a rising tide lifts all boats. If indeed there are any consequent equity
issues, it is for the government to take corrective action. It will be costly for the
central bank to deviate from an optimal policy course to accommodate equity
concerns. Also, it is risky for an independent central bank to wade into
politically sensitive issues like equity.
This is a debate that frowns on moderation; we are unlikely to see a
consensus. But for me, the issue has always been clear. In a poor country like
India, the Reserve Bank just cannot afford to be insensitive to the distributional
consequences of its policies.

Public Debates on Monetary Policy

News and commentary on monetary policy would normally remain confined to


the business pages of newspapers, and business TV channels. Occasionally,
however, some issues spill over into the larger public space.
One such instance I recall centred on the changing dietary habits of low-
One such instance I recall centred on the changing dietary habits of low-
income households. Reserve Bank research showed that one of the structural
drivers of inflation in India has been the persistent rise in the prices of protein
foods. This, in turn, was a consequence of rising rural incomes. We know from
development economics that when low-income households experience an
increase in their incomes, one of the first significant changes they effect is to
shift their diet from carbohydrates to protein food, pushing up the prices of the
latter. The Reserve Bank acknowledged this trend in its policy statements; and I
also recall having made this point in a couple of speeches.
A member of Parliament took umbrage at the Reserve Bank pointing this out
and charged me of looking upon the improvement in dietary habits of poor
households as an unwelcome development which needed to be reversed to help
contain inflation. It was a completely ill-informed and inappropriate value
judgement. If anything, in the Reserve Bank we welcomed this development.
Yes, it was a problem but, as I said before, a problem of success. What the
situation warranted was a supply response by way of increased production of
protein foods to meet the growing demand without stoking inflation. I refrained
from joining issue on this for fear of giving currency to a debate that had no
merit in the first instance.

Another debate that wrong-footed me centred around a new normal for inflation.
As part of the silver jubilee celebrations of the Indira Gandhi Institute for
Development Research (IGIDR) in December 2012, there was a panel discussion
on the outlook for growth and inflation. I moderated the discussion, which
comprised former governors: C. Rangarajan, Bimal Jalan and Y.V. Reddy. At
some point during the discussion, Y.V. Reddy made the point that as the crisis
abates, advanced economies would settle at a higher normal inflation as a
consequence of the excesses of QE. He argued that if India’s standard practice
was to peg our inflation target a few percentage points above that of advanced
economies, the Reserve Bank should consider raising its inflation target.
There was a brief discussion following this comment, with both Rangarajan
and Jalan contesting Reddy’s view. As I brought the discussion to a conclusion,
in my capacity as the moderator, I said something to the effect that the Reserve
Bank would certainly examine Reddy’s argument, but made no comment on
Bank would certainly examine Reddy’s argument, but made no comment on
revising our strategy.
I was aware of the pitfalls of acknowledging a new normal for inflation,
especially at a time when the Reserve Bank was involved in a two-year battle
with inflation. I was also fully sensitive to the need to remain committed to the
medium-term inflation goal of 4–5 per cent that the Reserve Bank had set for
itself. But I thought Reddy’s point deserved more than an outright dismissal. All
I wanted to convey was that we had an open mind and would examine this
argument with professional integrity.
I was dismayed by how my comment was completely misinterpreted by some
analysts who said that RBI was admitting defeat in its fight against inflation.
They said that by acknowledging a higher normal for inflation, the Reserve Bank
was preparing the ground for monetary easing under pressure from the
government for lower interest rates. I was amazed at how some analysts saw
deep conspiracy in what was, by all accounts, an unrehearsed, free-flowing
conversation at the panel discussion conducted in an academic setting.
Even though the debate was not picked up by the rest of the media and had
indeed died down, I thought it advisable to unequivocally put across the Reserve
Bank’s position. At a speech to the Bankers’ Club in Delhi shortly after this
episode, I asserted that there was, in fact, no new normal for inflation.

Reforms to Monetary Policy Formulation

Even in the midst of fighting such fierce inflation, we introduced several


innovations to the monetary policy framework
The system I inherited had two policy rates, the repo rate, the rate of interest
charged on commercial banks when they borrow overnight from the Reserve
Bank, and the reverse repo rate, the rate of interest paid to banks when they
deposit money overnight with the Reserve Bank. Both these rates used to be
varied independently to calibrate the monetary policy stance. This system of two
independently varying policy rates afforded more degrees of freedom to the
Reserve Bank, but at the cost of higher uncertainty in the money market about
the precise monetary policy stance of the central bank.
We reformed the framework in May 2011 by increasing the degree of
certainty to the market by voluntarily curtailing our own degrees of freedom.
First, we said that the repo rate would be the only independently varying policy
First, we said that the repo rate would be the only independently varying policy
rate. The reverse repo rate would be made a dependent variable by pegging it at
a fixed 100 basis points (1 per cent) below the repo rate. Banks borrow from the
Reserve Bank’s liquidity adjustment facility (LAF) window by giving
government securities as collateral. But what happens if they do not have
sufficient government securities to borrow? The second bit of reform was to
provide for such a contingency by instituting a marginal standing facility (MSF),
which is a window open to banks to borrow at a penal rate of interest.
Third, we indicated that the weighted average call money rate would be the
operating target for the Reserve Bank, which is to say that the Reserve Bank
would manage liquidity in such a way that the call money rate would remain
within the 100 basis points band defined by the repo rate and the reverse repo
rate. Finally, we indicated that we would manage liquidity in such a way that the
commercial banks’ access to the LAF window where they borrow overnight
would be restricted to 1 per cent of the bank’s total net demand and time
liabilities.
The introduction of the corridor system and the explicit identification of the
weighted average call rate as the operating target of monetary policy allowed
banks to manage their daily liquidity more efficiently and reduced volatility in
the money markets.
A related reform was my decision to replace the benchmark prime lending rate
(BPLR) of banks by a base rate which was to be a floor for the interest rate
charged to its borrowers. Again technicalities aside, the intention behind this
decision was to discipline the banks into making the interest charged on the
borrowers more transparent and contestable. We realized though that even as this
reformed the system significantly, there still remained some lacunae which the
Reserve Bank is fixing, and is a work in progress.
One reform that was widely understood even at a layman level and much
appreciated was my decision in October 2010 to deregulate the interest on
savings deposits. Not many may recall, but prior to 1991, the Reserve Bank
regimented the entire structure of interest rates in the economy, both on the
lending and the deposit sides. This elaborate and extensive regimen was
gradually dismantled as part of the reform process starting 1991, but one rate
that remained pegged at 4 per cent was the interest rate on savings deposits.
Many of my predecessor governors considered letting go of this as well but
stopped short of making the final call, mainly because of uncertainty about how
the interest rate structure might unfold consequent on deregulation. On the one
hand, there was the attractive possibility that deregulation would spur
competition among banks, leading to product innovation, improved customer
service and an increased interest rate benefitting millions of low-income
households in the country for whom a savings deposit account is the only saving
option. But there was also the apprehension that competition among banks to
capture this large segment of low-cost deposits would raise the overall costs for
banks and distort the entire interest structure with potential financial stability
concerns. The discussion paper that we put out elicited wide commentary but no
consensus. Eventually, after much deliberation, I decided to bite the bullet.
This decision was widely applauded, with some people going as far as to say
that this decision, more than anything else, would determine my legacy. In the
event, the feared destabilization in the banking system did not materialize; but
neither did fierce competition or innovation. My only reading is that the benefits
of this move will take longer to manifest. My legacy hangs in the balance!
Another reform implemented on my watch was the introduction in mid-2010 a
mid-quarter policy review essentially doubling the policy reviews from four to
eight per year. The reason for this was that we found the prevailing gap of a full
quarter between two policy meetings to be too long in what was turning out to be
an uncertain macroeconomic situation. On several occasions, the fast-paced
developments forced us into off-schedule policy actions which, although
necessary, created market uncertainty. Besides, every data release triggered
speculation about an off-schedule response from the Reserve Bank which
compounded the already prevailing uncertainty. The mid-quarter reviews
enabled the Reserve Bank to respond to the data flow in a more structured
manner and helped manage expectations.
The introduction of the mid-quarter review reduced, but did not eliminate, the
probability of an off-schedule policy adjustment. For example, in March 2012,
we realized that systemic liquidity, already quite tight, might be further
exacerbated because of advance tax payments due by the middle of the month.
This happens because advance tax payments have the effect of transferring
money from the open pool and locking it up in the government’s account with
the Reserve Bank. To ease the liquidity situation, we cut the CRR by 75 basis
points just six days before the scheduled policy date, based on the judgement
points just six days before the scheduled policy date, based on the judgement
that waiting till the policy date would be too late.

Setting a Record despite Baby Steps

The global and domestic circumstances during my five-year tenure as governor


were unique in many respects, and the Reserve Bank’s policy responses too were
unique. As a result, I acquired many distinctions, most notably in interest-rate
setting. By calibrating the interest rate a total of twenty-three times, raising it
thirteen times and cutting it ten times, I remain the most activist governor to
date, no matter that some of the credit was earned in baby steps! Also, whereas
previous governors moved interest rates only in one direction, either up or down,
the macroeconomic circumstances during my tenure were so turbulent that I had
to move the interest rate both up and down. During the crisis in 2008–09, I cut
the rate, raised it in the two years following that to fight inflation, started cutting
it as inflation had come below the target level in 2012, but raised it again to
defend the rupee in 2013.
Source: Data on the policy interest rate of RBI.

This is a record I would like to preserve not so much because it makes me


unique but because I hope no other governor has to face such a crisis all through
his or her tenure.
4
‘When the Facts Change, I Change My Mind’
Do You Endorse Inflation-targeting?

In 2015, the Reserve Bank, under Governor Raghuram Rajan, adopted 4 per cent
consumer price index (CPI) inflation as the anchor for its monetary policy. As
governor, I had expressed reservations on inflation targeting. Several people
have asked me if I endorse Rajan’s approach. I do, notwithstanding some
reservations I continue to have. In order to explain my position, it’s necessary to
first understand the issue of inflation-targeting in a broader global context.

Inflation-targeting around the World

The years before the global financial crisis in 2008 saw a powerful intellectual
consensus building around inflation-targeting. A growing number of central
banks, starting with New Zealand in the late 1990s and thereafter numbering
over thirty, embraced the principle of gearing monetary policy almost
exclusively towards stabilizing inflation. This involved the central bank openly
committing to a target for consumer price inflation and making the achievement
of that target the overriding priority of monetary policy. This approach seemed
successful, delivering as it did the Great Moderation—an extended period of
price stability accompanied by stable growth and low unemployment. In the
world that existed before the crisis, central bankers were a triumphant lot. They
believed they had discovered the Holy Grail!
That sense of triumph was short-lived. The global financial crisis dented, if
not dissolved, the consensus around the minimalist formula of inflation-
targeting. Inflation-targeting was premised on the view that if policymakers took
care of price stability, financial stability would be automatically assured. The
crisis proved that wrong by actually demonstrating the opposite—that an
exclusive focus on price stability can blindside central bankers to threats to
exclusive focus on price stability can blindside central bankers to threats to
financial instability. In light of this received wisdom, central bankers found
themselves charged with neglecting financial stability in their single-minded
pursuit of an inflation target, and thereby abetting, if not causing, the global
financial crisis.
One of the big lessons of the crisis is that financial stability is neither
automatic nor inevitable and that it has to be explicitly safeguarded. Central
banks, in particular, cannot afford to keep financial stability off their radars.
Does this mean the inflation-targeting approach has to be abandoned
altogether? Alternatively, can inflation-targeting be made more flexible to
accommodate concerns about financial stability? Quite predictably, these
questions were in constant play in international policy conferences as well as in
the global media in the post-crisis period. The ensuing debate also raised a host
of related questions on inflation-targeting, financial stability and the broader
issue of the mandates of central banks. What exactly is financial stability? Is
monetary policy an appropriate instrumentality for preserving financial stability?
Is it sufficient? If not, what other policies are required and how should monetary
policy dovetail with these other policies? Apart from financial stability, how
should the inflation-targeting approach reckon with the imperatives of real-
sector variables like growth and employment? Is inflation-targeting possible in a
globalized economy where the prices of goods and services are set by global
rather than domestic demand–supply balance? How effective is inflation-
targeting in economies where wages are determined more by the government’s
immigration policy rather than the central bank’s monetary policy? How should
the mandates of central banks be redefined to reflect these fresh concerns?
By their very nature, these were open-ended questions, and the only broad
consensus that emerged was that inflation-targeting was not the magic bullet it
was once thought to be and that strict inflation-targeting should yield to more
flexible inflation-targeting, meaning that monetary policy should shift from just
stabilizing inflation alone to stabilizing both inflation around the inflation target
and real activity in the economy at its potential level, while simultaneously
keeping an eye on financial stability.

Inflation-targeting in India

Coincidentally, in India too, a debate about inflation-targeting started picking up


Coincidentally, in India too, a debate about inflation-targeting started picking up
momentum at around the same time, triggered, in part, by two high-profile
committee reports, one by Percy Mistry, and the other by Raghuram Rajan.
While Mistry strongly urged that the gold standard for stabilizing monetary
policy is a transparent, independent inflation-targeting central bank, Rajan held
that reorienting the Reserve Bank towards inflation-targeting will have to
dovetail with the government’s commitment to maintaining fiscal discipline and
not hold the central bank accountable for either the level or the volatility of the
nominal exchange rate.
The Rajan committee formally presented its report to the prime minister in
September 2008, shortly after I assumed office as governor. I was invited to that
meeting as were some Cabinet ministers and advisers to the government. I recall
that although the committee recommendations straddled a wide range of issues
in the financial sector, almost the entire discussion at the meeting was on
inflation-targeting. Opinion was quite varied on whether it was advisable for the
Reserve Bank to shift to an inflation target given our macroeconomic
circumstances. In any case, reaching a firm decision on the issue was not on the
agenda of the meeting, and we dispersed with the issue of inflation-targeting
remaining open-ended.
In my first year as governor, even as we were fully preoccupied with the
crisis, I had frequently encountered questions on inflation-targeting. Would the
Reserve Bank adopt inflation-targeting as suggested by Percy Mistry? Have the
preconditions indicated by the Rajan report been met? Is it advisable for the
Reserve Bank to move to inflation-targeting at a time when, world over, there is
a rethink on its advisability? My response to inflation-targeting got shaped in
this context. I was, in particular, concerned that the Reserve Bank should not
move towards inflation-targeting when the theory and practice on the subject
were in such a flux. Instead, we should wait for the lessons of experience to
become clearer and then adapt them to the Indian situation.
My reservations on inflation-targeting extended beyond the lessons of the
crisis to India-specific circumstances and vulnerabilities. In an economy where
short-term inflation is driven more by supply shocks, be they of food or energy,
than by demand-side pressures, can the Reserve Bank deliver on an inflation
target? Will the government support the Reserve Bank by remaining committed
to fiscal responsibility or will inflation-targeting become hostage to fiscal
dominance? How effective would inflation-targeting be in a situation where
dominance? How effective would inflation-targeting be in a situation where
monetary policy transmission is impeded not just by large fiscal deficits but also
by administered interest rates on small savings and illiquid bond markets?
Wouldn’t the Reserve Bank’s policy of managing large and volatile capital flows
compromise inflation-targeting?
My main concern was that inflation-targeting in the face of these compulsions
might lock the Reserve Bank into a no-win situation. If it is fixated on fulfilling
its inflation target, there may be occasions when the Reserve Bank may have to
tighten the interest rate so much that growth and jobs will be hit. On the other
hand, if it fails repeatedly to meet the target, it will risk losing credibility. Once
people have lost confidence in an inflation target, it becomes very hard for the
central bank to persuade them to trust the target again.
Besides these policy considerations, there was also a very practical issue that
prevented a change in the policy regime. A necessary requirement for inflation-
targeting is a single inflation index that is representative of the entire economy
of 1.3 billion people, fragmented markets, diverse geography and heterogeneous
economic conditions. We did not have one.
Notwithstanding my reservations on inflation-targeting, it is not as if I was
fully satisfied with the ‘multiple-indicator, multiple-target approach’ that guided
monetary policy during my tenure. Under multiple indicators, the Reserve Bank
monitored a host of variables—reserve money, money supply, industrial output,
bond yields and equity prices—and juxtaposed that data against output and
prices. As for multiple targets, price stability, growth and financial stability were
the joint and simultaneous targets of monetary policy, with the inter se priority
among them shifting in accordance with the evolving macroeconomic situation.
In theory, this was unexceptionable as it allowed monetary policy to respond
flexibly to the changing macro situation. In practice though, the multiple-
indicator approach, which allowed the Reserve Bank to shift from one priority to
another virtually seamlessly, confused the markets and fumbled our
communication. It also diluted the Reserve Bank’s accountability since any
policy mix could be explained away as being consistent with the multiple-
objective approach. Internally, we were deeply conscious of the need for our
policy calibration to be logical and consistent, but communicating that remained
a challenge always, with the result that our policy actions were sometimes
criticized in the media and by some analysts as being inconsistent and,
criticized in the media and by some analysts as being inconsistent and,
occasionally, even arbitrary.
Given this mixed record of the multiple-indicator, multiple-target approach,
the shift to an inflation-targeting regime under Governor Rajan’s leadership was,
I believe, a well-advised move. In saying so, I am following the example of no
less a luminary than Keynes whose famous riposte to a critic when accused of
being a flip-flopper was: ‘When the facts change, I change my mind. What do
you do, sir?’
I believe that at least some of the facts underlying my reservations on
inflation-targeting have changed. At a very practical level, we have today a
composite all-India consumer price index with long enough historical data points
to provide a nominal anchor for the inflation target.1 Even though the
government deviated from the fiscal road map in 2015–16, it reaffirmed its
commitment to fiscal responsibility in its budget for the fiscal year 2016–17. The
administered interest rate regime is being dismantled, with the government
indexing the interest rates on small savings to the yield on government
securities. That should ease the impediments to monetary policy transmission
and support inflation-targeting. The food distribution network is improving,
thereby reducing the chance of food supply shocks undermining the achievement
of the inflation target. With the softening of oil prices, the probability of supply
shocks from oil has also become low.
Also, contrary to my initial apprehension, the Reserve Bank’s inflation-
targeting framework builds in significant flexibility. Importantly, the monetary
policy framework agreement between the government and the Reserve Bank
acknowledges that the objective of the monetary policy is to maintain price
stability ‘while keeping in mind the objectives of growth’, thus discouraging the
Reserve Bank from adopting a rigid approach to achieving the inflation target.
The statement on the Reserve Bank’s website ‘that the relative emphasis
assigned to price stability and growth objectives in the conduct of monetary
policy varies from time to time depending on the evolving macroeconomic
environment’ reiterates the flexible inflation-targeting approach. Moreover, the
wide tolerance band of ±2 per cent around the inflation target of 4 per cent
reinforces this flexibility.
In the event of failure to meet the inflation target, the framework agreement
enjoins the governor to report to the government the reasons for failure, as also
the remedial action being taken to return inflation to the target range. This
the remedial action being taken to return inflation to the target range. This
provision is comforting as it acknowledges the possibility that the target could be
missed under extenuating circumstances, thus minimizing the probability of the
Reserve Bank pursing the inflation target ‘at any cost’.
Going forward, the success of the Reserve Bank’s inflation-targeting approach
will depend on two factors: first, how intelligently the flexibility of the
framework will be used, and second, the autonomy the government will allow
the bank in pursuing the target. Let me comment on both of these.
Global experience shows that an inflation-targeting framework is neither
necessary nor sufficient to maintain price stability. Just to cite one example, the
US Federal Reserve had adopted, as recently as 2011, a numerical target for its
inflation objective but as stated on its website, the Federal Reserve ‘is firmly
committed to fulfilling its statutory mandate from the Congress of promoting
maximum employment, stable prices and moderate long-term interest rates’.
Even with this multiple mandate, the Federal Reserve has a better track record
on managing inflation expectations, and thus inflation, than economies with an
explicit inflation target.
For sure, openly committing to an inflation target helps a central bank guide
expectations, and thereby maintain stability in the economy. But that very
stability can be impaired by a single-minded pursuit of the inflation target to the
exclusion of other macroeconomic concerns. The challenge in inflation-targeting
is maintaining credibility even while flexibly deviating from the target when the
circumstances so warrant.
The second condition for the long-term success of inflation-targeting is that
the government will have to steadfastly respect the autonomy of the Reserve
Bank notwithstanding its compulsions to accelerate growth in the short-term.
Growth and inflation are not independent variables, which is to say that you
cannot simultaneously set targets for growth and inflation. If one is fixed, the
other is automatically determined. In practical terms, this means that if the
Reserve Bank is enjoined to deliver an inflation rate, the government will have
to acquiesce in the growth rate that results. If the government imposes a growth
target on top of the inflation target, inflation-targeting will lose credibility. The
resultant macroeconomic implications will be costly.
In this context, the following provision in the draft Indian Financial Code
(IFC) is perplexing: ‘The objective monetary policy is to achieve price stability
while striking a balance with the objective of the central government to
accelerate growth.’ Is the government implying that accelerating growth is its
exclusive objective and the Reserve Bank does not share that objective? Will the
government therefore set a growth target and require the Reserve Bank to
balance its inflation target with the government’s growth target? Perhaps I am
overreacting, but it is important that the wording in the IFC is unambiguous and
the intent behind that wording is honoured. The point to recognize is that
monetary policy can only provide a conducive environment for growth to reach
its potential; it cannot raise the potential. That remains the government’s
responsibility and the task of its supply-side responses.
Needless to say, the Reserve Bank’s inflation-targeting framework is yet to be
fully tested. The test will come in a macroeconomic situation when growth is
trending down and inflation is trending up, not an unlikely possibility. The test
will come if and when commodity prices move back up, pressuring both
inflation and fiscal rectitude. The test will also come when the new framework is
called upon to address threats to financial stability arising, in particular, from
surges and stops of capital. The Reserve Bank will have to tread the fine line of
being flexible on inflation-targeting without compromising its credibility. That
will be a difficult—but not an impossible—challenge.
5
Inside the Chakravyuh
The Process behind Monetary Policy Formulation

The Reserve Bank is a ‘full service’ central bank with a wide mandate; setting
monetary policy is only one of its many responsibilities. Nevertheless, it is
monetary policy that is the most glamorous—it gets the maximum public
attention and media coverage. With growth in numbers of people shifting from
the informal to the formal sector of the economy, has also come a growth in the
number of people interested in the Reserve Bank’s monetary policy. Millions of
households which have taken housing loans have a stake in how the Reserve
Bank sets interest rates. This interest is no longer restricted to the English-
language media; the vernacular media too has joined in, thus extending the
outreach to hundreds of millions.
This increasing awareness of the Reserve Bank’s monetary policy is certainly
a force for the good. But there is still quite some way to go. My experience from
speaking to ordinary people during my travels across the country was that while
most people were aware that the Reserve Bank’s setting of the interest rate made
a difference to their finances, they did not understand how exactly that
happened.
Quite early in my tenure, I realized that explaining to the larger public how
the Reserve Bank’s monetary policy influences their finances and, therefore,
their daily lives, has to be an important part of my job chart. It is only when
there is wider awareness of what the Reserve Bank does can the larger public
hold it accountable for its performance. In my efforts at outreach, I did not
confine myself to a uniform format or any specific forum. I spoke about the
impact of the Reserve Bank’s policies on people’s everyday lives whenever the
opportunity presented itself; I would, of course, tailor the messaging to suit the
type of audience.
On the Learning Curve

I was familiar with the theory of monetary policy before I entered the Reserve
Bank. I also learnt a bit of the practice from the sidelines during my tenure as
finance secretary. But doing monetary policy hands-on was an altogether
different proposition—a fascinating, if also a challenging, learning experience.
For example, the open market operations by the Reserve Bank—buying and
selling government securities in the open market so as to increase or reduce the
money supply in the system—is an easy enough concept to understand at a
theoretical level. But doing it in practice—determining the amount, the timing,
the tenor of bonds to trade and indeed a host of intangible variables—is a
complex decision that requires you to superimpose your judgement on the
numbers thrown up by the models.
Central banks, as we know, set the policy interest rate in the expectation that
this very short-term interest rate will influence the entire interest rate structure in
the economy, which, in turn, impacts output and prices, through a process,
technically termed ‘monetary policy transmission’. But monetary policy
transmission does not happen automatically; central banks have to work at it by
managing the amount of money in the system—what they refer to as liquidity
management. OMOs are an important instrumentality for this.
At the heart of a decision on OMOs is an estimate of the money supply for the
period ahead consistent with the Reserve Bank’s growth and inflation objectives,
and an assessment of the short-term liquidity position of banks. In making these
projections, the Reserve Bank has to contend with a host of variables, some
predictable and some not. For example, money supply abruptly expands when
the government pays out salaries and pensions at the end of each month because
this entails money in the government’s bank account maintained with the
Reserve Bank being released into circulation; in a reverse process, money supply
contracts and banks’ liquidity position tightens after the quarterly advance tax
payments. Currency in circulation also goes up during festival times and election
times, tightening in the process the banks’ liquidity position.
These jump shifts in money supply and liquidity position of banks are largely
predictable, and the Reserve Bank can build them into its models. But there are
one-off events that can affect money supply too. For example, recall the auction
of telecom licences by the government in 2010 which yielded bids much higher
of telecom licences by the government in 2010 which yielded bids much higher
than expected. When the winning bidders deposited the bid amounts, the
transactions involved shifting money from the commercial banking system into
the government’s account with the Reserve Bank, in the process sharply draining
liquidity in the system and pressuring money market rates.

Pre-policy Consultations

There is a well-set process leading to each monetary policy review which


works to clockwork precision. The drill for a mid-quarter review is slightly less
intensive as it is not accompanied by an extensive consultation and
dissemination exercise like in the case of a quarterly review. With eight policy
reviews coming roughly at six-week intervals and the end of one round marking
the countdown for the next, life felt like a relentless continuum of monetary
policy. There was never any respite.
Early on in the policy calendar, the governor and his top management team
hold a series of pre-policy consultation meetings with stakeholder groups,
typically with banks, non-banking financial companies, including microfinance
institutions, urban cooperative banks, and representatives of financial markets
and chambers of business. As finance secretary, I had participated in the finance
minister’s pre-budget meetings in Delhi. The Reserve Bank’s pre-policy
meetings are different from the government’s pre-budget meetings in the sense
that they are smaller, about twenty invitees on average, and are less formal and
more interactive. I found these meetings very useful not only to get stakeholder
views on the monetary policy stance, but also to give them an opportunity to
raise issues that they believe warrant the Reserve Bank’s attention. In fact, many
reforms initiated by the Reserve Bank beyond the monetary policy domain have
their origins in these consultations.
Of all the pre-policy meetings, the meeting with the chambers of commerce
would be the most predictable since the business and industry representatives
would invariably ‘talk their book’, pleading for a rate cut, no matter the
macroeconomic situation. This argument that a rate cut by the Reserve Bank
would improve the investment sentiment never cut much ice in the situation
prevailing during much of my tenure as governor. All through the policy-
tightening cycle, our staff appraisal was that there were many factors, most
importantly implementation bottlenecks and governance concerns, which were
importantly implementation bottlenecks and governance concerns, which were
holding back investment. Certainly, the interest rate was an important variable in
an investment decision, but at that juncture it was far from being a binding
constraint.
Just to check if our understanding of the ground situation was right, in one
such meeting, where some of India’s largest corporates were present, I asked
how many of them would make an investment commitment in the following
month if we did actually cut the rate. They all looked at each other sheepishly
but not one hand went up! There was some collective embarrassment on both
sides. I felt guilty too because they may have thought I was putting them on the
mat. That certainly was not my intention.
I added to the list of pre-policy consultation meetings by introducing a
meeting with economists drawn from the financial sector, the academia and the
media. These meetings were always very lively, invariably brought fresh
perspectives on familiar issues and certainly deepened my understanding of the
macroeconomic situation. In all the pre-policy meetings, and even more so in the
meeting with the economists, the effort from our side was to engage them in
active communication, but without betraying any bias towards any one point of
view. I went into these meetings with an open mind although I was aware that at
least some participants felt that we suffered from what psychologists call
‘confirmation bias’—filtering out all ideas and views that did not accord with
ours.
I can’t recall any meeting with economists where there was a consensus or
even a near-consensus on the policy advice to the RBI. This may be no surprise
given the cliché of two economists and three opinions, but for me it was also
comforting since no matter how I decided, there would be someone agreeing
with me!
Needless to say, we were spoilt for choice by way of the large talent pool of
economists we could draw from. But that very luxury of choice posed a problem
for drawing up the list of invitees for the meeting. Our experience told us that the
optimal size for meaningful and effective consultation was fifteen which meant
we had to make ruthless choices. The grapevine had it that being invited to these
meetings was seen as a badge of honour in professional and media circles, which
only increased our obligation to ensure that the process of selecting invitees for
each round of meetings was objective and also was seen to be objective. We
developed a roster but there would inevitably be complaints and grievances after
developed a roster but there would inevitably be complaints and grievances after
each meeting from some of those left out.

Internal Strategy Meetings

There are two reports accompanying each policy review. The report on
macroeconomic and monetary developments, abbreviated for convenience as the
money macro report, containing an analysis by the Reserve Bank staff of the
macroeconomic situation, financial conditions and market developments, is
released a day prior to the policy review, while the governor’s monetary policy
statement is released on the day of the policy.1 These two reports would be
works in progress, constantly being updated and edited, till they went to print a
day before their scheduled release. The two reports are prepared by two different
departments of the Reserve Bank on the logic that the money macro report
should be a stand-alone, objective document uninfluenced by the proposed
policy action which will be contained in the governor’s statement.
One of the critical inputs into the monetary policy is the internal monetary
policy strategic group which meets at least twice before every quarterly policy
review—the first meeting about three weeks before the policy review and the
second just a week before. This group brings together economists and analysts
from three different departments of the Reserve Bank—the monetary policy
department, the department of economic policy and research, and the department
of statistics and information management. From the management side, the
governor, all the deputy governors, executive directors and several heads of
departments, altogether about fifty staff members, assemble to think through the
strategy for the forthcoming policy.
At the heart of these meetings are presentations by each of the departments of
its outlook on the macroeconomic situation and estimates for growth and
inflation. These, in turn, would be based on all available data as well as on
several surveys conducted by the Reserve Bank covering household inflation
expectations, consumer confidence, industrial outlook, corporate performance,
order book, inventory position and capacity utilization in the industry, and credit
conditions. The three departments are enjoined to work independently. This has
been a long established and deliberate arrangement instituted to mitigate the
hazard of groupthink at the institutional level. In practice, the dividends this
process yielded have been much richer; it gives the top management the benefit
of a diversity of analytical insights and viewpoints. I also used to notice an
undercurrent of competition between the teams to be more incisive in their
analysis and more accurate in their projections which I found very charming.
The list of issues we would discuss at these meetings would actually make for
a rich and interesting collection of box items in a standard economics textbook.
At one meeting, the discussion veered to the impact, if any, of the government’s
decision to terminate minting of the 25 paise coin. The issue really was whether
all prices would be rounded up to the next 25 paise limit or some might be
rounded down too, and how consumers might respond. Our staff ran some
statistical models and concluded that the net impact on inflation might be
neutral.
There would be a lively debate following the presentations that was invariably
very rewarding. I used to make an active effort to engage everyone in a free-
flowing conversation around the analytical issues and found it very endearing
that some of the younger staff would challenge my views. In fact, this culture of
speaking freely without any fear of consequences, rare in India’s hierarchical
traditions and even rarer in its bureaucracy, is one of the institutional strengths of
the Reserve Bank, a legacy from which I benefitted immensely.
At the end of each strategy meeting, I used to take a poll of all the staff
present, mostly mid-level professionals, on three options—cut the rate, pause or
raise the rate. Although this was an oversimplification of the policy matrix, it
used to give me a sense of ‘the wisdom of crowds’ within the Reserve Bank—a
crowd that I deeply valued.

Technical Advisory Committee

Under the RBI Act, it is the governor who decides on monetary policy. As I
write this, there is an initiative under way to introduce the system of a Monetary
Policy Committee so as to make monetary policy-setting the collective decision
of a committee rather than that of an individual. Even though there was no MPC
during my time, the Reserve Bank has had, since 2005, a Technical Advisory
Committee (TAC) to advise the governor on the policy stance. The committee is
chaired by the governor and comprises all the four deputy governors and seven
external members, all nominated by the governor. Two of the external members
external members, all nominated by the governor. Two of the external members
are drawn from the board of the Reserve Bank while the other five are chosen
from a wider pool of economists from the academia and think tanks.
The meeting of the TAC is convened typically a week before the policy date.
The TAC members receive, in confidence, a draft of the money macro
document, which forms the basis for the discussion.
Chairing a meeting, big or small, formal or informal, is always a challenge.
Through my long civil service career, I learnt that there is no one-size-fits-all
strategy for an effective meeting. It depends on the subject matter, the format,
nature of participants and the expected outcomes of the meeting. In some
meetings, you have to loosen hold so as to allow a free flow of ideas; in others,
you have to hold a tight leash to prevent the discussion going off track. But one
norm that almost always helped was to maintain discipline about the start and
end times of a meeting. Rakesh Mohan, who evidently was aware of this time-
discipline syndrome of mine, advised me before my first TAC meeting that I
relax my tight leash and allow these meetings to be open-ended and free-
flowing. I followed Rakesh’s advice and benefitted immensely from doing so.
The TAC meetings would typically run for four to five hours, and on occasion
even longer. There is an extensive presentation by the Reserve Bank staff of
their analysis which is freely interspersed by several interventions, clarifications
and comments by the members. After the presentation and discussion, and
several rounds of samosas, pastries and tea giving ample food for thought, each
external member would be invited to give his or her perspective on the
macroeconomic situation, estimates for growth and inflation, and specific advice
on the policy parameters.
The evolved best practice in central banks has been to release the minutes of
their monetary policy committee meetings after a gap of three to four weeks.
This transparency is aimed at guiding market participants on the different points
of view and nuances that informed the final decision of the committee. Although
the TAC is strictly not a monetary policy committee, we decided, in consultation
with the external members, to adopt the global best practice, and in 2011, began
the practice of putting out the minutes of the TAC meeting in the public domain
four weeks after the meeting date. The recommendations of the members would
be recorded in the minutes without attribution so that the market could get a
sense of the TAC advice that informed the governor’s decision.
More often than not, I differed with the advice of the TAC, especially during
More often than not, I differed with the advice of the TAC, especially during
the tightening cycle when the TAC typically advised a softer approach relative to
my final decision. Quite unsurprisingly, the media would play this up with
catchy headlines like ‘Subbarao differs again with his advisers’, or ‘Governor
overrules his committee’. Even if there was a bit of sensationalism in the
headlines, I welcomed this publicity since generating a discussion, hopefully an
informed one, on the deliberations of the TAC was indeed the intent behind the
release of the minutes.
Given how often I differed with the majority view of the committee, I began
to get uncomfortable about whether the members of the TAC would
misunderstand the committee process. What if they thought that the whole TAC
process was a charade, that the Reserve Bank had no respect for the views of the
members but was simply going through the motions just so as to earn brownie
points for its consultative approach?
But then this begs the question why I differed so often with the majority view
of the TAC. It was clear was that this divergence arose from differences in the
way we saw the growth–inflation balance. When the external members advised a
softer approach, their motivation was the slowing growth and the recognition
that the government was not doing anything about it, leaving an interest-rate cut
as the only possible stimulus. On the other hand, from within the Reserve Bank,
we saw inflation control as a prerequisite for sustainable growth and believed
that interest rate was not a binding constraint for investment in the prevailing
situation.
I was conscious that this differing judgement of the growth–inflation balance
was not a sufficient explanation for the internal–external divide within the TAC
since it would raise the logical follow-up question of why indeed did the two
sides see the balance differently. Both sides draw their analytical foundations
from the draft money macro report and the presentations at the meeting. It is in
interpreting that analysis based on their experience and expertise that differences
arise. I believe on both sides there was realization that inflation was being driven
by demand-side pressures as well as supply shocks. Perhaps the external
members assigned a higher weight to supply shocks and thought that monetary
policy was an inappropriate instrument for tackling such an inflation, whereas
we, from within the Reserve Bank, thought that no matter what the driver of
inflation, monetary policy has to be the first line of defence as persistent high
inflation can harden inflation expectations and accentuate the pressure. All this,
inflation can harden inflation expectations and accentuate the pressure. All this,
of course, is in the realm of conjecture.
Even as a clear explanation remained elusive, I levelled with the members of
the TAC in one of the meetings to tell them that we respected their advice and
that the TAC discussion added enormous value to our final judgement. I pointed
out that during the entire tightening cycle, the TAC advice was never
unanimous, suggesting that my decision was always finely poised. If I agreed
with the minority view, it was just incidental.
The external members of the TAC are typically big names with impressive
track records in the academia and economic policy. Some of them are respected
columnists; and even others used to write or comment in the media sporadically.
Unsurprisingly, their views would often address monetary policy issues. Both
their pre-and post-policy commentary had potential market ramifications. The
pre-policy view would be seen, quite logically, as the advice the member would
give in the TAC, thereby setting off speculation on how it might influence the
governor’s decision. Similarly, any criticism by them of the policy after the
release risked being misinterpreted as a note of dissent. On occasion, this
became quite contentious. But we also believed that forcing an obligation of
total silence on the TAC members would be unfair and unwarranted since their
expression of views decidedly added value to the public discourse. To resolve
this, in consultation with the TAC, we imposed a code of conduct for the
external members—a voluntary ‘shut period’, beginning two weeks before the
policy and ending a day after the policy, during which time they would not
express any opinion in the media on monetary policy issues.
I made it a standard practice to follow up the full TAC meeting with a meeting
with all the deputy governors. They too were members of the TAC and I
believed it was only fair that I sought their views as explicitly as I did with the
external members. There was seldom consensus even within this smaller,
internal group; in fact, I can’t recall even a single occasion when we were all
agreed on a single policy mix.
You should have got the big picture by now. Opinion and advice from the
wider world of analysts is all over the map, and neither the TAC nor even the
core insider group of the TAC, produces a consensus. It is in this complex
situation that the governor has to make a judgment call. More than ever before, I
could relate to the phrase, ‘the buck stops here’.
could relate to the phrase, ‘the buck stops here’.

Pre-policy Interaction with the Government

There is a standard practice of the governor meeting the finance minister a few
days before the scheduled policy review to apprise him of the Reserve Bank’s
assessment of the macroeconomic situation and the policy stance.
In the aftermath of the terrorist attacks in Mumbai, Chidambaram moved from
the finance ministry to the home ministry in November 2008, two months after I
took over as governor, and returned to the finance ministry in August 2012 after
Pranab Mukherjee became the President of India, roughly a year before I stepped
down. So, during much of my tenure as governor, Pranab Mukherjee was the
finance minister, with Chidambaram returning for the last thirteen months. The
prime minister held the finance portfolio for brief periods during the transitions.
The meetings with Chidambaram and Pranab Mukherjee were different in
their setting. Chidambaram would always meet me alone, although occasionally
he would invite the finance secretary and the chief economic adviser to join for
the last ten minutes or so. He would typically hear me out and give his point of
view, or ‘advice’ as he called it, unequivocally and firmly.
The meetings with Pranab Mukherjee, on the other hand, were more formal
and larger in setting with all the secretaries of the finance ministry and all his
advisers being present and actively participating.2 All the talking at these pre-
policy meetings would be done by his team while he himself mostly stayed
quiet. I could never figure out if they had a strategy session in preparation for
this meeting or if all of the presentations of the ‘finance minister’s view’ by his
staff were spontaneous.
There was also a difference, at a substantive level, in the meetings with
Pranab Mukherjee and Chidambaram. Mukherjee’s stance was straightforward—
that the Reserve Bank should ease on the interest rate to support growth.
Chidambaram, on the other hand, was more nuanced; he believed that I should
cut rates in acknowledgement of his efforts at fiscal consolidation, and would
assert his arguments more firmly and forcefully.
I have been asked both while in office, and even more so after I stepped down,
if there was pressure from the government to not tighten interest rates. I will
write about this in a little more detail in a later chapter devoted to the autonomy
and accountability of the Reserve Bank but the short answer is that there indeed
and accountability of the Reserve Bank but the short answer is that there indeed
was pressure.
Despite these pressures and disagreements, the meetings were always cordial;
both Chidambaram and Pranab Mukherjee were invariably courteous. I know
many people think that Chidambaram has an abrasive streak but I never
experienced it. Even when I was his direct subordinate as finance secretary, he
always treated me with courtesy and respect. Sure, he would, on occasion, show
some irritation, but certainly no more irritation than I did with my own
colleagues in the office. Chidambaram’s behaviour towards me after I became
governor was even more meticulous. For example, if there was going to be any
delay in making it at the appointed time, his office would invariably call my
office to let us know of that so as ‘not to keep the governor waiting’.
There was some old-world charm to the way Pranab Mukherjee held both the
institution of the Reserve Bank and the office of the governor in high esteem. As
finance minister, he was criticized for being locked into the ’70s mindset, not
realizing that the world of finance had undergone a sea change in the three
decades since. There were some positive dimensions to this so-called ‘lock-in’
though; one of them was that he looked upon the Reserve Bank with the respect
that he developed for the institution in the ’70s when as a younger and
aspirational politician, he looked up to the stalwart governors of the Reserve
Bank.

I have already written about how, when I went to call on him after my
appointment as governor, the prime minister encouraged me to see him
whenever I felt the need to. In deference to this suggestion, I made a meeting
with the prime minister a standard task in the pre-policy drill. These meetings
were always one-on-one. One of Dr Manmohan Singh’s strong qualities is that
he is a good listener and I always found him eager to get the Reserve Bank’s
perspective on every macroeconomic issue. The fiscal situation would, of
course, figure in our conversation and my tale of woe about how the fiscal stance
of the government was undermining the Reserve Bank’s anti-inflation position
was standard fare. To his enormous credit, he never interfered in the policy
action. ‘I hope you’ve settled this with the finance minister’ was all he’d say. I
never felt comfortable about this bit of the conversation but I would nevertheless
never felt comfortable about this bit of the conversation but I would nevertheless
tell him of the finance minister’s reservations, and the matter would rest there.
This quarterly conversation with the prime minister typically extended beyond
macroeconomic issues. He once asked me, from out of the blue, if banks were
functioning normally in extremist-affected areas. I was deeply embarrassed
because it never occurred to me to probe this question. He was also given to
seeking my views on political economy issues weighing on his mind such as, for
example, allowing foreign direct investment in multi-brand retail, the land
acquisition bill or expanding the employment guarantee scheme and even on
issues that do not directly fall within the domain of the Reserve Bank such as the
goods and services tax. My expertise on these issues was modest; but that did
not stop me from masquerading as an expert and pontificating! He also looked
upon me as an Andhra expert and would inquire about issues like agricultural
distress, farmer suicides and the agitation for a separate Telangana. I had left
Andhra Pradesh over fifteen years ago and could not keep abreast of all the
developments there because of job pressures. Almost always, I felt inadequate in
giving him any fresh insights.
On one occasion, sometime in mid-2010, the prime minister surprised me by
asking why so many people in the government were airing views in the public on
the Reserve Bank’s monetary policy. This was at a time when virtually every
Delhi policy mandarin, major or minor, was commenting on what the Reserve
Bank ought to be doing. I had no answer for his question but I told him that this
was certainly vitiating the already fraught relationship between the government
and the Reserve Bank. The Reserve Bank is a respected institution and people
should not play with it, was all he said. He surprised me again by calling me a
few days later to tell me that he had issued instructions that government
functionaries should refrain from commenting on the Reserve Bank’s policy.
The Delhi decibels remained subdued after that, at any rate in the public domain.

The importance of keeping the policy decision strictly confidential is quite


obvious. Any leakage would cause market turmoil, potentially embroil the
Reserve Bank in legal action for unduly benefitting some individual or group
and inflict serious damage to the bank’s credibility. Within the Reserve Bank,
there is a firm protocol on confidentiality, and disclosure is entirely on a need-to-
there is a firm protocol on confidentiality, and disclosure is entirely on a need-to-
know basis. Outside of it, only the prime minister and the finance minister, and
on occasion a few top ministry officials, are in the loop. That there never has
been a policy leak is a tribute to the diligence and professional integrity of the
Reserve Bank staff.
I had one unpleasant surprise though—on the day of the policy review in
April 2012, when, after thirteen rate hikes, I cut the rate by 50 basis points.
Finance Minister Mukherjee was scheduled to address a business chamber in
Delhi an hour before the policy release time. As he was entering the meeting
hall, he commented informally to the corporates and the media that surrounded
and greeted him—a doorstop interview as it were—that ‘the governor will
shortly give you good news’. This was most inappropriate and indiscreet. I am
positive the finance minister did not intend any mischief; nor did he want to
undermine the Reserve Bank. I think he was just being naive, overanxious to be
the bearer of good news to the corporates in the midst of widespread criticism of
policy paralysis in the government, hoping that some of the credit for this would
rub off on him.

Agonizing over Language

The policy documents, as I said before, remain work in progress for a couple of
weeks up until the final print order. Typically, on the weekend before the policy
review, a small group of us—the deputy governor and the executive director in
charge of monetary policy, the head of the monetary policy department and I—
would sit over an extended session, going through the policy statement in great
detail, discussing every turn of phrase and nuance. Let me give an illustration of
how we used to agonize over how every adjective and adverb might be
interpreted.
In the mid-quarter review of September 2010, as part of the forward guidance,
we had said: ‘The Reserve Bank believes that the tightening that has been
carried out over this period has taken the monetary situation close [emphasis
mine] to normal.’
There were two communication dilemmas here. The first was whether we
should say ‘close to’ or ‘closer to’. After much deliberation, we determined that
saying closer to had no additional information content; it would be restating the
obvious. On the other hand, saying ‘close to’ would convey that there was some,
albeit a small, room for further rate action.
The second dilemma was about whether ‘normal’ would be interpreted as
‘neutral’. This dilemma arose in the context of the question frequently asked of
us as to ‘whether the policy rate had become neutral’. As per textbook
economics, the neutral policy rate is the policy rate consistent with potential
growth and low and stable inflation. But we also know from textbook economics
that it is not possible to precisely determine the neutral rate, especially for a
rapidly growing and structurally transforming economy like that of India. On the
other hand, the ‘normal’ rate is the sweet spot which balances demand and
supply, and can be broadly inferred from the crest and trough of the policy rate
over the growth-inflation cycle. Obviously, such an elaborate explanation in the
statement would be out of place. Realizing though the importance of this
message, I made an extra effort to communicate our intent in the post-policy
dissemination exercise.
Agonizing over language, I realize, is a standard item on the job chart of a
central bank governor. In his memoirs, The Courage to Act, Bernanke writes:
‘We sweated every word. Should I say that additional rate cuts “may be
necessary” or “may well be necessary”? Should I say that we stood ready to take
“substantive additional action” or “meaningful additional action”? The absurdity
of our discussion did not escape us, but we had learned through bitter experience
that a single word often mattered.’

Policy Dissemination

The pre-policy drill also includes a briefing session for the governor by the
senior management on probable questions in the media conference following the
policy. Even though the media conference is scheduled in the context of the
policy, the engagement is not restricted to monetary policy. There has for long
been a tacit agreement between the Reserve Bank and its media interlocutors that
the entire domain of the central bank’s functions would be par for the course.
Our preparation too would accordingly cover a wide canvas, with senior staff
stretching their imagination to think of possible questions and tips on how
responses might be nuanced. These prep meetings would be conversational and
free-flowing, far from the ‘murder boards’ of the American political and
free-flowing, far from the ‘murder boards’ of the American political and
corporate scene where the staff pose as the media and the CEO practises his
answers.
The media build-up on the policy starts a week before and reaches fever pitch
by the announcement date. What with proliferation of business channels, there
would be dozens of commentators on air talking about what the Reserve Bank
should do and what it would do. As a matter of habit, I am not much of a TV
person; I usually got my inputs from the print media but there would be enough
speculation there as well, although less dramatic than that on TV. Polls of
economists and analysts on the Reserve Bank’s policy stance are now common
fare. Some friends would ask me if all the speculation in the media prior to the
policy review influenced my decision. I don’t believe it has, but of course, by
definition, I cannot speak for any unconscious osmosis of ideas.
As early as 8 a.m. on the policy day, OB vans park outside the Reserve Bank
central office with reporters from TV channels and wire agencies milling around
and sending live feeds from the scene of action. There is understandably
competition among TV channels to ‘be the first with the policy’ which entails
the risk of the first outburst of comment being incoherent or even ill-informed.
To mitigate this risk, the Reserve Bank provides privileged access of the policy
statement to reporters in advance with a strictly enforced embargo protocol.
At 9 a.m., these privileged reporters are conducted into the ‘embargo room’
where they surrender their cell phones and data cards and settle down in front of
their systems sans any communication tools. A Reserve Bank official reads out
the embargo rules, including a clause that once the policy document is given to
them, they cannot leave the room even to use the loo! As soon as the statement is
handed over, the room turns into an examination hall. All one can hear is the
shuffle of papers and the click of keyboards as they prepare their headlines and
stories while a hawk-eyed Reserve Bank staffer keeps a close watch on them.
Moments before 11 a.m., the Reserve Bank staffer gets an alert and the
countdown begins: ‘5-4-3-2-1-Go.’ The policy is announced—simultaneously on
the Reserve Bank website and on TV screens and wire agency channels. But
there is time enough only to give quick headlines before they rush for the
governor’s media conference.
A few minutes before the release time, the deputy governors, the monetary
policy team and I would gather in my office on the eighteenth floor, watching
the TV of course, and much like actors in a play, wait for the cue to enter the
the TV of course, and much like actors in a play, wait for the cue to enter the
stage. When the alert comes, we would troop down three floors in the express
elevator, go through the photo op with cameras clicking and bulbs flashing, and
then enter the conference room for the media interaction.
Early on in my tenure, I used to start the media conference by reading a short,
prepared statement but found that pattern to be too stilted. After a few meetings,
I abandoned the practice in favour of an informal opening briefing after which
we would get into conversation. Even as I thought I was well tutored by my staff
for this ‘inquisition’, there would invariably be questions, or at any rate nuances
on questions, which we had not thought of. I valued the opportunity of the media
interaction as it was a useful platform for us to disseminate the rationale and
expected outcomes of the policy in spoken and simpler language. It was a space
where we could put out clear messages and oftentimes even explain some of the
dilemmas we went through. In one interaction, I volunteered that opinion among
my advisers too was divided on the policy action. Some of the media personnel
were surprised that I would be so transparent but I thought communicating that
the policy decision was finely balanced had its own signalling impact.
In an effort to improve the quality of our dissemination of the policy, we
introduced a teleconference of analysts targeting a range of non-media
stakeholders predominantly from the financial sector, but also drawing from the
corporate world and academia. Deputy Governor Subir Gokarn was the
inspiration behind this. The idea was to allow a day for the analysts to absorb the
policy as also for an initial reaction by the media so that the questions would be
more thought through. At the same time, the analysts’ teleconference allowed
those of us within the Reserve Bank an opportunity, through our responses, to
reinforce some of the messages or correct any overt misinterpretation. I was
pleased to see the teleconference rapidly gaining in popularity with not only the
numbers signing up from both within the country and outside increasing, but
also the depth and quality of questions improving.

Monetary Policy Outreach

The monetary policy process is anchored in the monetary policy department of


the Reserve Bank, and even there only a handful of senior officers are in the loop
about the entire process and on the final decision. On the other hand, the Reserve
Bank is so quintessentially identified with monetary policy that the larger public
Bank is so quintessentially identified with monetary policy that the larger public
sees every staff member of the Reserve Bank as having had a say in making the
policy. Imagine a situation where a middle-level officer, say in the non-bank
supervision department of the Reserve Bank, runs into a friend in the aisle of a
supermarket and is accosted: ‘Why did you people raise the interest so much
yesterday? My EMI has shot up by 800 rupees.’ I could relate to the
embarrassment of my colleague who would have to say sheepishly that she
works in a different part of the Reserve Bank, is not in the loop on interest rates
and, in fact, knows as little as her friend! Embarrassment aside, this was also a
foregone opportunity to demystify the Reserve Bank.
I believed that every staff member of the Reserve Bank should be broadly
aware of the policy perspectives of the bank across its broad remit, irrespective
of the narrow domain of his or her job chart in order to be an effective
ambassador for the bank to the outside world. To operationalize this, we
introduced a monthly thematic video conference, anchored in rotation by a
specific central office department. The conference would link all the regional
offices of the Reserve Bank, and the central office staff would run the agenda
explaining the current policy perspectives. I also asked that the deputy governor
and the executive director in charge of monetary policy do such a thematic video
conference after each quarterly policy review so that all our officers could
communicate the Reserve Bank’s policy rationale to the larger public with
greater knowledge and confidence.
Recall what I said earlier about my effort to increase awareness about what
the Reserve Bank does so that it can be held to account for its performance. I,
therefore, attached a lot of value to a more decentralized dissemination of the
monetary policy. My idea was that universities and think tanks across the
country, especially in non-metro and second-tier cities, should hold special
sessions to discuss and debate policy. I realized that this would not happen by
mere exhortation, and at least in the early stages, the Reserve Bank had to act as
the catalyst. I used to urge our staff, both in the central office in Mumbai and our
regional offices across the country, to take the lead in this. Given the limited
staff resources, our reach was modest; so we prepared a roster for balanced
geographical coverage.
I got a call one late evening in May 2013 from a senior citizen in Nagaland
profusely thanking me, in halting English, for sending someone out there to
explain what the Reserve Bank does. Just like my ninety-three-year-old mother-
in-law, he gave me a detailed account of the pension he got, his growing
monthly expenses and how it was becoming increasingly difficult to make ends
meet. ‘Do something about the prices, sir, especially the price of cooking oil,’ he
pleaded with me. It didn’t miss me that in his own innocent and polite way, he
was seeking accountability from the Reserve Bank.
He made my day.
6
Demystifying the Reserve Bank
How Does the Reserve Bank Make a Difference?

As I’ve already written, almost the entire first year of my tenure as governor was
focused on crisis management—cutting interest rates, pumping in liquidity and
stabilizing the markets. Everywhere I went, people seemed to be interested in
knowing only one thing: when would I next cut the interest rate? Within weeks, I
became quite an expert at giving a standardized, if also a sterile, reply to this
FAQ. I also used to joke with my media interlocutors that contrary to my fears,
the governor’s job was, in fact, quite easy since all it required was cutting
interest rates and what’s more, the whole country cheered you as you went about
the job with abandon!
Then in August 2009 when I was in London for a conference, an interviewer
from Reuters asked me: ‘You’re soon going to complete one year as governor of
the RBI. What goals have you set for yourself for your term?’ You’d guess, and
rightly so, that I was unprepared for this. Any question beyond cutting the
interest rate was clearly outside the syllabus, as our students would say, and I
was quite flustered. As I thought on my feet, I blurted out something to the
effect: ‘First, I’d like to position the RBI as a knowledge institution; second, I
would want to make the RBI the best practice model among emerging-market
central banks for expertise in making policies in a globalizing world; and third, I
want to demystify the Reserve Bank.’
The last bit of my reply was playing in my mind through the rest of the day.
Why indeed had the need to demystify the Reserve Bank come to me at such a
pressured moment? Sure enough, I was quizzed quite a bit in subsequent
interviews about what I meant by demystifying the Reserve Bank which forced
me to give a concrete structure to my unconscious thought process.

Demystification—a Priority
Demystification—a Priority

There were two reasons why demystifying the Reserve Bank seemed such a high
priority. The first was my strong feeling that the Reserve Bank has to render
accountability for the outcomes of its actions. The Reserve Bank has, in fact,
embarked on a number of voluntary initiatives to render accountability. But
these measures are all in the nature of ‘supplying’ accountability; of what use are
they unless they are matched by ‘demand’ for accountability from the larger
public? And how can the larger public demand accountability unless they have at
least a basic understanding of the role and responsibilities of the Reserve Bank.
It struck me that the large majority of people, even educated people, do not
know very much about what the Reserve Bank does. Many know it prints
currency but beyond that, the Reserve Bank is a black box, a mysterious
institution, a sort of monolith, doing obscure things that have no real relevance
for the everyday lives of people.
The reality is, in fact, very different. The Reserve Bank prints and distributes
currency, of course, but it does a lot of other things besides. It is the monetary
authority of the country, which means its main job is to keep inflation under
control while also supporting growth. It is the gatekeeper of the external sector
which entails monitoring and regulating capital inflows and outflows, and
keeping the exchange rate steady. It regulates and supervises banks to ensure
that the money which people save in banks is safe and is productively deployed
towards generating economic activity; similarly, it regulates non-banking
financial companies and segments of financial markets, again with the aim of
channelling savings into productive investment. The Reserve Bank’s regulation
extends also to the payment and settlement systems with the objective of making
financial transactions safe, robust and efficient. The Reserve Bank is the central
bank—that is, it is the bank of banks, and the bank for the Central government as
well as state governments. On top of all this, and importantly, the Reserve Bank
has a key role in the economic development of the country and drives an
impressive social development agenda.
That, in a nutshell, is the range and diversity of responsibilities of the Reserve
Bank. And what it does affects the everyday lives of people across the country—
from the prices they pay in the market, the interest they earn on their bank
deposits, the interest they pay when they borrow from a bank, like, say the size
of the EMI (equated monthly instalment) they pay on a house loan. It affects
of the EMI (equated monthly instalment) they pay on a house loan. It affects
how much foreign exchange they can take out to spend or invest outside the
country, say, for medical treatment or to educate a child abroad, and how the
government pays for new roads, schools and hospitals.
My view was that if the Reserve Bank had to be held to account, we needed to
demystify the institution so that the larger public understood what it did and how
that connected to their lives.
There was another equally important motivation for my wanting to demystify
the Reserve Bank. Not only do people not know what the Reserve Bank does,
but they also have negative perceptions of the institution. A widely held
stereotypical view of the Reserve Bank is of a rigid, wooden-headed monolith,
making rules and regulations with little understanding of the realities of India.
I have personal experience of this negative stereotypical view of the Reserve
Bank and how it becomes the scapegoat for virtually all maladies in the financial
sector.
My first posting in the IAS after I completed training was as subcollector of
Parvathipuram division in Srikakulam district of Andhra Pradesh. Those with
long enough memory will recall that the tribal belt of north coastal Andhra
Pradesh, particularly the tribal belt of Srikakulam district, was the first region
outside of Naxalbari in West Bengal to come under the hold of the Naxalite
movement in the late 1960s. By the time I went to Parvathipuram in the mid-
1970s, the Naxalite influence in Srikakulam was tapering off; they had moved
on into neighbouring Chhattisgarh.
The tribal people had historically suffered ruthless exploitation by the non-
tribals—the ‘plains people’, as they were called—which pushed them into debt
and even bondage. The ground-level administration was seen as not only being
indifferent to but even complicit in this exploitation. It was this alienation of the
tribal households which made them vulnerable to the Naxalite doctrine of
begetting social justice though violence. Our priority in the district
administration, therefore, was clear—improve the livelihoods of tribal
households so as to wean them away from extremist influence.
Tribal livelihood typically depended on podu (shifting cultivation on hill
slopes) which consisted of spraying the seed after the first rains and returning to
the field thereafter only to collect what grew without tending to the crop in
between. Between sowing and harvesting, they were engaged in collecting minor
forest produce and selling it in the ‘plains area’ village markets. Not only was
the income from these activities scanty, but it was also seasonal. To smooth their
incomes, tribal households typically borrowed from the moneylenders in the
plains, and since default was quite common, they lost what land or animals they
had to the moneylender and then ended up being bonded labour.
One of our tribal welfare tasks, therefore, was to reduce their dependence on
moneylenders by designing and implementing income-generating schemes
supported by bank credit. It was quite common for me as subcollector to visit
banks to canvass loans for these tribal welfare schemes. Banks, however, used to
be quite wary of lending to the tribals for fear of default. They would come up
with one excuse after another, and when their imagination ran out, they would
invoke their brahmastra—they can’t give more loans because of ‘RBI
restriction’.1 I remember one MLA who, while campaigning for re-election, had
gone to the extent of saying that if the government was really interested in tribal
welfare, the first thing they should do was to abolish the Reserve Bank!
This is just one example, perhaps an extreme one, of the common
misperception about the Reserve Bank. As I moved on in my civil service career,
I realized that there was much exaggeration in this negative stereotype. But I was
never fully convinced that there was not some justification behind it.
Not until I became governor and got to see the Reserve Bank from within. In
the one year that I spent in the bank by the time of the Reuters interview, all my
misperceptions about the Reserve Bank had completely melted away. Not only is
the Reserve Bank not closed and negative, but on the contrary, it is a remarkably
open-and positive-minded institution. Its staff are caring and sensitive, and they
always act in the larger public interest.
So, what explains the negative image? I figured that the reasons are
inadequate information and even misinformation. Let me illustrate with an
example.
The Reserve Bank, among other things, is also a financial sector regulator
with the responsibility of ensuring that financial activity in the economy serves
the larger collective good. For example, the Reserve Bank has decided to restrain
the growth of deposit-taking NBFCs. A narrow evaluation might make this seem
like a negative measure depriving the public of an opportunity of a high-risk,
high-reward investment option. But if you factor in how millions of poor
high-reward investment option. But if you factor in how millions of poor
households are lured by these high rewards, not knowing the risk involved and
end up in financial ruin, the wisdom behind this regulation becomes clear. The
culprit here is inadequate information about the rationale for this regulatory
restriction.

What Needs to be Done to Demystify the Bank?

What needed to be done to demystify the Reserve Bank, therefore, was quite
clear. I must spread understanding about the role and responsibilities of the
Reserve Bank widely and deeply, and also correct information flaws. The
answer certainly was not to carve out a Department for Demystification of the
Reserve Bank nor was it to entrust the task to a few people. The answer was to
make demystification a part of everything we do every time and all the time. We
must be more open, transparent, communicative and engaging—disseminating
the right information deeply, which in itself should check the spread of
misinformation.
I spoke many times at several places on the role and responsibilities of the
Reserve Bank and on how all our actions and decisions are guided by the larger
public good. The topic of my convocation address at Sambalpur University in
February 2011 was, in fact, ‘The Reserve Bank of India: Making a Difference to
Everyday Lives’. The focus of my comments at all village outreach events was
to explain the activities of the Reserve Bank in a manner and at a level that semi-
literate village folk could understand and relate to. I took the opportunity of my
formal speeches and informal comments to explain the rationale behind some of
the decisions of the Reserve Bank which were topical at that time. For example,
I explained the pros and cons of deregulation of the savings deposit rate, at a
town hall meeting in Bhopal as part of the extensive campaign we had launched
to get public opinion on this issue in which everyone who had a bank account
had an interest.
Let me illustrate with some more specific examples. I’ve already written about
how we tried to simplify the language and streamline the messaging of our
quarterly monetary policy statements. But even after all this reinvention, they are
still too technical to be understood by people beyond the world of economics
and finance. The media and the analysts do some job of interpreting and
explaining our language and our message, but much of that too is beyond the
explaining our language and our message, but much of that too is beyond the
reach of most people. Besides, it is no substitute for the Reserve Bank itself
doing more towards disseminating its reports, explaining in non-technical
language what the report says and how the expected outcomes would impact
everyday lives. I used to urge the Reserve Bank’s economists to go to different
parts of the country and hold seminars in collaboration with the economics
departments of local universities on the Reserve Bank publications. The rule, of
course, was that they should step out of the metros and go to tier-2 cities. My
hope and expectation is that in the course of time, the Reserve bank itself would
bring out a non-technical companion to all its technical reports.

Financial Literacy

By far the most systemic and sustainable way to demystify the Reserve Bank is
through spreading financial literacy. Financial literacy is a large programme with
several dimensions and the Reserve Bank is only one of the many players in the
space. The Reserve Bank runs a huge financial literacy programme and also
encourages banks to do so.
The one initiative in financial literacy that was dear to me was the
introduction of a curriculum on finance in school textbooks so that the next
generation of children would pass out of schools financially literate and in the
process also develop an understanding of the role and responsibilities of the
Reserve Bank. In fact, canvassing this would be part of the standard agenda of
my meetings with chief ministers across the country. The Reserve Bank has
prepared standard introductory material on finance at various class levels
through the schooling period. I used to offer to the chief ministers that the
Reserve Bank staff would work with the state school boards to adapt the
standard material to the state context and even translate the material into the
local language and idiom.
This is, by its very nature, a work in progress and my success has been partial.
But I do count this effort of mine at financial literacy as one of the flagship
initiatives to demystify the Reserve Bank in a robust and sustainable way.
7
Rupee Tantrums
The Challenge of Exchange Rate Management

Remember I began this book with the old Chinese saying: ‘May you live in
interesting times’. In the five years I was at the Reserve Bank, I had more than
my share of ‘interesting times’, managing the once-in-a-generation global crisis
in 2008–09 and combating a decade-high inflation in 2010–11 which segued into
a battle against the slide of the rupee starting mid-2012 up until the close of my
tenure in September 2013. Many people ask me about my most difficult
challenge in the Reserve Bank, almost invariably expecting me to reply that
managing the impact of the global financial crisis in 2008–09 as a greenhorn
governor was my most testing time. There is surprise, therefore, when I say that
battling the sharp depreciation of the rupee in 2013 was by far my toughest
challenge.

Most Formidable Challenge

Why was the rupee problem my most formidable challenge? For several reasons.
First and foremost, exchange rate battles are typically of the ‘here and now’
variety. In deciding on monetary policy to rein in inflation, for example, there is
time—time to deliberate, time to analyse, consult, weigh the alternatives, time
even to agonize. I felt the same way while managing the global financial crisis.
Notwithstanding all the anxiety and uncertainty of that time, there was enough
time to reflect and deliberate before deciding on any action. In responding to
sharp exchange rate movements, however, there is no such luxury of time; you
are oftentimes forced to decide and act ‘on the go’, as it were.
Of course, we had a time-tested policy and a big-picture strategy in place for
exchange rate management. The Reserve Bank also has a well-established
process for operationalizing the strategy in the form of a financial markets
process for operationalizing the strategy in the form of a financial markets
committee which meets every morning, and in crisis times, several times during
the day to review the tactical plans. Even so, market developments are often so
volatile, and twist and turn in such unforeseen ways that we are forced to swiftly
tweak our tactics in real time.
The second factor that makes exchange rate management an especially
daunting task is the challenge of managing expectations. Managing expectations
to alter behaviour is critical to the success of several aspects of Reserve Bank
policy, such as, for example, preserving financial stability and controlling
inflation. What is different in managing expectations about the exchange rate is
that in times of pressure, market behaviour becomes susceptible to even stray
bits of news, leading to speculative self-fulfilling prophecies. When expectations
about the exchange rate become as volatile as the exchange rate itself, spiralling
one-way bets on the currency become a distinct risk.
Why do I specifically pick on the 2013 exchange rate pressure as a
particularly difficult challenge? For sure, we had exchange rate episodes earlier
in my tenure too, most notably in the midst of the global financial crisis towards
the end of 2008. But in 2008, we were not alone; many countries, both advanced
and emerging, had exchange rate pressures, giving us the comfort of numbers.
Also, in 2008, our macroeconomic situation was more supportive; inflation had
suddenly fallen—in large part because of the crash in the global oil price; output
growth was still rapid, the fiscal deficit was on the mend, and most importantly,
our forex reserves were relatively robust. In 2013, in contrast, we were one of a
small group of emerging economies, the ‘fragile five’, which came under severe
pressure. Our reserves were low, inflation was high, commodity prices were
firming up, fiscal consolidation lacked credibility, and growth prospects were at
their bleakest in nearly a decade.

Taper Tantrums

The ‘taper tantrums’ that reverberated across the world, setting off capital flight
from emerging markets and plunging their currencies to new lows, were
triggered by a statement in May 2013 by Ben Bernanke, the then chairman of the
US Federal Reserve, that they were considering gradually tapering their asset
purchase programme, popularly known as ‘quantitative easing’.
I would have thought that any news like this, implying that the American
I would have thought that any news like this, implying that the American
economy, the epicentre of the global financial crisis, was showing signs of a
robust recovery, would have been cheered by the financial markets; instead, the
panic sell-off showed that investors, used to the ease of abundant liquidity, were
unprepared for the ‘punchbowl’ being snatched away. The transition from the
comfort of making investment decisions in a world of ample liquidity to the
challenge of making investment decisions based on economic fundamentals was
always going to be a difficult one; the reaction to Bernanke’s statement showed
that it could even cause panic.
As capital fled in the tidal wave of taper tantrums, the rupee tumbled steeply
from ₹55.52 to a dollar on 22 May 2013, the day after the Bernanke statement,
to ₹67.03 on 4 September 2013 when I stepped down from office, recording a
depreciation of 17 per cent in just a little over three months.1

Changing Perspectives on the Exchange Rate

I have often been asked if there were differences between the government and
the Reserve Bank on exchange rate management. The short answer is, not very
much. There was a time, even after the regime-changing economic reforms of
1991, when the political class in India looked upon a strong exchange rate as a
sign of economic might and a depreciation of the currency as an erosion of that
might. However, with India’s rapid integration into the global economy, and
two-way movements of capital as well as exchange rate, that emotional
perception has yielded to a more agnostic view. We no longer attach any
political economy significance to the exchange rate and have grown to look upon
it as a pure macro variable. We understand that not just a weak rupee, but even a
strong rupee can cause pain. This was clearly in evidence going by the broad
political support for the exporters’ agitation—when the rupee appreciated
sharply in the pre-crisis years of 2006–08—that the Reserve Bank should check
the rise of the rupee.

Shared Responsibility but Differing Messages

Unlike monetary and regulatory policies where the Reserve Bank is, or at any
rate, should be autonomous, management of the exchange rate is a shared
responsibility of the government and the bank. In normal times, the Reserve
responsibility of the government and the bank. In normal times, the Reserve
Bank typically acts on its own and keeps the government in the loop, but in
times of crisis, there is invariably consultation, coordination and, where
necessary, synchronized action. During these ‘tantrum months’, Chidambaram
and I met several times; deputy governors Harun Khan and Urjit Patel were in
constant touch with Finance Secretary Arvind Mayaram and Chief Economic
Adviser Raghuram Rajan. We were largely agreed on the overall strategy for
managing the exchange rate although there were the inevitable differences on
tactics and timing. Quite obviously, on neither side did we have an idea of how
much bleeding would take place and when it would stop.
Even as we were engaged in a fierce exchange rate defence, one issue that
troubled me all through was the narrative that was taking shape about the origin
of the problem. The government, in particular, was attempting to paint the rupee
problem as caused entirely by external factors. Sure, the timing and pace of
depreciation were a response to the impending ‘taper’ of the ultra-easy monetary
policy by the Fed. But global factors were just the proximate cause for our
exchange rate turmoil; the root cause lay in our domestic economy where, for
years, we had been heaping pressure on the rupee, an issue that the Reserve
Bank consistently raised in its monetary policy statements. An implosion was
inevitable; it was incidental that the trigger came by way of the taper tantrums.
My concern was that we would go astray in both the diagnosis and remedy if
we did not acknowledge that at the heart of our external economy problem were
domestic vulnerabilities. I had several conversations with Chidambaram on this,
but found him reluctant to face up to this inconvenient truth. He is too intelligent
not to have seen the point; I suspect he found it politically convenient to point to
an external scapegoat rather than call attention to domestic structural factors.
What were these domestic structural factors? At its root, the problem was the
huge current account deficit (CAD) we had been running for three years in a row
and possibly for the fourth year in 2013–14. In other words, at the economy
level, our total import bill was far higher than our total export earnings, making
us dependent on external financing for filling the gap. The CAD was 4.2 per cent
of GDP in 2011–12, 4.8 per cent in 2012–13, and most forecasts put the CAD
for 2013–14 at over 4.0 per cent2—well above 3.0 percent of GDP, the
sustainable limit as estimated by the Reserve Bank.
Why indeed did the CAD widen so much? A potent cocktail of factors was at
play. First, recall that we had a classic V-shaped recovery from the crisis even
while much of the world was still struggling with recession. This meant that our
imports grew rapidly even as our export prospects remained bleak because of
subdued global demand. The pressure was exacerbated by some real
appreciation of the rupee, a consequence of our higher inflation relative to that of
our trading partners, which made importing more attractive and exporting more
difficult.3 Second, the global crude price had spiked which added to our import
bill, and thereby to the CAD. Third, gold imports surged, more than doubling
from 1.3 per cent of GDP in 2007–08 to 3.0 per cent in 2012–13 due to larger
import volumes and higher global prices. Finally, judicial orders unwittingly
added to the pressure. The Supreme Court struck down the coal block allocation
made by the government to private parties which resulted in a sharp decline in
domestic production and forced power producers to turn to imports to meet the
shortage. The Supreme Court also banned iron ore mining, on environmental
grounds, which affected ore exports.

Reserve Bank’s Exchange Rate Defence

There were two dimensions to our exchange rate management strategy. The first
was to smooth the trajectory of the exchange rate adjustment path by tactically
selling foreign exchange from our reserves. The second was to manage
expectations and contain potential herd behaviour in the market by implementing
measures to augment inflows and stem outflows.
We regularly intervened in the forex market all through this period by selling
dollars from our forex reserves. The standard operating procedure I followed
was to approve the quantum of intervention for a limited period, say for a week,
but leave the operational details to the staff. Consistent with global practice
across central banks, the Reserve Bank does not disclose its interventions on a
daily basis but markets, by and large, manage to get a sense of that by analysing
the volumes of forex coming into the market.4 They then speculate about the
coded message that the bank might be sending through the size and timing of its
interventions. Managing this messaging is part of the Reserve Bank intervention
strategy which requires an understanding of the markets, intelligence, tact and
quick thinking, all of which the forex dealers of the Reserve Bank have in
abundance. This is a quiet but enormously talented bunch of professionals.
The other dimension of our exchange rate management, as I said, was capital-
flow management measures. We increased the quota for foreign buying into the
rupee-denominated debts issued by both the government and the corporates. This
was consistent with our road map for the gradual opening up of the capital
account although the timing was admittedly influenced by the taper tantrums.
If an Indian corporate defaults on its domestic borrowing, it hurts its credit
rating. If an Indian corporate defaults on its foreign borrowing, it hurts the credit
rating not just of the corporate but of the entire economy. Because of this
spillover impact, the Reserve Bank disciplines external borrowing by corporates
by imposing an upper bound on the total debt servicing cost, technically called
‘all-in-cost’. Considering the need to augment inflows, we relaxed the upper
bound of the all-in-cost for external commercial borrowing so as to make it
easier for corporates to negotiate external loans.
For a long time, Reserve Bank regulations allowed corporates to contract
foreign borrowing only to meet forex expenditure, but over time, we relaxed this
requirement, making it possible for them to use foreign loans even to meet rupee
expenditure. Corporates were also allowed to keep their forex borrowing meant
for rupee expenditure outside the country until they actually needed to spend it at
home. To relieve the pressure on the rupee, we now mandated that all ECB
raised for rupee expenditure should be brought into the country immediately
even if their project was not yet ready to absorb the loan proceeds.
India provides two main facilities for NRIs to invest their savings in the
country: non-resident external (NRE) rupee accounts where the exchange rate
risk is borne by the NRI depositor; and foreign currency non-resident (FCNR)
accounts where the exchange rate risk is borne by the deposit-accepting bank.
The Reserve Bank regulated the maximum interest rate that banks can offer on
NRI deposits mainly out of a concern that if there was no such restraint, banks
would race to the bottom by offering ever higher interest rates to NRIs which
would aggravate our collective vulnerability. Given the pressure to augment
capital inflows, we withdrew this ceiling on the interest rate on rupee-
denominated NRI accounts, thereby allowing freedom to banks to set the interest
rate themselves; we continued, however, with an interest rate cap on FCNR
accounts but raised the cap.
accounts but raised the cap.
One of the big problems to contend with in exchange rate defence is
speculative pressures as they can be both self-fulfilling and self-reinforcing. For
example, in a scenario where the rupee is sliding continuously, exporters would
defer bringing in the export receipts, and importers would buy forward, and both
those actions, what markets call ‘leads and lags’, would exacerbate the run on
the currency. One of our aims, therefore, was to restrict the options open to the
market participants, including banks, to take undue advantage of the market
volatility. Towards this end, we restricted the flexibility available to both
exporters and importers to maintain open foreign exchange positions and
reduced the limits available to banks to trade on the rupee.
We have two separate markets for taking a position on the future of the rupee
—the over the counter (OTC) ‘forwards’ market which is restricted only to those
having an underlying foreign exchange exposure—for example, importers and
exporters—and the exchange-traded ‘futures’ market which is open to all. In
normal times, the two markets would be roughly synchronized, and together they
help efficient price discovery; in crisis times though, there is oftentimes a
disconnect between the two markets which opens up opportunities for
speculators to exploit the arbitrage and reinforce the one-way pressure on the
exchange rate. To limit such opportunities, we proscribed proprietary trading by
banks in the currency futures market; in other words, banks could transact in this
market only on behalf of their clients.

Restraints on Gold Imports


As I wrote earlier, gold was a big source of import pressure. The Indian appetite
for gold is part of folklore, but why indeed did the demand for gold spurt so
suddenly? Clearly, some idiosyncratic factors were at play. Our gold demand
comprises three segments. The largest segment is the ‘folklore’ demand,
especially from middle-and low-income households, who find investing in gold
to be an attractive option as it provides a hedge against inflation while also
providing liquidity, as gold can be sold or offered as collateral for emergency
borrowing. The second demand segment comprises jewellers who import raw
gold and convert it into jewellery for re-export. Finally, there is speculative
demand from people taking positions on the global price of gold, which itself is
a consequence of the global macro outlook. Between 2009 and 2012, the folklore
demand for gold had shot up, as our inflation remained elevated and the real
returns on bank deposits turned negative. The speculative demand spiked too as
average gold price zoomed from $867 per troy oz (₹12,890 per 10 grams) in
2008–09 to $1654 per troy oz (₹30,164 per 10 grams) in 2012–13, making
investment in gold look like a one-way bet.
The need for imposing restrictions on gold import to help reduce the CAD
was obvious. The direct, blunt, and possibly the most effective in the short-term,
way of doing this was to raise the customs duty on gold so as to raise the import
cost of gold. This, however, entailed big risks. As part of the reform process in
the 1990s, India had liberalized the import of gold, which put an end to
smuggling and to the crime and mafia activity that came with it. Raising customs
duty would mean undoing those gains and the need for treading cautiously was
clear.
Between May and August 2013, the government raised the customs duty on
gold imports from 6 per cent to 10 per cent, clearly wary of crossing the tipping
point beyond which smuggling would become an attractive option. From the
Reserve Bank side, we imposed restrictions on the import of gold as well as on
its use as a collateral for loans. We banned the import of gold coins and
medallions, prohibited non-banking financial companies from lending against
the security of gold in any form, restrained loans against gold by banks, and
restricted import of gold on consignment basis by both banks and other agencies.
One constant vexation in the middle of this rupee turmoil was that many large
corporates had not hedged their foreign exchange exposures and had set
themselves up for huge losses as the rupee rapidly lost value. Notwithstanding
past experiences where several of them had lost heavily because of unhedged
exposures, they still calculated that the costs of hedging outweighed the benefits.
This is clearly a miscalculation as one ‘black swan’ episode can wipe out all the
past gains. Our investigations revealed that banks too were quite negligent about
educating their corporate borrowers on the prudence of hedging their forex
exposures.
We were concerned about this nonchalance—bordering on indifference—as
corporate defaults on external borrowing can complicate what is already a
complex problem. For a long time, the Reserve Bank had been cautioning banks
on the importance of encouraging their corporate borrowers to hedge their forex
on the importance of encouraging their corporate borrowers to hedge their forex
exposures. As persuasion did not work, we had to eventually issue a regulatory
mandate that every bank should have a board-approved policy regarding hedging
of forex risks by its corporate borrowers, including small and medium
enterprises, and that they should take into account the risk of unhedged foreign
exposures in pricing the credit risk premium.

The currency turmoil in emerging markets continued all through May and June
2013. It did not help that Bernanke reiterated his message about the taper with a
follow-up statement in a press conference in June 2013 that if the US economy
continued to improve, they could start winding down the asset purchase
programme in 2013 and wrap it up in 2014. Markets around the world sold off
aggressively on the news, with major indices dropping more than 1 per cent.
At home, because the exchange rate adjustment was not yet complete, the
rupee continued to slide with no obvious reversal in sight even as the calendar
turned to July 2013. The rupee problem required my undivided attention which
meant that I had to pare down most other commitments. I felt guilty though, as
there were only two more months to go of my tenure and I had piled up a huge
number of commitments. Most of all, I wanted to complete visiting all the
regional offices of the Reserve Bank. There are altogether twenty-nine of them
across the country and I had visited twenty-seven; I wanted to go to the
remaining two—in Kanpur and Shillong—before I stepped down, but that
remained an unfulfilled wish. I had attended the BIS bimonthly meetings of
governors fairly regularly and I was looking forward to attending the June-end
meeting which would be my last, but I decided to skip that. All through my
tenure, I tried to honour all speaking commitments, as I was conscious that
postponing at the last minute would be very disruptive to the hosts, but with my
schedule going haywire, I had to opt out of them as well.
Both Chidambaram and I were to travel to Moscow for a G20 meeting
scheduled on 19–20 July. On 15 July, I met Chidambaram in Delhi and told him
of my decision to deploy monetary policy to sharply tighten market liquidity as a
measure of exchange rate defence. The specific measures consisted of raising the
marginal standing facility rate by a whopping 2 per cent, imposing a quantitative
restriction on banks’ access to the repo window and open market sales of
restriction on banks’ access to the repo window and open market sales of
government securities.
This decision to use monetary policy to defend the exchange rate was by far
one of the toughest decisions I had to make as governor. It is not lightly that a
central bank, particularly the Reserve Bank, would use its monetary policy
weaponry for exchange rate defence. For sure, the Reserve Bank’s regular
monetary policy decisions, calibrated with other objectives such as inflation and
growth in view, would have an impact on the exchange rate, but that is an
incidental, albeit considered, by-product. Directly deploying monetary policy to
manage the exchange rate itself is an altogether different ball game. But as one
central bank colleague told me: ‘Sometimes, it is time to think the unthinkable.’
I thought the time had come for me then.
The motivation for this bazooka action, as some analysts called it, was to curb
speculative activity which was exacerbating the one-way pressure on the rupee.
We had market intelligence to believe that the relatively comfortable liquidity in
the system and the relentless one-way movement of the rupee were together
fuelling speculation, especially in the overseas non-deliverable forwards (NDF)
market. Tightening domestic liquidity was imperative to make it more expensive
to borrow in rupees to take dollar positions. Furthermore, we believed that this
extraordinary action would signal our resolve to stem the rupee volatility.
Incidentally, given that the rupee depreciation was inflationary, these measures
to arrest its slide were consistent with our inflation management objective, both
in terms of their potential impact on the exchange rate itself and through the
more conventional monetary policy channel.
Over the years, the Reserve Bank had liberalized the capital account by not
only making it easier for non-residents to bring in capital and take it out, but also
allowing options for resident Indians to convert their rupee holdings into foreign
currency for investment abroad under the Liberalized Remittance Scheme
(LRS). On 14 August, we reduced the maximum amount that individuals and
corporates could take out under LRS. The market reaction was swift and brutal;
the rupee fell from ₹61.43 to a dollar on 13 August to ₹68.36 on 28 August,
while the bellwether stock index Sensex fell from 19,230 on 16 August to
17,996 on 28 August.
Why was the market so unforgiving? After all, deploying price or quantity
controls to calibrate capital flows in order to manage pressures on the exchange
rate had been standard practice for the Reserve Bank. For example, in 2007–08,
rate had been standard practice for the Reserve Bank. For example, in 2007–08,
the year before the crisis, when there were large inflows that put the rupee under
severe appreciation pressure, governor Y.V. Reddy, in an effort to throw sand in
the wheels of inflows, had tightened the ECB policy, making the conditions
under which corporates could borrow abroad more exacting. During the financial
crisis in the months after I took over, when the rupee came under depreciation
pressure, I did the opposite—reversed the restrictions on ECB to increase
inflows. Similarly, interest rates on NRI deposits were adjusted in the past both
up and down to neutralize the impact of large capital flows in either direction.
If, as described above, the market is used to the Reserve Bank using controls
to calibrate capital flows, what was different about the restrictions on LRS that
they triggered such a sharp reaction? Evidently, the market saw the LRS
restrictions not as a usual, temporary capital-flow management measure but as
an unusual and regressive move. My calculation was that this decision would be
interpreted as the Reserve Bank’s resolve to contain expectations about the
rupee’s fall. Instead, the market saw this perceived willingness to deviate from
the broad thrust towards increasing rupee convertibility as an extreme action
triggered by panic which reinforced the negative perceptions on the currency.
Did I make a costly misjudgement of the market reaction? That’s a question
that I agonized over all through the next couple of weeks till I left the Reserve
Bank and indeed several times even afterwards. My only comfort is that I was
not alone. Virtually every central bank governor has experienced market reaction
contrary to expectation at some time or other. Bernanke, I am sure, must have
been surprised by the panic set off by his advance warning of ‘the taper’ in May
2013, and Xiaochuan, governor of the People’s Bank of China, must have been
surprised by the sense of shock in the global financial markets when China
adjusted the exchange rate peg of the yuan in August 2015, ostensibly as a
prelude to making the exchange rate more market determined.
Is it presumptuous then on the part of central banks to believe that they can
accurately judge market psychology? An analogy from physics comes to mind.
We all know that the two great theories of twentieth century physics—Relativity
and Quantum Mechanics—are inconsistent with each other. All through his life,
Albert Einstein could not reconcile to the probabilistic nature of the universe
implied by the quantum theory and famously declared: ‘God does not play dice.’
To this, his friend and pioneering quantum physicist Neils Bohr replied, ‘Albert,
stop telling God what he can or cannot do.’ Similarly, central bankers can hardly
stop telling God what he can or cannot do.’ Similarly, central bankers can hardly
presume to tell markets how to behave no matter the intentions behind their
policy moves. If the crisis has taught us anything, it is that central banks have to
be more humble about their ability to predict market behaviour.

Challenges in Exchange Rate Management

Let me now turn to some challenges we confronted in exchange rate


management during this period. By far the most formidable challenge was to
manage expectations. Fears were stoked by a number of factors. Some
commentators, for example, wondered whether India was once again heading
into a twin deficit problem—a combination of a large fiscal deficit with a large
current-account deficit that can derail growth, fuel inflation and threaten
macroeconomic stability. The origins for this apprehension trace back to our
balance of payments crisis of 1991 which, it is now widely agreed, was a direct
consequence of the fiscal profligacy—the government borrowing way beyond its
means—of the 1980s. We were once again experiencing a potent mix of twin
deficits, in 2012. Might we be setting ourselves up for another balance of
payments implosion?
I thought these fears were overdone and I did my best to emphasize why an
implosion had been imminent in 1991 and how 2012 was different from 1991.
Between 1991 and 2012, the structure of the Indian economy had changed in
fundamental ways. Our exchange rate was now largely market determined. Our
financial markets had become more mature, more diverse and much deeper, and
were capable of absorbing most shocks. Our regulatory systems and our crisis
response mechanism were more robust and sophisticated. Our forex reserves,
both in absolute and relative terms, were much larger, and our external debt, as a
proportion of GDP, much lower than in 1991. Importantly, the share of services
in the GDP was significantly lower in 1991 than in 2012 which is a source of
resilience, as service activity is less vulnerable to shocks than agriculture and
industry.
I was, of course, conscious of the risk of sounding too complacent or even
upbeat. So, every time I gave this reassuring message, I used to take care to
balance it with the warning that we had, by no means, insulated ourselves
against all future crises. There were several fissures in the macroeconomy which
against all future crises. There were several fissures in the macroeconomy which
needed to be fixed to keep the economy from derailing.
The feedback I got was that this message went down well with the markets.
The prime minister had seen media reports of my public comments and on more
than one occasion commended me in private for sending out such a measured
message, combining reassurance with a firm call to action to fix the growing
vulnerabilities.
Preserving credibility is the other big challenge in exchange rate management.
Loss of credibility can be costly for any institution, public or private, but the
stakes are much higher for central banks. If a central bank is credible, its actions
deliver the intended outcomes effectively; and if its credibility is low or
impaired, even good decisions fail to deliver results, which explains why central
banks attach so much value to maintaining their credibility. Nowhere is the
credibility issue more evident than in exchange rate management where, as
accumulated experience from central banks around the world demonstrates, a
failed defence can be worse than no defence at all.
Resisting currency appreciation and currency depreciation are both complex
challenges that test a central bank’s credibility, but between the two, the former
is arguably a better problem to have because of an important asymmetry that
goes largely unrecognized.
When a central bank is trying to prevent appreciation of its currency, it
intervenes in the market, buying forex by paying for it in the domestic currency,
thus increasing the supply of domestic currency and reducing its value. A central
bank’s war chest of domestic currency is, at least in theory, unlimited as it can
print any amount of the stuff it wants. There are, of course, negative side effects
to such an action. The domestic currency that the central bank unleashes into the
system in payment for the forex can fuel inflation, trigger asset bubbles and
threaten financial stability. These are admittedly costly to deal with, but to the
limited extent of exchange rate defence, the market can be in no doubt about the
virtually unlimited firepower of the central bank.
Fighting depreciation of the currency, on the other hand, requires the central
bank to sell forex from its finite reserves. If the central bank is seen to be losing
reserves even as capital continues to exit and the domestic currency continues to
fall, the nervousness in the markets can pull the currency down in a vicious
spiral. This is a bigger risk.
The possibility of a putative tipping point is another challenge in exchange
rate management. What is a tipping point? It is the point at which the floor caves
in, foreigners lose confidence in the currency and pull out ‘to cut losses’, setting
the exchange rate into a free fall. After May 2013 when the rupee slid sharply
with no reversal in sight, some commentators started speculating on what the
tipping point for the exchange rate might be—₹65 to a dollar? Or ₹70?
I was not persuaded by this tipping point argument. It is, in fact, possible to
turn the argument around. The tipping point could actually act as a floor, the
level below which the exchange rate will not go, because that will be a point at
which it becomes more costly for foreign investors to pull out than to stay in and
ride out the currency adjustment!

Criticism of Exchange Rate Management

The Reserve Bank’s action and inaction on the exchange rate front attracted
plenty of criticism which intensified as the rupee continued on its relentless
slide. This criticism was all over the map and straddled virtually every
dimension—policy, strategy, tactics and communication. Abstracting from all
the details, I can crystallize the criticism into two distinct strands. First, that I
was too hands-off, did not build forex reserves when there were copious capital
inflows in 2010 and 2011, and that failure had cost us dearly in managing the
exchange rate when it came under pressure in 2013. The second strand of
criticism was that the Reserve Bank’s defence of the rupee was too hesitant and
tentative, and lacked credibility. That, as governor, instead of projecting
confidence and resolve, I betrayed diffidence and ambiguity which, according to
this school of thought, undermined our efforts to arrest the slide.
As I look back on those anxious months from this distance of time, I see that
at least some of the criticism was valid. Perhaps this is an appropriate point to
explain where I was coming from, not so much to defend my record, but to
communicate some of the dilemmas I confronted as governor.
Take the first criticism that I did not intervene in the market when there were
capital inflows in 2010 and 2011, thereby failing to build a defensive buffer of
reserves for a future fight against exchange rate depreciation. What was worse,
by allowing the rupee to appreciate through my hands-off approach, I had dented
India’s export competitiveness.
India’s export competitiveness.
This alleged inaction on my part has to be evaluated in the context of the
Reserve Bank’s stated exchange rate policy, which is not to keep the rupee at a
certain level but only to tamp down volatility in the exchange rate. In other
words, during an episode of depreciation, for example, the attempt is not to
prevent the fall of the rupee but only to engineer the trajectory of the fall.
Admittedly, we had large inflows in 2010 and 2011, but there was no
volatility in the exchange rate; it was gradually moving up on the strength of the
inflows. Intervention under these circumstances, I believed, would not be
consistent with our stated policy. I felt obliged to walk the talk.
Besides, intervention under these circumstances would also involve a moral
hazard. As we were gradually opening up the external sector, it was important
that all market participants, in particular the corporates, learnt to manage
exchange rate risks. If the Reserve Bank were to step in every time the exchange
rate moved, they would never learn to cope with exchange rate movements and
would happily outsource their exchange rate risk management to the Reserve
Bank. Exchange rate panics are never pretty, but their virtue is that they restore
fear and humility to the market players.
My relative hands-off stance also arose from the view that intervention in the
absence of any evident volatility would be interpreted by the market as targeting
a specific exchange rate, notwithstanding assertions to the contrary by the
Reserve Bank. Believing that they are insured against exchange rate losses,
speculators will then make the rupee a one-way bet and we would become
vulnerable to being gamed.
I must admit that on the policy spectrum, my bias was towards non-
intervention; in other words, the weight of evidence had to be higher than normal
for me to approve intervention in the forex market. My staff as well as senior
officials in the government would sense this. All too often they would persuade
me to act, and the argument would be that in times of volatility, exchange rates
overshoot and intervention is important to correct the overshoot and bring the
rupee back to its equilibrium level.
The logical next question then is: what is the equilibrium exchange rate? It is
that level of the nominal exchange rate which corresponds to a neutral real
effective exchange rate (REER = 100). I did not find this argument persuasive.
First, it is difficult to detect overshoot in real time. Second, the neutral real
effective exchange rate has never been an anchor for the nominal rate. In other
effective exchange rate has never been an anchor for the nominal rate. In other
words, when the rupee had been relatively stable, the nominal exchange rate did
not correspond to the neutral real exchange rate. Also, if indeed there was an
overshoot of the exchange rate, it would correct itself, and intervention would be
an avoidable waste of scarce forex resources.
There are, of course, counterarguments on all these counts, but the bottom line
is that targeting the real exchange rate can be as complex and futile as targeting
the nominal exchange rate.
Many times during this period of turmoil, I had wondered about the gap
between the Reserve Bank’s stated exchange rate policy and its actions in the
forex market. For one, ‘volatility’ is the crucial word in the policy statement, but
we have never defined what we meant by that, or more specifically, what level
of volatility would trigger interventionist action. Analysts who track the Reserve
Bank’s behaviour would note that we had intervened in the market even when
there was a sharp one-way movement in the exchange rate. How does this square
with any definition of volatility in the policy statement? Is building reserves an
acceptable justification for intervention? If so, what according to the Reserve
Bank is the optimal level of reserves?
These questions would be standard fare in the countless situation room
meetings we had during those tumultuous months. My staff would concede that
the market could be bewildered by the Reserve Bank’s actions but would not
acquiesce in the idea that we should make our policy more explicit. Their main
argument was that the exchange rate is a sensitive and critical macro variable,
that the Reserve Bank should retain all flexibility to act swiftly and decisively,
and should not voluntarily become hostage to a more explicit and restrictive
policy statement. Besides, no central bank, they would contend, is transparent
about its exchange rate policy and it does not pay for any one country to be an
outlier, especially in a world of ‘currency wars’.
Notwithstanding the global acrimony over the currency wars, I believe there is
a case for the Reserve Bank to review and restate its exchange rate policy. I can
hardly attempt to outline a full policy statement here, but the revised policy
should be based on the following premises. First, the Reserve Bank should be
less interventionist than it has traditionally tended to be; in other words, it should
minimize the moral hazard by shifting more of the burden of adjustment to
exchange rate movements to market participants. Second, reflecting the less
interventionist stance, it should indicate more clearly what would be considered
interventionist stance, it should indicate more clearly what would be considered
‘excess volatility’ that would trigger intervention. Admittedly, the more
precisely ‘excess volatility’ is defined, the less flexibility it will leave for the
Reserve Bank. But I think more rules and less discretion will, in the long run,
yield sustainable benefits by better managing expectations and minimizing
opportunities for self-fulfilling, speculative behaviour. Finally, the Reserve Bank
should admit what is now evident to everyone, that building forex reserves is an
objective of exchange rate management, and in order to be credible, should
indicate the norms that will determine ‘adequate’ level of reserves.
A logical question would be: what prevented me from reshaping the policy as
above? The only explanation I can offer is that I was fully persuaded about the
imperative of reviewing the policy only after my experience with rupee tantrums
in 2013. But a change of policy when the exchange rate was on the boil would
have been absolutely the wrong thing to do. The exchange rate cooled only after
I left the Reserve Bank, not giving me a window of opportunity for any policy
re-engineering.
Let me turn to the second strand of the criticism, that during the entire rupee
episode, communication by the Reserve Bank, particularly by me as the
governor, lacked credibility and, therefore, what we were saying was shaking
rather than bolstering market confidence.
How indeed should the governor have spoken about the rupee? There were
some suggestions that the Reserve Bank should have been much more assertive,
more ‘alpha male’, as some commentators put it, like the Swiss National Bank
(SNB). Recall that the Swiss franc came under massive and sustained
appreciation pressure when the European Central Bank unleashed huge liquidity
into the markets to fight the sovereign debt crisis. The euros so released were
flooding the safe haven of Switzerland and putting upward pressure on the Swiss
franc. In the face of this, the SNB declared that it would not allow the franc to
appreciate beyond 1.20 francs to a euro.
The ‘alpha male’ imagery was striking but the parallel with the SNB was
misplaced. The SNB was seeking to prevent a potential appreciation of the franc
unrelated to their economic fundamentals; whereas we, in the Reserve Bank,
were engaged in preventing a sharp depreciation of the rupee driven largely by
economic fundamentals. There is, as I said before, an asymmetry between the
two battles. The SNB was in the fray from a position of strength, whereas we
two battles. The SNB was in the fray from a position of strength, whereas we
were battling from a position of weakness. More importantly, given the external
and internal pressures ranged against the rupee—elevated inflation, declining
growth, large fiscal deficits and the large and unsustainable current-account
deficit—it would have been very unrealistic, if also enormously costly, to draw a
line in the sand on the rupee exchange rate. We had necessarily to cross the river
by feeling the stones.
What or who exactly is an alpha male? I googled and was baffled by the
variation and confusion in the meaning and description of an alpha male. At this
point, it is not even clear to me whether I should take not being an alpha male as
a badge of honour or as a certificate of weakness. I have decided to let the matter
rest. But could I have been more confident, consistent and, importantly, more
tactful? With the benefit of hindsight, I can see that I could have done better on
all these criteria. Let me illustrate with some examples.
In the post-policy media conference in late July 2013, at the height of the
rupee crisis, I had said that the Reserve Bank’s actions were not aimed at
defending any specific exchange rate, but aimed only at facilitating an orderly
adjustment of the exchange rate to its market-determined level. As far as I was
concerned, this was just an unequivocal reiteration of the Reserve Bank’s
standard policy and should not have stirred any reaction. But the markets
decided that I had announced an immediate end to all intervention in the market,
and reacted sharply. My statement was seen as too dovish, maybe even as too
indifferent, and the rupee plunged to a three-week low within hours.
Needless to say, I was quite perturbed by the unsparing market reaction. Was I
guilty of fraying market nerves when I should actually have been soothing them?
I reflected on this overnight and used the opportunity of the post-policy
conference with analysts the following day to get the communication back on
track. I asserted that the Reserve Bank would use all the instruments at its
command to defend the rupee; I was careful not to make any reference to a
‘target rate’ or ‘volatility’, and added that we had enough firepower to stem the
rupee’s fall. The strategy worked. The statement helped assuage the concerns
raised by my previous day’s ‘hands-off’ approach, and within hours, the rupee
recorded its biggest intra-day gain of 2013.
I had another chastening experience in the context of the savage market
reaction to the capital controls imposed by us on corporates and individuals in
mid-August 2013 that I wrote about earlier. Note that these restrictions applied
mid-August 2013 that I wrote about earlier. Note that these restrictions applied
only to the capital that residents could take out; we did not curb the freedom of
non-residents in any way. Besides, at the level these facilities were being used,
they would not have been binding except in a very few cases. So these capital
controls triggered fear not so much because they were limiting on a stand-alone
basis, but because they were seen as prelude to more draconian controls down
the line.
I took the opportunity of the Palkhivala Memorial Lecture in late August 2013
to allay the fears on capital controls by reiterating that it was not the policy of
the Reserve Bank to resort to capital controls or reverse the direction of capital
account liberalization and that these measures were temporary and would be
withdrawn when the rupee stabilized.

Structural Causes of the Rupee Turmoil

The thrust of my communication effort all through this period was to drive home
a more basic message: India was running an unsustainable current-account
deficit by spending more on imports than we were earning from our exports.
What was worse, we were importing not capital goods that would add to
production capacity and help resolve our massive supply constraints, but were
importing unproductive goods like gold.
Just as a household cannot spend more than it earns unless someone is willing
to lend it money, even an economy cannot run a current-account deficit unless an
external party is willing to lend it foreign currency to finance the deficit. And the
more we depend on external financing—kindness of strangers, as it were—the
more vulnerable we become to ‘sudden stop and exit’, a phrase that has become
popular to describe a situation when external finance not only stops but even the
investment already made is withdrawn. In normal times, there are checks against
pressures building up to such unsustainable levels, as external financiers would
raise the price of funding and alert us to the impending implosion. The system
would self-correct through an exchange rate depreciation to limit the deficit to
the available external financing.
Such an adjustment did not take place in our case because these were not
normal times. Advanced economies were running historically easy monetary
policies to stimulate their economies and all the ‘quantitatively eased’ money
they were unleashing was flooding the global markets. This money was looking
they were unleashing was flooding the global markets. This money was looking
for quick returns, and short-term investments in emerging markets like India
looked like an attractive option. These investments financed our deficits, and in
the absence of the usual alert signals, we were lulled into complacency even as
pressure was building on the rupee. By not addressing our structural imbalances
and bringing the current account down to its sustainable level, we had set
ourselves up for an abrupt and painful adjustment. Finding a scapegoat in
Bernanke’s statement was politically convenient but, from an economic
management perspective, clearly misleading.
My view was that the government and the Reserve Bank could not, and indeed
should not, stand in the way of this adjustment as any such effort would be futile
and costly. On the other hand, the sooner the exchange rate correction was over
and done with, the sooner we would be able to make a fresh start. The effort of
the government and the Reserve Bank, I thought, should be focused only on
navigating the adjustment and guiding the exchange rate to its market-
determined level.
I had genuinely believed that acknowledging that a massive correction in the
rupee was unavoidable would not only manage expectations but also act as a
lesson for the future. In the event, this did not go down well and was interpreted
as being defensive and hapless.
After stepping down from the Reserve Bank, I reflected on my efforts at
communication during this crisis period. Some people have told me that I was
right on the message but wrong on the timing. In other words, I should have
deferred the message till after the pressure had subsided, and focused, during the
crisis, only on building confidence. I am not persuaded that this would have been
the right strategy. My message was clearly situated in the context of the crisis
and aimed at managing expectations. If that message had to be effective, it had
to be given during the crisis.

The Endgame

Notwithstanding the exchange rate defence launched by the Reserve Bank, the
bloodletting continued into August 2013. Adding to the domestic and external
economic factors, political economy developments too came into play. The most
significant was the threat of armed intervention in Syria in mid-August 2013
which caused crude oil prices to spike, and renewed the stampede of capital out
which caused crude oil prices to spike, and renewed the stampede of capital out
of emerging markets. These developments sent the rupee to its trough on 28
August when it sank 21 per cent below its 1 May level.
Several factors helped the recovery of the rupee starting early September. By
far the most important was that the adjustment had run its course; second, the
risk of a flare-up in Syria abated; third, the Fed announced that it was postponing
the taper indefinitely.
Finally, the scheduled leadership change at the Reserve Bank and the
formidable reputation of my successor, Raghuram Rajan, helped restore
confidence in the Indian markets. In fact, as chief economic adviser to the
government, Raghu was on board all through the exchange rate turmoil and was
more actively involved in all the decisions after he was named in early August as
my successor.
As we approached the close of my term in the first week of September, Raghu
and I had both agreed that the next steps should be to open a special forex
window for oil companies and incentivize our commercial banks to raise tier-2
capital through their branches and subsidiaries abroad, and swap the dollars for
rupees with the Reserve Bank at a premium. Raghu was kind enough to offer
that I announce these measures before signing off. But I thought that the
measures would be more effective if he announced them as the incoming
governor. At least on this issue, my judgement worked!

Do Nothing in Defence of the Exchange Rate?

Let me conclude my experiences of steering the rupee in turbulent waters by


reiterating a standard dilemma. Given my position that a sharp correction of the
exchange rate was programmed and forex intervention by the Reserve Bank
would only postpone the inevitable, wouldn’t it have been more rational to just
stay put till the adjustment had been complete?
Albert Edwards of Société Générale had an interesting analogy from football.
‘When there are problems, our instinct is not just to stand there but to do
something. When a goalkeeper tries to save a penalty, he almost invariably dives
either to the right or the left. He stays in the centre only 6.3 per cent of the time.
However, the penalty taker is just as likely (28.7 per cent of the time) to blast the
ball straight in front of him as to hit it to the right or left. Thus, to play the
percentages, goalkeepers will be better off staying where they are about a third
of the time. They would make more saves.’
But goalkeepers rarely do that. Because it is more embarrassing to stand there
and watch the ball hit the back of the net than do something (such as dive to the
right or left) and watch the ball hit the back of the net.
The Reserve Bank is like a football goalkeeper. It knows that ‘do nothing’ is
the best course. But it can’t just stand pat.5, 6
8
The Signal and the Noise
The Challenge and Opportunity of Communication

One of the nice things about being a central bank governor is that the markets
hang on every word you say, treating every syllable, nuance and twitch of the
face as a market cue. One of the stressful things about being a central bank
governor is that the markets hang on every word you say, treating every syllable,
nuance and twitch of the face as a market cue. That about sums up both the
opportunity and challenge of central bank communication.
I believe there would be virtually no central bank governor who has not taken
an ego trip on the magic of his spoken word or rued the fallout of some
miscommunication. Experience helps, but is no guarantee against markets
deciding that you said something different from what you believe you’ve said. I
learnt along the way; and maybe, even the hard way. Before I write about my
own experiences with communication, some broader context maybe useful.

The Power of Central Bank Communication

There are powerful examples from around the world of how central banks have
exploited the power of their communication to enhance their policy
effectiveness. Hours after the 9/11 terrorist attacks in the United States in 2001,
the Federal Reserve put out a simple statement: ‘The Federal Reserve System is
open and operating. The discount window is open to meet liquidity needs.’
These two seemingly banal sentences, coming so soon after the attacks, had a
remarkable calming effect on the US financial markets, and by extension, on the
global financial markets. The ‘announcement effect’ was striking.
Similarly, in the midst of the eurozone crisis when the collapse of the euro
seemed imminent, it was the European Central Bank President Mario Draghi’s
famous words in April 2012 that the ECB will do ‘whatever it takes’ that did
famous words in April 2012 that the ECB will do ‘whatever it takes’ that did
more to save the euro than all the exhausting summits, emergency conclaves and
emphatic communiqués of the eurozone leaders. Or take the case of the
unconventional monetary policy (UMP) of the US Federal Reserve in the wake
of the financial crisis of 2008. Analysts are now widely agreed that the UMP
would have been futile had it not been accompanied by unconventional
communication aimed at reassuring the markets that the exceptionally easy
money regime will be maintained over an ‘extended period of time’.
The positive impact of communication is not limited to crisis times, however.
The received wisdom today is that greater transparency, active outreach and
more open communication are always positive for central banks; the impact, of
course, is more dramatic during crisis times.

Central Bank Communication—Old and New Orthodoxies

Given the potency of their communication, one would have thought central
banks would have actively embraced communication as a valuable policy tool.
The reality has, in fact, been quite the opposite. Until quite recently, the
conventional role model prescribed for central banks has been that they should
remain strictly in the background, and if their policies are credible, they would
speak for themselves. Governors themselves should be backroom boys, speak as
little as possible and when they do speak, they should do so with extreme
circumspection.
A telling illustration of this old-school model comes from what Greenspan,
then chairman of the Federal Reserve, said in 1987: ‘Since becoming a central
banker, I’ve learnt to mumble with great incoherence. If I seem unduly clear to
you, you must have misunderstood what I said.’
The caution to central banks on communicating during crisis times was even
more dire. In his bestselling book, Lords of Finance, a detailed and compelling
account of the role played by four central bank governors (of France, Germany,
the US and the UK) during the Great Depression of the 1930s, Liaquat Ahamed
says that in times of crisis, the advice to central banks used to be to follow what
mothers, cutting across cultures, tell their children when guests are expected: ‘If
you can’t say anything nice, don’t say anything at all.’ This followed from the
fine line that central banks have to tread between being reassuring without being
dishonest.
So, what explains this remarkable shift in the theology of central bank
communication from deliberate obscurity and caution to active engagement and
transparency? There were three broad factors behind this. The first was the
growing notion that in a democratic society, a central bank that prizes its
independence has also to be conscious of its obligation to render accountability.
An important way of doing this is for the central bank to explain its policies, the
thinking underlying these policies and the expected outcomes so that the larger
public can hold it to account for results.
The second factor that drove this shift towards more open communication was
the realization that successful monetary policy is not just a matter of effective
calibration of overnight interest rates, but also about shaping expectations on
how those policies influence real-sector variables like growth and employment.
As citizens, we are all consumers of information put out by government
departments and public agencies. But the information put out by a central bank is
different from all the rest, and in an important way. Assume, for example, that
we are talking not about the central bank’s monetary policy, but about, say, the
government’s rural development policy—in particular, a decision by the
government to connect every village with an all-weather road. It does not matter,
except of course for reasons of electoral politics, whether the government
announces this decision through a high-profile press conference on the TV or
through a low-key press release or even if there is no prior announcement. When
the road is built, people will benefit from it whether or not they knew about it in
advance. It is different with monetary policy. If people know in advance how
inflation and unemployment will unfold on the way forward, they will change
their behaviour in ways that will be supportive of these outcomes. For example,
if workers expect lower inflation, they will demand lower wage rises that will
keep costs low and prices subdued, thereby actually delivering the low inflation
outcome that the central bank wants. This type of behavioural response
reinforces the need for central bank communication to shape expectations for the
way forward.
The third factor that chipped away at the restraint of central banks towards
more open communication was that the conventional wisdom about being
reticent during crisis times turned on its head. Contrary to the notion of the
reticent during crisis times turned on its head. Contrary to the notion of the
1930s depicted by Liaquat Ahamed, modern central bankers have found that in
an atmosphere of anxiety and uncertainty, levelling with the markets—far from
stoking fears—had actually helped to allay concerns and bolstered confidence.
The difference arises from the vast changes between the 1930s and today by way
of global integration and communication technology. Market participants today
attach enormous value to knowing the true state of the economy and of the
financial sector, no matter that it might be bad, as it allows them to make the
necessary adjustment.
This is best illustrated by the dilemma that Bernanke talks about in his book,
The Courage to Act, on the issue of releasing the results of the bank stress tests
that the US regulators had conducted in the aftermath of the crisis. On one side,
he writes, there were apprehensions that disclosing banks’ weakness could
further erode confidence, possibly leading to new runs and even sharper decline
in bank stock prices. On the other hand, there was the prospect that releasing as
much information as possible would reduce the ‘paralyzing uncertainty’ about
banks’ financial health. In the event, releasing the results in full had a salutary
impact on confidence in the US banking system, a clear reinforcement of the
new orthodoxy about central bank communication during stress times.

Communication Practices at RBI

As an institution, the Reserve Bank is deeply sensitive to its responsibility to


communicate with the public, not just on monetary policy but on the entire range
of its broad mandate—financial market developments, external sector
management, regulatory issues, printing and distribution of currency and
development issues. The Reserve Bank uses a variety of communication tools—
governor’s post-policy media conferences, interviews with the governor and
deputy governors, speeches of the top management, press releases and lately,
increasing dissemination through its website. In many respects, the Reserve
Bank I inherited was ahead of even its advanced country peers in terms of
communication. When Fed Chairman Bernanke held a media conference in
2011, it was reportedly the first in over thirty years, whereas the governor’s post-
policy media conference has been a regular feature in the Reserve Bank for at
least a decade.
Even as the Reserve Bank set best practices in several dimensions of
Even as the Reserve Bank set best practices in several dimensions of
communication, I felt that we were still falling short, especially on two
dimensions. First, our communication, except for the media conferences, was
largely one way. We spoke but did not listen enough, much less engage in an
active conversation. Second, we were not making sufficient effort to reach out to
the larger public by communicating at a level and in a language accessible to
them. Early on, I resolved that I should put a lot of effort into ‘demystifying’ the
Reserve Bank, a topic I’ve addressed separately.

Forward Guidance on Monetary Policy


Giving forward guidance on monetary policy was a big, if also challenging,
institutional innovation introduced during my time. At the heart of forward
guidance is an indication by the central bank of how it would react to the
evolving macroeconomic developments so as to shape market expectations and
allow market participants to make the necessary adjustments.
In central bank circles, forward guidance on monetary policy has been a
contentious issue and indeed remains so. It would figure frequently in the formal
discussions and informal conversations at the BIS bimonthly meetings of
governors in Basel, Switzerland. Even as central banks, as I’ve written earlier,
embraced more open communication, there remained a view that giving forward
guidance was taking openness too far. Some central bankers took a strong
position, holding that surprise was an essential element of monetary policy and it
would be foolhardy for central banks to voluntarily give up that weapon. There
were others who were less robustly opposed; they were circumspect about
making a policy commitment that they may not be able to honour.
The crisis tilted the cost-benefit calculus of forward guidance. Central banks
discovered, to their pleasant surprise and I may add, enormous relief, that in a
time of unprecedented uncertainty and anxiety, a carefully crafted forward
guidance can yield rich dividends by way of calming the markets and nudging
market behaviour in the desired direction. By far the most high-profile example
of forward guidance was the one given by the Fed that the federal funds rate
would be maintained at an exceptionally low level ‘for an extended period’.
At the Reserve Bank, we deliberated internally on whether to adopt the
practice of forward guidance. We recognized that it would not be a totally
benign option but decided to go ahead nevertheless, because we felt that the
benign option but decided to go ahead nevertheless, because we felt that the
benefits outweighed the costs, especially in a situation of continuing global
uncertainty and India’s contrarian macroeconomic developments.
The forward guidance is typically one short paragraph in a six-to-eight-page
policy document, but we realized that crafting it can be a test of communication
skills. Aware that there is a minor industry that sustains itself by parsing these
few sentences in great depth and probing for coded messages behind plain
English, we spent a disproportionate amount of time debating the exact choice of
words, the precise turn of phrase and alternative ways of nuancing. Such
agonizing might seem absurd to the uninitiated, but it always proved to be
efficient use of time.
Along the way, we discovered several inherent challenges in giving forward
guidance. For one, a central bank’s indication of how it would act in the future is
typically contingent on economic developments. But markets tend to ignore the
caveats, and interpret the guidance as an irrevocable commitment, with the result
that they find themselves wrong-footed when the actual outcomes do not turn out
as expected. For example, in our policy reviews both in October and December
2011, we said that ‘the cycle of rate inverses had peaked and further actions are
likely to reverse the cycle’. This generated a widely shared expectation of a rate
cut in the January 2012 policy meeting, an expectation that did not materialize
because inflation had not trended down as earlier thought. Even though our
‘inaction’ was consistent with the guidance, the market was unforgiving and
believed we had reneged on our commitment.
Moreover, it is when financial conditions are uncertain that markets want
greater and more specific guidance, but paradoxically it is precisely when
financial conditions are uncertain that central banks are least able to deliver. Let
me cite an example to illustrate this dilemma. In our November 2010 policy
statement, we said: ‘Based purely on current growth and inflation trends, the
Reserve Bank believes that the likelihood of further rate action in the immediate
future is relatively low. However, in an uncertain world, we need to be prepared
to respond appropriately to shocks that may emanate from either the global or
the domestic environment.’
Our guidance was situated in the context of domestic uncertainty about
agricultural prospects and their impact on growth and inflation, as well as
external uncertainty arising from the eurozone sovereign debt crisis. Many
analysts thought the guidance, especially alerting markets to possible rate action,
should actual outcomes deviate from the expected ones, was helpful; a few,
however, thought that it was too vague to be of any use.
Mixed experience with forward guidance has not been unique to India. Many
advanced economy central banks, too, had come under criticism for what they
said, how they said it and for their inability to honour the guidance. The Bank of
England had said in 2013 that interest rates would not be raised until
unemployment came down to below 7 per cent and added for good measure that
that was not likely to happen until 2016. But unemployment in the UK dropped
below 7 per cent as early as in 2014 even as the BoE was not ready to raise rates.
Technically, the BoE had not strayed from its commitment, since the
unemployment rate was only a necessary, but not a sufficient, condition for rate
raise. Regardless, some analysts criticized the bank for reneging on its guidance.
The experience of the Bank of Japan with its quantitative and qualitative
easing (QQE) is a more recent illustration of the challenge of managing forward
guidance. Under the much-acclaimed QQE launched in April 2013, the BoJ set
an inflation target of 2 per cent to be achieved in two years. Successive policy
statements of BoJ kept asserting how the bond-buying programme under the
QQE was consistent with the 2 per cent inflation target, even as other numbers
put out by the BoJ seemed to be acquiescing in the timetable for the inflation
target slipping away.
At RBI, as we moved on, I realized that markets demand not just guidance but
also ‘guidance on guidance’—in other words, an explanation of what the
guidance means. This can be tricky because, as I said, a lot of thought goes into
crafting the guidance and attempts to further explain risk distorting the message.
For instance, in the post-policy media conference following the November
2010 guidance I cited above, I was pushed to elaborate on what we meant by
‘immediate future’. I could have stonewalled the question but that was not my
practice. I replied that what we implied by ‘immediate’ was around three
months, thereby implying, although not saying so explicitly, that we would stay
away from a policy rate hike in the December 2010 mid-quarter review which
was six weeks away and consider a hike only at the next quarterly policy review,
three months away. This elaboration triggered criticism that a three-month pause
implied by the guidance was too dovish and did not sit tidily with our statement
on risks to inflation. We could have avoided all this by refraining from giving
on risks to inflation. We could have avoided all this by refraining from giving
any guidance at all, but we persisted with it as we believed that we owed this
obligation to the markets.
There are parallels from advanced economies on ‘guidance on guidance’ too.
The Fed, for instance, had said in 2014 that it would be ‘patient’ in increasing
interest rates, a comment which set off a flurry of speculation on what ‘patient’
meant. Rarely had investors lavished so much attention on a single word. When
pushed to explain what ‘patient’ meant in Fedspeak, Janet Yellen, the
chairperson of the Federal Reserve, interpreted that as ‘not raising rates for at
least two meetings’. In the event, the Fed honoured this commitment but it is
quite possible that macroeconomic developments could have pushed it to renege
on this.

Monetary Policy Documents

Another significant improvement in monetary policy communication that came


on my watch was the streamlining of the policy documents. This initiative owes
to Subir Gokarn who joined us as deputy governor in charge of economic and
monetary policy, in November 2009. Subir told me shortly after coming on
board that while the Reserve Bank’s policy documents were rich in analytical
content, they needed to be streamlined by way of cutting out overlap and
repetition, making the language more direct and simple, and most of all,
significantly trimming the length of the documents.
In his prior career as a leading analyst and commentator on India’s
macroeconomic policy, Subir was an avid consumer of the Reserve Bank’s
policy documents and he spoke from rich personal experience. I wholeheartedly
supported the initiative as it was consistent with my goal of extending the
outreach of RBI policies. My yardstick was that chief executives in the finance
and corporate sectors, who are put off by the language and length of our policy
documents and depend instead on summaries prepared by their staff, should now
feel encouraged to read the original documents themselves. In addition to
changing the style and presentation, we agreed on new standards in terms of
length—a maximum of sixty pages for the money macro document and twelve
pages for the governor’s policy statement.

My Experiments with Communication


My Experiments with Communication

I have already written about my several communication missteps as I traversed a


steep learning curve as governor. During the early part of my tenure, while
battling the global financial crisis in 2008, I underestimated the importance of
the governor frequently reassuring the market; instead, I yielded the stage to
others, thereby letting all the noise distort the message. While combating
inflation during 2010–11 when growth was also seen to be stalling, I had openly
mused about the nuances of the growth–inflation trade-off instead of showing
undivided commitment to inflation control. It was in managing the exchange rate
during 2012–13 though that my communication faculties were put to the most
gruelling test. I realized that what you said, or didn’t say, was important, but
how you said it and when was even more important. Let me illustrate.
Recall that on 15 July 2013, in the midst of the taper tantrums, I took the
extraordinary step of raising interest rates to manage the exchange rate. Quite
understandably, the decision attracted a lot of commentary and the usual share of
compliments and criticism. We had a regularly scheduled quarterly policy
review on 30 July, just two weeks after the above unscheduled policy tweaking.
In the scheduled review, I saw no case for any further policy adjustment; we just
reiterated our concern about the need for correcting the domestic structural
imbalances to bring stability to the external sector.
The post-policy media conference that afternoon was to be my last as
governor. For a long time I had been looking forward to this conference,
expecting that it would be along the lines of a farewell engagement. Instead of a
serious question-and-answer session on substantive issues, we would spend
much of the time reminiscing about my five years as governor. That wasn’t to
be.
That the exchange rate issue would dominate the media conference was also a
no-brainer. Sure enough, the first question was whether and when the monetary-
tightening measures instituted to manage the exchange rate would be withdrawn.
As I wrote earlier, the intent behind this unusual action was to squeeze systemic
liquidity in order to curb speculation on the rupee, and thereby send a strong
signal to the market about the Reserve Bank’s resolve to defend the currency. I
replied that these measures were temporary and would be rolled back once the
exchange rate regained stability. On the timing of the rollback, I said that the
Reserve Bank was sensitive to the short-term economic costs of tight liquidity
Reserve Bank was sensitive to the short-term economic costs of tight liquidity
but that I was in no position to get locked into a time frame for the rollback. My
intention was to allay market fears that the tight liquidity policy of the Reserve
Bank would choke the incipient growth impulses in the economy in the midst of
growing concerns about rapidly declining economic activity.
The market reaction to my response was unsparing; the rupee fell from ₹59.63
to a dollar to ₹60.48 by market closing that day. According to media analysts
and commentators, I sounded apologetic about my decision to use monetary
policy for exchange rate defence and that my concern for growth was misplaced
in a context when the market expected the Reserve Bank to be focusing on the
exchange rate to the exclusion of all other concerns. Here is how the Financial
Times of 1 August 2013 reported my statement: ‘The Governor insisted he was
not trying to defend the battered rupee but only stopping a vicious spiral of one
way bets that could lead the currency to overshoot its fair value.’
As I look back, I realize that I may have been guilty of a communication
misstep. I should have known that at a time when the rupee was under such
pressure, being firm and assertive on the exchange rate was way more important
than holding out reassurance on growth. Moreover, I muffled the message by
openly deliberating on other concerns when I should have shown undivided
focus on the exchange rate.
At the same time, I was also puzzled by the market reaction since my reply
was almost exactly along the lines we had stated in the printed document. I
checked with Harun Khan, deputy governor, Alpana Killawala, the
communications chief, and a few other colleagues. The consensus view was that
the criticism of ‘apologetic tone’ stemmed not so much from the precise content
of the reply rather than from the nuance and perhaps the body language.
Even as I was close to finishing my job as governor, I had yet to learn a rookie
lesson in communication: markets don’t take what the governor says at face
value. At least, I had learnt to be opportunistic! I used the analysts’
teleconference the following day to correct this misinterpretation. While replying
to a related question, I asserted the ‘Reserve Bank’s single-minded commitment’
to stabilizing the rupee, and added that in the given context, the benefits of rupee
stability outweighed any short-term sacrifice of growth. This was entirely
consistent with what I had said at the media conference the previous day, but
rephrasing it this way conveyed the message in the form that the market wanted
to hear. I corrected for the nuance too. The previous day, I had said that these
measures will be withdrawn when the rupee became stable. Now I turned around
the nuancing to affirm that that these measures will not be withdrawn until the
Reserve Bank had firm evidence that the rupee had stabilized. Perhaps that
sounded alpha male enough. The market reacted positively and the rupee swiftly
reversed the losses of the previous day.
It was fortuitous that there was an analysts’ conference the following day
offering me an opportunity to regain control of the narrative. What would we
have done in the absence of such coincidence? Very rarely do central banks
issue rejoinders on the statements by their governors or the senior management,
and when they do, it is mostly to correct a misquotation rather than a
misinterpretation. I found that the best way to correct a misinterpretation is to be
opportunistic and slip in the ‘guidance’ slyly in a doorstop interview or in a
speech.
For example, in early December 2011, we noticed that the daily aggregate
borrowing by the commercial banks from the Reserve Bank’s LAF window had
suddenly spiked, breaching the indicative norm (1 per cent of NDTL) for several
days in a row. This tightness arose from a combination of circumstances,
including advance tax payments which have the effect of shifting money from
open circulation to the government’s account with the Reserve Bank. This was
also a time when the rupee was under pressure and we were intervening in the
forex market fairly regularly. Since we were selling dollars for rupees, our
intervention was squeezing out rupee liquidity and adding to the liquidity
tightness.
In a media interview in Kolkata later in December, following the Reserve
Bank board meeting there, I had acknowledged that systemic liquidity was tight
and said that we would be taking action to ease the situation. There were many
options open to the Reserve Bank to ease liquidity, and withdrawing from the
forex market was by no means the sole option. However, the market decided that
I had declared my intent to stop forex intervention with immediate effect! I was
frustrated by this tendency of the market to look for coded messages behind
plain English, a clear example of what psychologists call ‘confirmation bias’, the
market hearing not what was said, but what it wanted to hear.
Since this misinterpretation would distort market expectations, it was
Since this misinterpretation would distort market expectations, it was
important for us to correct it. At the same time, it would have been
uncharacteristic—and perhaps not expected—of the Reserve Bank to issue an
explicit clarification. I was looking for an early and unobtrusive opportunity to
correct it and it came a few days later when I was scheduled to speak at the
annual convention of the Institute of Chartered Accountants of India (ICAI) in
Mumbai.
By this time, over three years into my job, I was quite familiar with the
standard drill of the governor’s public-speaking engagements. As soon as the
inaugural session where I would typically be featured draws to a close, when the
delegates are breaking for coffee and I would be getting off the stage, the media
attending the conference would mob me for a question-and-answer session. TV
cameras would start rolling, still cameras would be clicking and flashing, and
dozens of mikes would jostle for space in front of my face. I had routinely
discouraged such impromptu media interviews for a number of reasons,
including my realization that the media would flash what I said on the sidelines
rather than what I had just said in the scheduled speech. I always felt that this
was unfair to the hosts of the conference who are entitled to media coverage of
their event.
Occasionally, I would break my discipline though, if only to use the
opportunity to slip in a message that I wanted to. This time around, for example,
after the inaugural session of the ICAI convention, when I was mobbed by the
media for a ‘quick sound bite’, I had said that we would use all the instruments
available to us, including intervention in the market, to check the rupee
volatility, thereby delinking exchange rate action from liquidity management
action.
Through the five years I was at the Reserve Bank, I had accumulated my share
of mistakes, both on policy and the communication of that policy—more than
my share maybe, according to some critics. Viewed from a cosmic perspective,
communication mistakes are, in general, less egregious than policy mistakes, as
their impact on the markets would typically be transient and the long-term
economic damage quite minimal. Even so, ironically, it was my communication
mistakes that weighed me down more than my policy mistakes. Might it be that I
thought they were avoidable or that they damaged my personal credibility much
more, at any rate in the short-term? As I write this two years after I have left the
Reserve Bank, I am still unable to be objective about this assessment.
Reserve Bank, I am still unable to be objective about this assessment.
It is some comfort though that virtually every central bank governor has his or
her share of communication mistakes or gaffes. Some are more publicized than
others. The most recent example, as I write this, comes from Mario Draghi, the
president of the ECB who, despite a formidable reputation for his savvy
communication skills, seems to have fallen short in anticipating the market
reaction to what he said in a post-policy media conference in December 2015. In
the backdrop of the stalling eurozone economy at that time, the market
expectation was that the ECB would top up its ongoing quantitative easing by a
weighty stimulus. The ECB did come up with some easing but the market
shrugged it off as too feeble. What riled the markets even more was the
statement by Draghi in the press conference that what was done was ‘adequate’.
The markets reacted sharply to these dashed hopes of stronger monetary
stimulus with a wave of selling that rippled from Frankfurt to Paris, to Madrid
and Milan. Draghi corrected for this by asserting just a few days later that ‘there
is no particular limit to how we can deploy all our tools’. The Wall Street
Journal wrote: ‘Mr. Draghi’s comments were an attempt to fight the market’s
reaction to the policy meeting. The content of the speech is not enough to
reverse yesterday’s “own goal” but it does represent something of a pushback
against tightening monetary conditions.’
In his book, The Courage to Act, Bernanke admits to some communication
mistakes as he was traversing up the learning curve. He writes that in April
2006, when he was at a social event, he vented his frustration on a well-known
TV anchor about the markets misinterpreting his recent testimony to the
Congress. He thought this conversation with the anchor was off the record, but
she didn’t think so and reported the remark which played up in the media as
Bernanke ‘reversing himself’ and suggesting that interest rates could actually go
up at a time when he actually wanted to convey the opposite message.

Lessons from the Communication Experience

Learning is an unending task and my education in communication continued all


the way to the close of my tenure.
I learnt, for example, that being too direct or explicit is sometimes
inadvisable. In the post-policy conference on 30 October 2011, I was asked
whether the Reserve Bank would intervene in the forex market to build up forex
whether the Reserve Bank would intervene in the forex market to build up forex
reserves, and I gave an ‘in the face’ answer: ‘No, we would not.’ My answer
should not have surprised anyone or caused anxiety since I was just stating the
obvious: that the only condition, under the Reserve Bank’s declared policy
which would trigger forex intervention was exchange rate volatility. However,
the rupee came under heavy pressure the next day and some analysts faulted me
for being too explicit and suggested that no matter what the intent, I should not
be such a ‘straight bat’.
I had also learnt, indeed several times over, that nothing the governor says is
off the record no matter when and in what context you are saying it. For
example, in mid-January 2013, I was speaking at IIM Lucknow and explaining
to the students how the tension between growth and inflation is overplayed and
why low and steady inflation was a necessary condition for sustained growth.
This was just a couple of weeks before our scheduled policy conference on 29
January and there was more than the usual media buzz about what we might do
with the interest rate, especially since Chidambaram had openly criticized the
Reserve Bank after our previous policy meeting in October for abandoning him
to ‘walk alone’.
My remarks to the IIM students were not situated in the ‘here and now’
context; my intent was to convey to them the broader dilemma of making a
judgement call on a complex policy issue. The media would have none of it.
They interpreted my comments as further policy tightening in the upcoming end-
January policy review, and the news was on the wire agency tickers even before
I finished speaking. Several of our usual interlocutors chided me for not
realizing that that there was no question of the governor ever speaking ‘in an
academic context’.
And finally, I learnt of the need to shape my message better to ensure fuller
and accurate coverage. For example, at the BANCON 2010, an annual bankers’
conference, I focused my comments on the efficiency of the Indian banking
system, while covering a host of issues, including the relative efficiency of
public and private banks, their asset-liability management, credit standards and
customer service, as well as the use of technology. In passing, I made a comment
on the salary structure of public sector bank chiefs and said that it needs to be
reviewed in order to attract talent.
I was perplexed by how the media reporting made it look like I had devoted
the entire speech to bemoaning the salary structure of public sector bank CEOs
and how, in my view, fixing it was critical to improving the efficiency of the
Indian banking system. The Mint, in its edition of 8 September 2010, reported on
my speech with the bold headline: ‘Subbarao favours higher salaries for chiefs of
state-run banks’. In follow-up articles and opinion pieces, there was extensive
comparative analysis of the salary structure of public, private and foreign bank
CEOs. Some lateral-thinking media analysts even put the measly salary of the
Reserve Bank governor in their comparative charts. In an analytical piece titled
‘RBI Governor earns less than 5 percent of top paid bankers’, the Economic
Times of 5 September 2010 wrote: ‘In an irony of sorts, RBI gets to approve the
salaries of all top level bankers in the country but the central bank’s top officials
themselves get less than 5 percent of what is paid to bank chiefs.’ Admittedly,
much of this reporting was constructive, but I still felt that the larger issues of
banking system efficiency should have made it to the commentary.

Metaphors and Humour

I quickly learnt a few other things. The use of metaphors and humour often
helped in making a point or evading a tricky question. In the summer of 2010,
we were all in Thiruvananthapuram for the RBI Board meeting. Because of the
drought in the previous year, there was nationwide anxiety about how the
monsoon might turn out that year. This was also the time when we, in the
Reserve Bank, were engaged in exiting from the accommodative policies of the
crisis period which acquired additional urgency in view of inflation picking up
momentum. Adjusting interest rates to subdue inflation and stimulate growth can
be a tough job at the best of times but can get much tougher when the monsoon
—some 60 per cent of India’s farms are rainfed—fails.
In the media interaction following the board meeting, there was the inevitable
question about whether the Reserve Bank would tweak its ‘exit path’ in view of
the monsoon prospects. Instinctively, what came to my mind was a book I had
read several years ago—Chasing the Monsoon by Alexander Frater—a
fascinating account of the New Zealander’s journey across the Indian
subcontinent in pursuit of the monsoon. Frater’s romantic adventure, quite
expectedly, starts in Thiruvananthapuram, where we then were. In answer to the
question on the monetary policy stance, I replied that like millions of farmers
across the country, we in the Reserve Bank too were chasing the monsoon. The
media decided that I had answered their question. Perhaps they liked the imagery
of the RBI governor sitting alongside farmers under a village tree, looking
skywards for guidance on the interest rate policy. Here is a citation from a
feature story, ‘RBI’s Subbarao Chases Monsoon’, in the online edition of the
Wall Street Journal:
All RBI governors face this problem [of inflation caused by rising food prices on account of
weak rainfall]. But it has a special resonance for Mr. Subbarao, as he discussed with reporters
last week . . .
. . . District collectors and sub-collectors play an important role when it comes to rains and
water. They assess the ground situation to decide whether to declare a drought or to declare a
flood—two events often generated by the monsoon rains, or lack of them.
It was during that time that Mr. Subbarao realized ‘my emotional well-being, my career
prospects depended on rains,’ he said at the RBI function.
Nearly four decades later, he remains hostage to the monsoon.
Now at the end of my career as the Governor of Reserve Bank, I realize that (my) entire
performance will depend on the monsoon and not what I do about interest rates,’ Mr. Subbarao
quipped. ‘If there is good monsoon, it is ok. Otherwise the Governor of the Reserve Bank is to
be blamed.’

Humour also helps in making a point. I was asked once if I consult the finance
minister on monetary policy decisions. I replied, no, I mostly decide by the toss
of a coin: heads I raise rates; tails I cut rates, and if the coin lands on the edge, I
consult the finance minister.
Humour also aided me in responding to criticism on the confusion about
which measure of inflation the Reserve Bank was using. During my time, we
were using wholesale price index inflation as the fulcrum of monetary policy
instead of Consumer Price Index inflation which is, in fact, what people
experience in the marketplace. This was clearly a second-best option but we
were handicapped by the fact that there was no single CPI representative of the
whole country. In fact, the Reserve Bank, on my watch worked with the
government to develop two all-India CPIs—one for rural and the other for urban.
Even as the new indices were brought into force starting January 2011, we could
not shift immediately to CPI inflation-targeting for want of long enough
historical data series. To facilitate the transition though, our monetary policy
documents contained analysis of both CPI and WPI inflation. Some confusion
was inevitable in this transition, but the analysts understood what we were trying
to communicate. Nevertheless, there was criticism about this confusion.
I used my inaugural speech at the Annual Statistics Day celebrations in 2012
to respond to this criticism by deploying one of my hair jokes. I said: ‘Most
analysts think that I am unable to interpret inflation. There must be some truth to
that because even at a personal level, I am failing on that count. Twenty years
ago, when I had a thick mop of hair, I used to pay ₹25 for a haircut. Ten years
ago, after my hair started thinning, I was paying ₹50. Now, when I have
virtually no hair left, I pay ₹150 for a haircut. I struggle to determine how much
of that is inflation and how much is the premium I pay the barber for the
privilege of cutting the governor’s non-existent hair.’
Humour, of course, is not always benign and can land you in tricky situations
as I realized once while talking about financial stability. During the crisis,
financial stability was an ‘elephant in the room’ type of issue with extensive
dissection of the topic by policymakers, media analysts and academic scholars.
What vexed everyone though was that a clear definition of financial stability
proved to be elusive.
I was at a panel discussion in Hyderabad in August 2009 as part of the
Reserve Bank’s platinum jubilee celebrations where the topic of financial
stability, in particular its definition, came up. I said: ‘Financial instability is like
pornography; you know it when you see it.’ Most people thought that I had
conveyed the message to great effect although some said that this was not
dignified centralbankese.
Of all my experiments in humour, the one that got the most play was what I
said about constituting a committee to advise me on whether the Reserve Bank
should pay interest on the cash reserve ratio. As I wrote earlier, the Reserve
Bank locks up a prescribed portion of each bank’s deposits as a monetary as well
as a prudential measure—to be released to the bank if ever it gets into liquidity
pressure. Banks don’t like this. Their grievance is that not only does the Reserve
Bank lock up their money, but it doesn’t even condescend to pay any interest on
that! In the summer of 2012, the CRR issue heated up, with the staid but mature
Pratip Chaudhuri, chairman of State Bank of India, arguing for payment of
interest, locking horns with the gutsy and irascible Reserve Bank Deputy
Governor K.C. Chakrabarty, himself a former commercial banker, who was
totally dismissive of the idea.
totally dismissive of the idea.
The annual FICCI-IBA banking conference, usually held in September, is a
premier event that brings together corporate and banking sector leaders to
deliberate on issues of mutual concern. The hosts extend the courtesy of
inaugurating the conference to the governor and I had the privilege of doing so
for five years on the trot.
In the September 2012 conference, I was going to speak about the challenges
of implementing Basel III banking regulations in India. As I got up to speak, I
told the audience, with a grim face, that I had an important announcement to
make before moving on to my prepared speech. I continued: ‘Before coming to
this event, I just signed off a paper constituting a committee to advise the
Reserve Bank on payment of interest on CRR.’ Some reporters present at the
event texted my remarks to their anchors and editors even before I finished, and
very shortly the news was on some wire agency tickers and TV scrolls.
Obviously, oblivious to the stir that I had unwittingly created, I went on: ‘The
members of the committee will be Deputy Governor Chakrabarty and SBI
Chairman Pratip Chaudhuri. They will both be locked up in a room, and will not
be let out until they have reached an agreement. Also they are mandated not to
reach an agreement until my tenure is over.’ The audience broke into laughter.
And as the reporters got the joke, they rushed to withdraw their earlier messages
so as to cut losses.
Following the event, there was the usual complement of bouquets and
brickbats. Some thought that I had used humour effectively to extinguish the
CRR interest debate by indicating openly where I stood, while others thought
that I didn’t show enough discretion by joking about such a market-moving
issue.

Editors’ Conference

The media is a bridge between the Reserve Bank and the larger public. It
disseminates our news and our messages, and critiques our policies and actions
through opinion pieces and analyses. All of this enhances public understanding
and gives us, within the bank, valuable feedback. This process is enhanced if the
senior management of the Reserve Bank and the senior editors in the media meet
occasionally to exchange views and understand each other’s perspectives.
This was, of course, not an original idea or a new initiative. Every governor
This was, of course, not an original idea or a new initiative. Every governor
before me had his own way of engaging with the editors—some met them
casually and individually, others met them in small, informal groups. My
strategy was to have an annual editors’ conference with about fifteen–twenty
editors for an in-depth discussion—‘background’ in media parlance.
Since the format was untested, the first time we organized the conference, in
August 2010, we prepared an agenda indicating the topics for discussion. The
objective behind the preselecting of topics was only to keep the discussion
focused and prevent it from going all over the map. Some editors did not like
this idea and thought that my ‘control freak’ disciplining of the format inhibited
a free-flowing discussion. On the other hand, I was not comfortable with a total
‘stream of consciousness’ style of discussion as it might muffle our
understanding and even distort the messages. We agreed on a compromise.
Ahead of the conference, the Reserve Bank would provide the participants with
a long menu which we would narrow down to three or four topics in consultation
with the invitees. We will devote one half of the meeting to discuss the
preselected topics, while the remaining half will be spent on a free-flowing
conversation.
A host of issues figured on the agenda of these conferences. They ranged from
hot-button issues like the monetary policy stance and exchange rate management
to regulation of microfinance institutions and deregulation of the interest on
savings deposits, allowing corporates into the banking space and the FSLRC
(Financial Sector Legislative Reforms Commission) and the FSDC (Financial
Stability and Development Council). The meetings were held under the Chatham
House Rule—the editors could use the discussion at the conference to write their
commentary or opinion without any attribution to the Reserve Bank. Needless to
say, I found these meetings not only enjoyable but immensely rewarding.
Over the years I spent at the Reserve Bank, I developed an enormous respect
for the media not only for the role they play in enhancing the effectiveness of
Reserve Bank policies, but even more importantly for the role they play in
making the Reserve Bank accountable. I was also impressed by the depth of
media analyses and the insightful editorial and opinion pieces. Needless to say, I
grew fond of the reporters on the Reserve Bank beat who would follow me on all
public events within the country even if they put me in a tight spot more often
than I liked. What I found most endearing of all was that they too loved the
Reserve Bank as much as those of us inside it did, cared about the institution’s
Reserve Bank as much as those of us inside it did, cared about the institution’s
reputation and credibility, and rejoiced in its successes and lamented over its
setbacks.

Mixed Record

Like on other dimensions, on the communication dimension too my record at the


Reserve Bank was a mixed bag. I was largely commended for bringing a culture
of openness to a conservative and inward-looking institution, and was
complimented for making the bank more transparent, responsive and
consultative, for listening as well as speaking, for streamlining our written
documents and simplifying our spoken language. In its assessment of my term as
governor, titled ‘Subbarao—End of a turbulent tenure’, the Hindu BusinessLine
of 3 September 2103 wrote: ‘Without providing “sound bites”, he still increased
the tempo of communication from the central bank and tried to inculcate a
culture of transparency. In particular, his attempt to provide “forward guidance”
to markets while making it clear that he was retaining his options to act
differently, were notable innovations.’
I was both praised for speaking up and derided for not speaking enough when
the occasion demanded. I was criticized for showing self-doubt and reticence
instead of conveying certainty and confidence, for not staying consistent with the
message and for too much straight talk and too little tact. In an article defending
my record in the Business Standard of 1 June 2011, Abheek Barua’s concluding
sentences were: ‘Markets tend to like uber-confident alpha male central bank
governors. Dr. Subbarao was not one. In retrospect, that may turn out to be his
biggest flaw.’ On the contrary, many others wrote that it was, in fact, my low-
key demeanour and low-profile personality that commanded respect and aided
effective communication. I will let it rest there.
There are many things I miss about being the governor. One of them is that I
can no longer move the markets by my spoken word. Equally, there are many
things I enjoy about not being the governor. One of them is that I can speak
freely without any fear of moving the markets.
9
Walking Alone
Autonomy and Accountability of the Reserve Bank

Is the Reserve Bank independent? I don’t have a binary answer to this question.
The best I can do is offer a long and nuanced response.
A widely shared view is that the Reserve Bank has no independence and that
the government pressures the Bank to act as per its bidding. This view is largely
impressionistic, shaped more by perception than hard evidence. It is also an
urban legend that has gained currency by sheer repetition. I have also often been
struck that foreign media, whenever they write about the Reserve Bank,
routinely qualify it as ‘one of world’s least independent central banks’. I believe
this too is an uninformed bias rather than the result of any rigorous research on
the relative independence of central banks around the world.
In my five years at the Reserve Bank, I was asked repeatedly about the
independence of the Reserve Bank. I was not the first governor to confront this
question and I know I won’t be the last. It is an issue that keeps coming up in
public discourse, in part aided by our energetic and enthusiastic media.
My predecessor, Y.V. Reddy, had a stock response to this question: ‘The
Reserve Bank is totally free within the limits set by the government.’ This
answer is clever, even technically correct, but still ambiguous. What indeed are
the limits set by the government? Are they well defined and is there a shared
understanding on both sides of their respective obligations and code of conduct?
What are the remedies if there is a transgression?

Why Do Central Banks Need Autonomy?

Perhaps we should establish some basics here before getting into specifics. The
issue of central bank autonomy typically arises in the context of its monetary
policy function. Why is it important that a central bank have autonomy in setting
policy function. Why is it important that a central bank have autonomy in setting
the monetary policy? The principal aim of monetary policy is to preserve price
stability by maintaining low and steady inflation consistent with the economy’s
potential growth rate. This requires taking a long-term view even if the path to
price stability might entail some short-term pain. But political regimes,
especially democracies, have little tolerance for such pain; electoral politics push
them into compromising long-term sustainability for short-term expediency.
This is where an autonomous central bank comes in. The hope and expectation is
that an autonomous central bank, insulated from political pressures, will ensure
that long-term macroeconomic stability is not held hostage to short-term
compulsions.
In addition to being the monetary authority, the Reserve Bank is also a
regulator. It regulates banks, non-banking financial companies, segments of the
financial markets, and the payment and settlement systems. The theory of
regulatory autonomy is now well established and I will not go into details here
except to say that regulatory autonomy is critical to inspiring entrepreneurial
impulses and investor confidence in the economy.
The Reserve Bank has other responsibilities too beyond monetary policy and
regulation. It manages the external sector, prints and distributes currency, is the
banker to the Central and state governments and to commercial banks, and has
important responsibilities in furthering financial inclusion and economic
development. There is no issue of autonomy on these other functions; the
Reserve Bank works in consultation and coordination with the government.

Autonomy of the Reserve Bank in Theory and Practice

Under law, the Reserve Bank is not fully autonomous. The RBI Act lays down
that: ‘The Central Government may give directions to the Reserve Bank where
considered necessary in public interest to do so, but after consultation with the
Governor.’ It is possibly this legal provision that is at least partly behind the
perception that the Reserve Bank is not independent. But two points are to be
noted here. First, the authority of the government to ‘direct’ the Reserve Bank is
not absolute; it is circumscribed by the need to consult the governor beforehand,
as well as the requirement that the direction be in the public interest. Second and
more importantly, in the eighty years that the Reserve Bank has been in
existence, the government has not invoked this provision even once. In some
existence, the government has not invoked this provision even once. In some
sense, this is a tribute to the sense of responsibility of both the government and
the Reserve Bank.
But that is on the formal side. What about informal interference behind the
scenes? Let me first talk about monetary policy. I have been asked several times
if there was pressure from the government on setting interest rates. There
certainly was, although the precise psychological mechanics of pressure would
vary depending on the context, setting and the personalities.
I have already written about how I would schedule a meeting with the finance
minister before every policy review to apprise him of the macroeconomic
situation and of my proposed policy decision. For much of the time during my
tenure, although not always, there were differences of view on the anti-inflation
stance of the Reserve Bank. Both Chidambaram and Pranab Mukherjee were
piqued by the Reserve Bank’s tight interest rate policy on the ground that high
interest rates were inhibiting investment and hurting growth.
As a columnist for the Indian Express after demitting office, Chidambaram
wrote on 2 August 2015 (‘Across the Aisle—Monetary Policy Committee: Vote
or Veto?’): ‘There is a view among commentators that finance ministers and
central bank governors are always at loggerheads. That view may make
interesting copy but it is far from the truth. On 8 out of 10 monetary policy
statements or actions, the Government and the RBI will be, and in the past have
been, on the same page.’
Chidambaram was finance minister for far longer than I was governor. The
ballpark average that he cites—agreement eight out of ten times—may be his
experience, but it certainly does not accord with mine. I found that all through
my tenure, the government was distinctly uncomfortable with the Reserve Bank
raising interest rates and seemed convinced that monetary policy was choking
growth.
I invariably pushed back against the government’s suggestions for softer
interest rates. My standard counterargument to the finance ministry used to be
that it was not high interest rates that were standing in the way of investments.
What matters in investment decisions is not the nominal interest rate but the real
interest rate, which is the interest rate after knocking out the impact of inflation.
Even though the Reserve Bank was raising the policy interest rate to control
inflation, real interest rates remained lower than in the pre-crisis period when we
clocked record investment levels and sizzling growth. If interest rates were the
clocked record investment levels and sizzling growth. If interest rates were the
only constraint, there should have been a similar investment boom now. The fact
that there wasn’t shows that it was not interest rates but other policy and
implementation bottlenecks that were inhibiting investment.
Obviously discomfited by the ball being thrown back into their court, the
government would rebut—argued in different ways by different people—that
investors are influenced not by real interest rates but by nominal interest rates, an
argument that I always found unpersuasive. The other argument that the
government would routinely trot out is that a policy rate cut was necessary to
buoy investor sentiment. The logic of why the Reserve Bank should compromise
its judgement so as to become a cheerleader for the economy never appealed to
me.
A tacit agreement between the government and the Reserve Bank was that we
should keep our differences behind closed doors. That did not, of course, stop
the media from speculating about internal squabbles—stories that would gather a
momentum of their own. Notwithstanding these so-called squabbles, it is
standard practice for the finance minister to issue a statement endorsing the
Reserve Bank’s monetary policy decision in the media shortly after it is
announced.
There was a high-profile deviation from this standard practice in October
2012 when Chidambaram went public with his displeasure at the Reserve Bank’s
decision not to cut interest rates. The events leading to this public rebuke of RBI
started unfolding in the week before the policy. In the pre-policy meeting with
him, I told Chidambaram of my decision to stay pat on the policy rate in view of
the inflation situation and the continued concern about the fiscal situation which
was undermining the fight against inflation. He was clearly unhappy with my
proposed decision, was upfront with it and argued strongly for a rate cut. I did
not believe I could yield.
Not one to give up so easily, Chidambaram took the battle forward by
unveiling the government’s road map for fiscal adjustment in a hurriedly
convened media conference just a day before the Reserve Bank policy meeting.
The finance minister’s prerogative to release the government’s fiscal road map
any time he chooses is unquestionable, but the timing of this particular
unscheduled announcement, just a day before the policy, was clearly an unsubtle
message to the Reserve Bank.
message to the Reserve Bank.
While releasing the statement, Chidambaram said: ‘Well, I am making the
statement so that everybody in India acknowledges the steps we are taking and
also acknowledges that the government is determined to bring about fiscal
consolidation.’ When he was asked if the Reserve Bank would cut rates based on
his announcement, he used the opportunity to send a loud message from Delhi to
Mumbai via the media: ‘I sincerely hope everybody will read the statement and
take note of that.’
I have high regard for Chidambaram’s competence; if there was one person
who could deliver on the demanding fiscal deficit target in an admittedly
complex and challenging political scenario, it was he. Even so, I was disinclined
to change my decision based on his fiscal road map as it was a mere
reaffirmation of the targets with no indication of the steps that would be taken to
deliver on those targets.
I was also not prepared to be let down yet again by the government’s promise
on fiscal targets. Just six months earlier, in April 2012, I cut the policy rate by
0.5 per cent instead of by 0.25 per cent as was widely expected, on the assurance
of Pranab Mukherjee that he would aggressively prune subsidies and deliver a
fiscal performance better than he had indicated in the budget. If that was the
case, why indeed did he not make a tougher commitment in the budget itself, I
asked. He could not show such drastic fiscal consolidation in the budget, he told
me, because of political compulsions. It so happened that he moved on from the
finance ministry to Rashtrapati Bhavan two months later, even as fiscal
deterioration continued to put pressure on prices. With that experience still fresh
in my mind, I was clearly unwilling to front-load another rate cut by relying
entirely on the promise of fiscal rectitude. I consulted my senior colleagues and
found that we were all on the same page.
My refusal to fall in line had evidently upset Chidambaram enough to do
something very unusual and uncharacteristic—to go public with his strong
disapproval of the Reserve Bank’s stance. In his ‘doorstop’ media interaction
outside North Block about an hour after the Reserve Bank put out its hawkish
policy statement expressing concern on inflation, he said: ‘Growth is as much a
concern as inflation. If the government has to walk alone to face the challenge of
growth, we will walk alone.’
Sure enough, Chidambaram’s ire at having been abandoned to ‘walk alone’
created quite a flutter in the media. I was on notice therefore for the first
created quite a flutter in the media. I was on notice therefore for the first
question put to me in the scheduled post-policy media conference later that
afternoon. Clearly reluctant to fan controversy during a difficult economic
period, I papered over the differences, saying: ‘The government and the Reserve
Bank have shared goals. Both of them want high growth and low inflation.
Differing perceptions on how to achieve these goals are common across many
countries in the world.’
Chidambaram and I were together in Mexico less than a week after that for a
G20 meeting. The ambassador of India in Mexico, Sujan R. Chinoy, graciously
hosted a dinner for the Indian delegation to provide an opportunity for the
finance minister to meet some of the leading public figures and businesspersons
of Mexico. When Chidambaram arrived, he greeted everyone, but pointedly
ignored me all through the evening, leaving me with an uncomfortable feeling.
Even though this public show of disagreement was a one-off, tension between
the government and the Reserve Bank persisted even after that. One particularly
contentious disagreement arose in the context of the mid-quarter policy of June
2013 when Chidambaram was of the view that the Reserve Bank should cut the
CRR to stimulate bank lending. This was at a time when the rupee was under
intense pressure because of the taper tantrums. Any monetary easing in this
situation, no matter how carefully explained, was sure to accentuate the
downward pressure on the rupee and undermine the credibility of our exchange
rate defence. He called me up and we had our usual disagreement. Showing once
again that he wouldn’t give up so easily, he fielded his entire team of officers
and advisers to canvass the government’s case. I stayed with my decision, and as
later events would prove, this was well advised as less than three weeks later, we
had to actually tighten policy in order to arrest speculation on the rupee.

Why Do Governments and Central Banks Differ?

Maybe, it will be instructive to step back a little and reflect on why indeed
governments and central banks have differences. They differ mainly because
they see the growth–inflation balance differently, as I said earlier—and this has
to do with differing horizons. Governments are typically swayed by short-term
compulsions whereas central banks are expected to take a long-term perspective.
Central banks can do so only if they are free of political compulsions.
Surely, the autonomy of a central bank on monetary policy cannot be
Surely, the autonomy of a central bank on monetary policy cannot be
boundless. After all, the source of that autonomy is the mandate granted by
politicians. There is wide agreement that it is the government that should set the
inflation target, but having set the target, leave it to the central bank to determine
the strategy for achieving the target. In other words, a central bank cannot have
goal independence; it has to defer to the inflation target set by the government.
At the same time, a central bank should have instrument independence; the
government should not meddle in how the central bank goes about achieving the
inflation target.
It is, in fact, a muted understanding of this principle that was at the heart of a
widely reported public spat in early 2013 between the Government of Japan and
the Bank of Japan. The Bank of Japan resisted the doubling of the inflation
target by the government from 1 to 2 per cent even though the government was
well within its right to do so. The Abe government, on its part, was widely seen
as having transgressed the principle of separation of powers by not only setting
the inflation target, but also prescribing that the Bank of Japan resort to
quantitative easing to achieve that target.

The Price to Be Paid for Asserting Autonomy


There is a price to pay, of course, for not falling in line. The government has
several ways of showing its displeasure, and the way it chose to do so with me
was by going against my recommendations in the reappointment of deputy
governors in the Bank.
As the head of the Reserve Bank, enjoined with a public responsibility, the
governor should have the privilege of selecting his team just as the prime
minister has the prerogative of choosing his Cabinet. There is no question, of
course, that under law, it is the government that has the authority to appoint the
governor and deputy governors of the Reserve Bank. There are rules about
eligibility and tenure, which have to be complied with, and the system of
selection has to be fair, transparent and contestable. Within that framework, a
healthy convention should be to defer to the governor’s recommendation on the
appointment of deputy governors. That privilege was denied to me.
Usha Thorat, whose term as deputy governor was expiring in October 2010,
was eligible for reappointment for another two years in accordance with the
convention followed till then of reappointing deputy governors till they attained
the age of sixty-two years. Even as I was planning to formally write to the
government recommending and requesting her reappointment, the secretary of
the Department of Financial Services, R. Gopalan, called one evening to say that
the finance minister had approved the constitution of a committee to select
Usha’s successor. I was pained that even if the government had decided to
deviate from the standard practice of consulting the governor on the
reappointment of an incumbent, they had not even told me about it before
constituting a selection committee. There was speculation that Pranab Mukherjee
was irked by some regulatory decision taken on Usha’s watch which, of course,
came on top of his general unhappiness with me.
I sought a meeting with Pranab Mukherjee—incidentally one of only two
occasions when I met him one-on-one1—and requested that Usha be reappointed
because of her competence, track record and because she met the eligibility
criteria for reappointment. He knew that he could not call into question Usha’s
competence or track record; it would have been presumptuous on his part to
override my judgement on this issue with his own. He pleaded rules instead, but
I was prepared for that point. I told him that the government had reappointed
Shyamala Gopinath, another deputy governor, an identical case, under the same
rule, and added for effect that he was the finance minister who had approved it.
He didn’t budge and Usha became a part of the price we had to pay for asserting
the autonomy of the Reserve Bank.
We had a replay of the same story in the case of reappointment of Subir
Gokarn whose three-year tenure as deputy governor was expiring in December
2012. By this time, Chidambaram had returned as finance minister. As early as
in August 2012, I requested Chidambaram to reappoint Subir for two more years
and told him and that I would send a formal recommendation accordingly. I
reiterated the request in October 2012. Chidambaram was clearly disinclined to
accede. The reason he gave was that all of us who entered the Reserve Bank
laterally had become hostage to the technocrats in the Reserve Bank and the
government felt it necessary to bring some fresh thinking into the Reserve Bank.
He was firm that we should go through a de novo selection process.
I reminded him that according to the rules framed by none other than him,
Subir was eligible for reappointment; the question of opening up the position to
other candidates would arise only if Subir was not recommended by the
other candidates would arise only if Subir was not recommended by the
governor, which obviously was not the case. Chidambaram did not budge and
insisted that we go through a process of selection. He agreed though that Subir
could be considered by the selection committee along with other candidates.
The selection committee, under my chairmanship, went through the due
process and agreed on a panel of three candidates, with Subir Gokarn at the top
of the list. A couple of days later, P. K. Misra, secretary of the Department of
Personnel, who was also a member of the selection committee, called me up to
say that the minutes had to be redrafted since the rules did not allow for the
committee to rank candidates in order of preference. I was surprised because he,
as the ‘minder of rules’, had not said so when we met in the committee. I told
him that I could not agree to the redrafting of the minutes through a bilateral,
oral arrangement and that we should follow the due process. He should write to
me explaining the rule position, then we should reconvene the committee to
review the decision, and if agreed, dispense with the ranking. I did not hear from
him again on this.
Subir’s tenure was coming to an end on 31 December 2012. But even after
Christmas, there was no news from the government. I was hoping that since his
name was on top of the list, the finance minister would, even if reluctantly,
acquiesce. We had a farewell function planned on 31 December to bid farewell
to a couple of senior officers who were superannuating that day. My staff asked
if we should cover Subir too under this farewell. I said ‘no’ in the hope that the
reappointment would come through literally even at the eleventh hour. In the
event, I underestimated Chidambaram’s desire to bring ‘fresh thinking’ into the
Reserve Bank. Later that afternoon, we got the news that Subir’s appointment
was not being renewed.
In an article titled ‘Silencing the RBI’ in the Business Standard of 9 January
2013, Rajeev Malik, a columnist, wrote: ‘In some ways, the government’s
decision not to extend Mr Gokarn’s term appears to be a censure of Governor
Subbarao. His second term ends in September this year, so he could not be
shown the door before without rattling investors. Perhaps it was unfortunate that
Mr Gokarn’s term ended when it did. It appears to have made him an easy target.
After all, the current government has not been shy of messing around with
institutions—the RBI is just the latest addition to that list.’
Another mischievous, if also clumsy, attempt by the government to assault the
autonomy of the Reserve Bank came by way of appointing the directors on the
autonomy of the Reserve Bank came by way of appointing the directors on the
central board of the Bank. As per law, it is the government’s prerogative to
appoint the directors but the law also guarantees the directors so appointed a
four-year term. In other words, the government cannot recall any director at will
during the four-year tenure. Presumably, the intent behind this provision was to
ensure that the directors acted independently without any threat of the
government ‘showing its displeasure’ by terminating their appointment.
It has been the standard practice for the government to conform to the
wording of the law with regard to the guaranteed four-year term. While
appointing a fresh batch of directors in 2011, however, the government changed
the wording in the notification to say: ‘xxx is appointed as a Director on the
Central Board of the Reserve Bank for a term of four years or until further
orders whichever is earlier [emphasis mine].’
We were surprised by this change in wording. Maybe a clerical error, I
thought. That didn’t seem likely though as all they had to do was copy the
standard wording of the previous notifications. Having worked in the
government, I am aware of the power of precedents; breaking a precedent
requires a clear application of mind. Here, someone in the government did apply
his mind to incorporate a new provision so as to keep the directors on the board
of the Reserve Bank on leash, not realizing that it was against the law. We
pointed this out to the government and they issued an amendment to bring the
wording back to the standard format. Yes, we held our ground, but it would have
been better if the matter hadn’t arisen at all.

Global Experience

As I said before, differences between governments and central banks are not
unique to India. They are much more common than we think but they play out
differently in different countries and different contexts. And they are also
managed differently.
The European Central Bank, the monetary authority for the nineteen members
of the eurozone, is, in theory at least, supposed to be the most independent
central bank in the world if only because it is not answerable to any single
government. But even the ECB gets enmeshed in political controversy more
often than we think. The irascible German Finance Minister Wolfgang
Schäeuble has for long been critical of the ECB’s policy cocktail of low interest
rates, large bond purchases and generous liquidity for banks. Even as I write this
in early 2016, Schäeuble has gone so far as to blame ECB President Draghi for
the rise of the Alternative for Germany (AfD), a new anti-immigration, anti-euro
party that surged into three regional parliaments with stunning victories.
In his autobiographical book, The Age of Turbulence, Alan Greenspan, the
former chairman of the Federal Reserve, writes extensively about his strained
relationship with President Bush Senior. According to Greenspan, the Bush
administration and the Fed differed on managing the economic downturn, and
the administration faulted the Fed’s tight monetary policy for all its economic
troubles. Greenspan writes that President Bush publicly challenged the Fed’s
hawkish stance by saying: ‘I do not want to see us move so strongly against
inflation that we impede growth.’ Treasury Secretary Nicholas Brady in the
Bush administration reportedly resented Greenspan’s reluctance to support
growth by slashing interest rates, and bluntly complained of lack of forceful
leadership at the Fed. Bush himself blamed Greenspan for his loss in his bid for
a second term when he told an interviewer, ‘I reappointed Greenspan and he
disappointed me.’
I was also struck by the fact that the Federal Reserve and its policies get
embroiled in sharper political controversies unlike anything we are used to in
India. Recall that Rick Perry, who campaigned for the Republican party
candidature in the presidential elections of 2012, had attacked the then Fed
chairman, Bernanke, charging him of printing money to play politics, which
according to him, amounted to ‘nothing less than treason’!
Most political systems would deem such a harsh attack as being outrageous,
but strangely the US political system took that in its stride and moved on. In
India, in particular, it is inconceivable that any politician would attack the
Reserve Bank so sharply, which is a tribute not just to the Reserve Bank but also
to our political institutions. Recall that during the campaign for the Parliament
elections in 2014, even a hint that the highly regarded Governor Raghuram
Rajan could be replaced should a Bharatiya Janata Party (BJP) government come
into office, was widely criticized for embroiling the office of the governor of the
Reserve Bank in electoral politics.

Autonomy Battles Beyond Monetary Policy


Autonomy Battles Beyond Monetary Policy

The Reserve Bank’s battles for autonomy on my watch extended beyond purely
monetary policy issues into other domains. By far the most high profile of these,
although it was not as dramatic as depicted in the media, came in the context of
an ordinance issued by the government setting out a procedure for resolving
disputes between financial sector regulators. The trigger for this was a spat
between the Securities and Exchange Board of India (SEBI) and the Insurance
Regulatory Development Authority (IRDA) in April 2010 on the jurisdiction
over regulating ULIPs.
After due deliberation, the government determined that the resolution of the
dispute required a statutory change. But instead of just restricting the legal
change to this specific dispute, the proposed legislative amendment sought to
establish a generalized mechanism of a joint statutory panel under the
chairmanship of the finance minister to resolve all future disputes between
regulators. I was given to understand that it also became necessary to amend the
Reserve Bank Act in the process to make the amendment consistent with all
existing laws. As Parliament was in recess, the government issued an ordinance
to settle the dispute on hand without delay. The ordinance would, of course, need
to be ratified by Parliament at its next session.
At face value, the government’s legislative initiative was unexceptionable, in
some sense even wise. Instead of addressing just the immediate issue, the
government was establishing a generalized mechanism for resolving all
regulatory disputes in the future. Ironically, it was this very broad-based action
—the statutory sanction to readily convene a committee whenever there was a
dispute between regulators—that triggered disquiet among all regulators,
including the Reserve Bank, about how it could potentially be abused to
compromise the autonomy of regulators.
There were several concerns. First, the bar for invoking the statutory
intervention was set very low. All that was required was a complaint by any of
the regulators or either of the secretaries, of economic affairs or financial
services, in the finance ministry. For a future finance minister intent on misusing
the authority of the committee to settle scores with regulators or to trim their
wings, this would be an easy enough prerequisite to meet. Second, it would also
make it possible for interested parties to pay regulatory arbitrage by deliberately
engineering a dispute to invoke the committee’s jurisdiction. Finally, whether or
engineering a dispute to invoke the committee’s jurisdiction. Finally, whether or
not the mechanism was misused, the very possibility of misuse was a concern.
The mere existence of an enabling provision of a statutory committee would
keep regulators anxious, besides strengthening the perception of potential
investors about the fragility of regulatory autonomy in the economy.
I consulted my colleagues and all of us agreed that I should formally take up
this issue with the government. The result was a letter that I wrote to the finance
minister listing the Reserve Bank’s concerns and requesting the government to
let the ordinance lapse by not seeking parliamentary approval for it.
The letter received extensive media coverage, with the Reserve Bank getting
both approval and reproval. On the positive side, the Reserve Bank was
complimented for upholding an issue of larger public interest by trying to
prevent politicization of regulatory oversight. As governor, I was praised for the
courage I showed in taking a firm and principled position on protecting the
autonomy of not just the Reserve Bank but of all financial sector regulators. In
an article titled ‘Subbarao learns to call a spade a spade’, the Economic Times of
4 July 2010 wrote: ‘Mr. Subbarao’s public expression of displeasure has put to
rest months of speculation on where his heart lies. The Mint Street clearly
trumps North Block.’
On the flip side, some people thought that the Reserve Bank’s concerns were
unrealistic and that we were seeing a deep conspiracy where none existed. Some
had alleged that the Reserve Bank was simply fighting a turf battle under the
cover of a grand cause. There were a few comments about how it was governors
who were drawn from the IAS that had problems managing differences with the
government, whereas the non-IAS governors evidently had no trouble in
functioning independently or in establishing a harmonious working relationship
with the government. In its editorial titled ‘RBI’s Consternation’, the Hindu
BusinessLine of 14 July 2010 wrote: ‘Nor is it a coincidence that the RBI which
is the oldest of the financial sector regulators by far has always exhibited a
predilection for greater independence when non-IAS officers have been
governors . . . It is the regulatory heads from the IAS who have problems with
the notion of standing up to the government which is understandable because it
is hard suddenly to jettison your sanskaras (training).’
The Reserve Bank’s locus standi on this issue was also called into question on
the argument that initiating a legislation was the government’s prerogative and
that the Reserve Bank could not demand to be consulted on every legislation
that the Reserve Bank could not demand to be consulted on every legislation
relating to it. This last bit of criticism was clearly misinformed because we were
not questioning the government’s prerogative to initiate legislation; nor were we
demanding that the Reserve Bank be consulted. We were agitating against the
content of the proposed legislation as an interested party.
The media saw blood and sensationalized the stand-off between the
government and the Reserve Bank. The issue was, of course, serious but the
actual ‘battle’ was much less dramatic. Far from being annoyed or agitated,
Pranab Mukherjee was gracious and understanding about the whole matter. He
invited me to a meeting in Delhi where we had a very frank and cordial
conversation. I made it clear to him that my concerns were as much about the
potential misuse of the statutory committee arrangement as about the perception
such a statutory provision would convey about regulatory autonomy which,
among other things, would erode India’s attractiveness as an investment
destination. From his side, the finance minister talked about the damage
regulatory disputes could do to investor confidence and the need for an
established and predictable mechanism to resolve disputes before they blew up
into public spats.
Pranab Mukherjee did not concede the main issue but agreed to remove one
possible source of misuse—which was that the secretaries in the ministry of
finance who were also members of the committee would not be able to register a
complaint to invoke the committee’s jurisdiction; it could only be invoked by a
complaint by one of the regulators. He also tried to assuage me personally by
designating the governor of the Reserve Bank as the vice chairman of the
statutory committee. This was not something I demanded, nor was it an issue
that mattered to me personally.
The autonomy tussle arising from the ULIP ordinance segued into a
contention over the establishment of the Financial Stability and Development
Council with a remit to deal with issues relating to financial stability, financial
sector development and inter-regulatory coordination. The finance minister
would be the chairman and all financial regulators would be members of the
FSDC.
Some background is necessary to see the FSDC issue in perspective. Financial
stability came centre stage in the aftermath of the global financial crisis with the
realization that it was the neglect of financial stability by governments and
realization that it was the neglect of financial stability by governments and
regulators that was the root cause of the crisis. The world view before the crisis
was that if governments and regulators took care of price stability and
macroeconomic stability, financial stability would obtain as an automatic by-
product. The crisis, coming as it did in the midst of an extraordinary period of
macroeconomic and price stability, demolished that view. The received post-
crisis wisdom is that financial stability has always got to be on the radar of
governments and financial sector regulators.
This big lesson of the crisis set a new direction for financial sector regulation,
but it also raised new questions. How should financial stability be defined? What
are the policies and instruments available to preserve financial stability and
when and how should they be deployed? Who should be in charge of what? In
other words, in any given jurisdiction, what role should the government play and
what should the division of responsibilities be across the several regulators?
What should the mechanism be for coordination among them? Should that
mechanism be different in normal times and in crisis times?
This is a long list of questions about safeguarding financial stability but as yet
there are no definitive answers. What complicates understanding is that the crisis
hit virtually every country in the world, showing that there is no clear best
practice in regulatory architecture. Even so, several countries, led by advanced
economies, instituted changes involving a redesign of the regulatory
architecture, redefining responsibilities of various agencies for financial stability
and establishing institutions for coordination. India’s FSDC initiative was in line
with these global developments.
Even as central banks around the world were struggling to adjust to the
received wisdom on financial stability, they were also agitated about the
possibility of the new arrangements creating a conflict of interest for them and
impinging on their autonomy. Abstracting from all the technical details, their
concern arose from the understanding that policies for price stability and policies
for financial stability are interlinked. What this means is that it might sometimes
be necessary to deploy monetary policy to preserve financial stability. Similarly,
an action taken by the central bank to preserve financial stability would impact
its monetary policy stance. Would that not create a conflict of interest? Besides,
there was the possibility that consultation and coordination with the government
on policies for financial stability could easily spill over into the government
interfering in monetary policy decisions under the cover of preserving financial
interfering in monetary policy decisions under the cover of preserving financial
stability. What would that mean for the central bank’s monetary policy
autonomy?
These apprehensions at the global level were equally relevant in the Indian
context. Having been through the crisis, I was deeply conscious of the critical
importance during crisis times of coordination among the regulators, with the
government in the driving seat. This was the standard practice in virtually every
country during the crisis and India was no exception. But did we need to set up a
permanent body like the FSDC? Wouldn’t existing mechanisms have been
sufficient to take care of financial stability during ‘peace’ times? Would the
proposed FSDC do more harm than good?
I must admit that I had greater reservations about the institutionalization of the
coordination mechanism for financial stability under the FSDC umbrella than on
the dispute resolution committee envisaged under the ULIP legislation, mainly
because it can make the government’s transgression into regulatory autonomy
appear seamless and even justified. We already had in existence a High Level
Coordination Committee on Financial Markets (HLCCFM) under the
chairmanship of the governor and comprising all the financial sector regulators
and the secretaries of economic affairs and of financial services from the
government. The HLCCFM was meeting regularly to coordinate on regulatory
issues. The mandate of this committee could easily have been redefined to
explicitly include financial stability. The government’s concerns on financial
stability could be pursued by the two secretaries who were members of the
committee. On the other hand, under the proposed FSDC structure, with the
finance minister in the chair, there is the risk of financial stability issues
transgressing into the domain of monetary and regulatory policies.
On the FSDC issue too, like on the ULIP issue earlier, Pranab Mukherjee was
broad-minded and gracious. He invited me for a meeting where we exchanged
views and discussed possible safeguards against the FSDC encroaching into
regulatory autonomy. He did not concede the main issue but held out several
assurances—that there would be a subcommittee of the FSDC under the
chairmanship of the governor which would be more active and meet more
frequently; the FSDC itself would play an active role during crisis times only.
He recalled that during the Parliament discussion on the ULIP ordinance, he held
out an assurance that the government would not interfere with the autonomy of
the regulators, and added that the same assurance would also hold in respect of
the FSDC.
As I look back on the developments of those days, it sometimes occurs to me
that I may have possibly overreacted and that my apprehensions were more
imagined than real. On the other hand, one cannot rule out the possibility that the
sensitivity to regulatory autonomy will erode over time, there could be mission
creep and we could end up in a situation where FSDC will routinely discuss
monetary policy in the context of discharging its responsibility for financial
stability. All this is in the realm of speculation and I do hope that we will build
robust and credible institutional protocols to prevent the FSDC from trespassing
into the regulatory domain even inadvertently. The FSDC structure will add
value only so long as the finance minister and all the members constantly guard
against these risks materializing.
The Financial Sector Legislative Reforms Commission, set up as part of a
budget decision of 2011, raised the autonomy issue again, although indirectly.
Again, let me give a brief background.
Just as the governor informs the finance minister of his monetary policy
decision in advance, the finance minister too briefs the governor ahead of the
budget on proposals that have relevance for the Reserve Bank. Both
Chidambaram and Pranab Mukherjee respected this convention. In such a pre-
budget briefing in 2010, Pranab Mukherjee told me about his proposal for the
FSLRC. He was preaching to the converted. I had myself strongly canvassed,
both in my public speeches as well as internal conversations with the ministry of
finance, the need to recast all our financial sector laws—in order to streamline
and simplify them. I readily endorsed the finance minister’s proposal but
cautioned him that the committee should restrict its task to recasting the existing
laws but should not, in the process, attempt to change the basic framework of our
regulatory architecture.
In fact, I took the opportunity of my inaugural speech at BANCON in
December 2010, to indicate my position on the FSLRC. Here’s what I said: ‘It is
important, however, to recognize that bringing about changes in policy or in the
regulatory architecture cannot be the remit of a legislative reforms commission.
Such changes have to be debated and decided upon as a prelude to the work of
the commission so that the commission has a clear mandate on the policy
directions. In short, policy directions should drive the work of the legislative
directions. In short, policy directions should drive the work of the legislative
reforms commission, not the other way round. That underscores why it is
important for all of us—the banks and the banking regulator—to deliberate on
the policy directives. I hope this conference will set the ball rolling by discussing
the various aspects of legislative changes required in the banking sector.’
Pranab Mukherjee assured me that my concern would be taken care of while
drafting the terms of reference of the committee and that he would also brief the
committee on this sensitivity before they set out to work.
In the event, the FSLRC interpreted its mandate in a much broader context
and went about proposing some fundamental changes to the regulatory
architecture. I must say for the record, although it may not matter since I am no
longer governor, that I endorse some of the recommendations of the FSLRC,
such as its emphasis on consumer protection and the establishment of a
Monetary Policy Committee to decide on monetary policy. But I have
reservations about some others like the division of responsibilities for capital
flows—the government regulating inflows and the Reserve Bank regulating
outflows—and entrusting systemic risk management to the FSDC.
Apart from the content of the recommendations, I also have a grievance with
the committee over the very minimal opportunity it gave to the financial sector
regulators to present their point of view. The committee held just one joint
meeting with all the financial sector regulators, maybe of about three hours’
duration. There was no prior indication of the specific issues on which the
committee wanted to hear the regulators’ views; we were simply asked to
present our respective briefs in an open-ended manner. The meeting was also
one-sided, since they heard us but did not engage us.
I was not too perturbed at that time because I thought this was only a
preliminary meeting and that the committee would give each regulator a separate
and exclusive opportunity after they had reached some preliminary conclusions.
It did not exactly unfold that way. The committee put all these preliminary
recommendations straightaway in the public domain, calling for feedback
without any further engagement with the regulators.
In the Reserve Bank, we had reservations about several of the
recommendations contained in the preliminary FSLRC report and requested a
meeting with the committee to represent our point of view. They did not concede
our request. All we got was an informal, off-the-record meeting with the
chairman and just one other member of the committee where they heard us out
chairman and just one other member of the committee where they heard us out
without actively engaging us on any of our reservations. For me, the whole
experience was very unsatisfactory.
There has been a high-decibel debate on the FSLRC recommendations since I
left the Reserve Bank in September 2013. The government is moving forward on
implementing some of the committee recommendations. Drawing presumably
from the FSLRC report, it has also put out a draft Indian financial code in the
public domain, calling for suggestions and feedback. Given all this flux, I am not
inclined to use this space to debate the issues on which I disagree with the
FSLRC. I do also concede that as an RBI insider, I could be seen as an interested
party, with my objectivity open to question.
However, I do have persisting questions about the way the FSLRC interpreted
its terms of reference, giving itself scope to alter the fundamental fabric of the
financial sector regulatory architecture. It was a Financial Sector Legislative
Reforms Commission, not a Financial Sector Reforms Commission. My
understanding was that its job was to recast the financial sector laws to make
them simple, streamlined and consistent with a modern financial system. If
indeed the committee was right in giving itself such a sweeping mandate, it
should have engaged the financial sector stakeholders, particularly the
regulators, more actively to debate the pros and cons of their proposals instead of
the summary way in which it went about its task.

Payment of Dividend to the Government

The Reserve Bank is not a commercial institution, nor is profit-making one of its
objectives. Nevertheless, the Reserve Bank generates a ‘surplus profit’ which, as
per statute, is transferred to the government. This is roughly the pattern across
most countries in the world which explains why governments have a stake in
how efficiently and profitably central banks manage their finances.
The main source of income to the Reserve Bank is the interest it earns on its
holdings of government securities, its overnight lending to commercial banks
and the returns on its foreign currency assets. Its main spending commitments
are the costs of printing currency, agency commission paid to commercial banks
acting on its behalf for government transactions, and employee cost.
The Reserve Bank typically makes a ‘profit’ from its operations, and from this
profit, allocations are made to two reserve funds. The first reserve fund is meant
mainly to absorb losses from its operations in money, securities and forex
markets, and to absorb shocks arising out of variations in exchange rates and
gold prices. The second reserve fund is maintained for meeting internal capital
expenditure and making investments in the bank’s subsidiaries and associated
institutions. The ‘surplus profit’ after allocation to the reserves is transferred to
the government. For a cash-strapped government, the surplus transfer from the
Reserve Bank, typically of the order of 0.5 per cent of GDP, is a significant
source of revenue in managing its fiscal responsibility mandate. For example,
during 2014–15, the Reserve Bank transferred a surplus of ₹660 billion,
equivalent to 0.6 per cent of GDP.
In the last few weeks before the budget, it is common practice for the finance
ministry to shore up revenues by pressuring public sector enterprises to raise
dividend payments. The Reserve Bank too comes under pressure to scale down
its allocations to the reserve funds so as to leave a higher ‘surplus profit’ for
transfer to the government. Ironically, I was on both sides of this tug of war. As
finance secretary, I pushed the Reserve Bank to raise the payment to the
government—much to the consternation of Governor Reddy—and as governor, I
resisted similar pressures.
The standard argument of the government is that the Reserve Bank is far too
conservative in its estimate of contingent liabilities and is building reserves
beyond any reasonable requirement. The Reserve Bank’s position has been that
the reserves are being built as per a formula recommended by a technical
committee which took into consideration, among other things, the point that the
Reserve Bank’s income can be quite volatile, dependent as it is on both domestic
and global macroeconomic developments. No more is being put away, the
Reserve Bank maintains, than is required by minimum levels of prudence. These
arguments go on every year and a settlement is reached with both sides showing
some flexibility. It is notable though that even as this issue is contentious, it has
never turned acrimonious.
Central banks are typically apprehensive about threats to their balance sheets
for mainly two reasons. Even though they can almost always discharge their
financial obligations by creating money if necessary, large exposures and
sustained losses can weaken their ability to conduct policy effectively. Second,
sustained losses can weaken their ability to conduct policy effectively. Second,
mounting losses can make it necessary for a central bank to approach its
government for capital infusion. This is a contingency that a central bank wants
to avoid, as negotiation with the government could erode its independence. This
might look like paranoia but some central banks, more so, surprisingly, central
banks in mature democracies, take this threat quite seriously.
In India though, even as the autonomy of the Reserve Bank is an issue, the
amount of surplus transfer or the capital requirement of the Reserve Bank have
never been variables in defining the government–central bank relationship.

Government Intrusion into Bank Regulation

The Reserve Bank is the regulator of banks, while the government owns as much
as 70 per cent of the banking system. This has been another area for friction
between the government and the Reserve Bank.
The Reserve Bank’s regulation is ownership neutral in the sense that the
regulatory norms are uniform as between public and private sector banks. Equity
holders in banks, as owners, have rights and responsibilities; there are also rules
and established conventions about how those rights may be enjoyed and
responsibilities may be redeemed. Problems arise if the government believes and
acts as if it has ‘ownership’ privileges extending beyond those of private owners.
The most conspicuous way in which the government had overstepped its
ownership privileges was the way in which it regularly ‘advised’ public sector
banks on how to set their interest rates in response to the Reserve Bank’s
monetary policy stance. It had almost become a standard practice for the finance
minister to call a meeting of the public sector bank chiefs following each
monetary policy review of the Reserve Bank and advise them not to raise their
lending rates even if the Reserve Bank had tightened the policy rate. This overt
repression of monetary policy transmission undermined the Reserve Bank’s
efforts to contain inflation. As the owner of public sector banks, the
government’s prerogative to influence the way in which a public sector bank
responds to the monetary policy signal of the Reserve Bank is unexceptionable.
But that prerogative must be exercised through its nominee directors on the
boards of these banks, not through a high-profile meeting in the North Block
chaired by the finance minister. I must admit that this happened more during my
predecessor Reddy’s time than mine.
predecessor Reddy’s time than mine.
But I had problems of my own. In 2011–12, D.K. Mittal, who was secretary of
the Department of Financial Services, started taking a more activist role in
managing public sector banks. He started issuing instructions to these banks on a
variety of issues, like cautioning them in raising funds through bulk deposits and
asking them to be more restrained in loan restructuring. He also forayed into the
regulatory domain by asking public sector banks to convert every banking
correspondent (BC) outlet into an ‘ultra-small’ branch.
In sections of the media, Mittal was praised for his zeal to jolt the ‘lethargic’
public sector banks into action, while he was also criticized for his
micromanagement. I also got reports that public sector bank chiefs were
unhappy with this meddling, but being ‘public servants’, refrained from speaking
up. Needless to say, in the Reserve Bank, we were clearly unhappy with this
activism.
In July 2012, at a public event in NABARD (National Bank for Agriculture
and Rural Development) where I had gone to give its silver jubilee lecture, I was
asked what I thought about all this micromanagement of public sector banks by
the government. I had clearly indicated the Reserve Bank’s position. First of all,
ownership or no ownership, this government creep into the regulatory domain
was wrong. On issues outside the regulatory domain too, the government does
not enjoy any privileged ownership position. It should pursue its policies by
projecting them in the boards of the banks through its nominee directors. I added
that the government should establish best practices for exemplary and
responsible corporate behaviour.

Rendering Accountability

Accountability is the flip side of autonomy. An institution like the Reserve Bank
that jealously guards its autonomy should also zealously render accountability
for results.
Curiously, the Reserve Bank of India Act does not prescribe any formal
mechanism for accountability of the central bank. Over the years, however,
certain good practices have evolved. The bank explains the rationale of its
policies, and where possible, indicates expected outcomes so that the public has
a framework for evaluating its performance. The governor holds regular media
conference after every quarterly policy review, which is an open house for
conference after every quarterly policy review, which is an open house for
questions related not just to monetary policy, but the entire domain of activities
of the Reserve Bank. The Reserve Bank also services the finance minister in
answering Parliament questions relating to its domain. Importantly, the governor
appears before the Parliament’s standing committee on finance whenever
summoned, which happens, on average, three to four times a year.
It has often struck me that for a public policy institution with such a powerful
mandate, these sporadic and voluntary mechanisms for accountability are
inadequate. Voluntary initiatives for rendering accountability, no matter how
effective and earnest, are no substitute for clearly prescribed formal mechanisms.
There have been some positive developments in this regard since I left the
Reserve Bank in 2013. Importantly, the Monetary Policy Framework Agreement
between the Government and the Reserve Bank, signed in February 2015,
prescribes an inflation target, and in the event of failure to deliver on the target,
enjoins the governor to send a report to the government explaining the reasons
for the failure and the remedial steps being taken to return inflation to the
targeted zone. This formal accountability mechanism for delivery on the
inflation target is a substantive step forward. But is this enough? It falls short on
at least two grounds. First, the accountability is restricted to the Reserve Bank’s
inflation mandate. What about all the other functions of the Reserve Bank, such
as, for example, external sector management, bank regulation, and printing and
distribution of currency? Second, a written communication from the governor to
the finance minister is a one-way channel, whereas effective accountability
should warrant two-way engagement.
I used the opportunity of the Palkhivala Memorial Lecture I delivered in
August 2013 to voice my concerns about the absence of a formal accountability
mechanism for the Reserve Bank. I argued that in India too, we must institute a
practice like in the US where the chairman of the Federal Reserve testifies before
a Congressional committee on a regular basis. On those lines, in India, the
governor of the Reserve Bank should go before the Parliament’s standing
committee on finance twice a year to present a comprehensive report on the
Bank’s policies and their outcomes, and respond to questions by the committee.
This can be in addition to the current practice of the standing committee
sporadically summoning the governor on specific issues. Besides establishing a
formal and comprehensive structure for accountability by the Reserve Bank, a
statutorily enshrined procedure like this, I believe, will deliver another
significant benefit. By rendering accountability directly to the legislature, the
Reserve Bank will be protected from potential assaults on its autonomy by the
political executive.
I had, in fact, made this suggestion to the FSLRC, but in the event, they did
not accept my advice. I gather informally that some members of the FSLRC
thought that such a prescription would not accord with our Constitution!
Instead, what the FSLRC recommended is that the annual report of all
financial agencies, including the Reserve Bank’s, contain a statement by the
chairperson, the governor in this case, on the activities and performance of the
institution and that the government lay the annual report on the table of
Parliament. This is far short of what I believe is necessary in the case of a public
policy institution like the Reserve Bank whose policies have such a wide impact
on people’s everyday lives.

Walking Alone

All through my occasional skirmishes with the government over the five years I
was at the Reserve Bank, I refrained from confronting it on the autonomy issue
in the public domain. It was only in the Palkhivala Memorial Lecture I delivered
on 29 August 2013, a week before I stepped down, that I rendered an account of
my experience of leading the Reserve Bank for five turbulent years, to issue a
repartee. This is what I said:
‘A final thought on the issue of autonomy and accountability. There has been
a lot of media coverage on policy differences between the government and the
Reserve Bank. Gerhard Schröeder, the former German chancellor, once said: “I
am often frustrated by the Bundesbank. But thank God, it exists.” I do hope
Finance Minister Chidambaram will one day say: “I am often frustrated by the
Reserve Bank, so frustrated that I want to go for a walk, even if I have to walk
alone. But thank God, the Reserve Bank exists.”’
The standing ovation that I received remains one of the most treasured and
enduring memories of my time as governor.
10
Two More Years
Reappointment as Governor in 2011

My first appointment as governor in September 2008 was for a term of three


years. When I went to see Finance Minister Chidambaram the morning after the
appointment was announced, I had many things on my mind to check with him,
almost all of them of immediate concern, such as the logistics of the transition.
There were also many issues on which I had to brief him before handing over to
my successor as finance secretary. The term of my appointment was nowhere on
my agenda. However, he himself kindly volunteered: ‘You know, we appointed
you only for three years. But don’t worry too much about it. You’ll surely get an
extension.’ Worry about it? I had far too many more immediate worries. I forgot
about that bit of conversation even before I exited his office.
The inevitable speculation about my extension1 and the kite-flying on a
putative successor started as early as March 2011, a full six months before the
close of my term. I was not much distracted by this; indeed, I was surprised by
my own indifference because it was so unlike me. I wouldn’t admit to being a
careerist, but all through my career, I had clear aspirations and cared very much
about my career progression. So, what explains this uncharacteristic
nonchalance? I figured that by way of a career, I got more than my due from the
government, and should they decide to replace me, I was prepared to hang up my
boots and move on.
But was I prepared to accept an extension if it were offered? Only a few
people were close enough to ask me this bluntly, Urmila among them. My
answer was a clear yes. I had weathered the global financial crisis and was in the
midst of fighting a raging battle against inflation. Going away at this time would
have felt like walking away from the battlefield, no matter that it would have
been involuntary. Besides, I had started enjoying the job of the governor. When I
came into the Reserve Bank three years earlier, I did so—as I wrote earlier—
came into the Reserve Bank three years earlier, I did so—as I wrote earlier—
with some trepidation and fear of the unknown. By now, I was in a comfort
zone. I had invested in learning and understanding, getting to know the issues
and the people, and setting my agenda and priorities. Leaving all this midway
would have felt incomplete at a deeply personal level. I had established personal
friendships and professional bonds; it felt too soon to tear them asunder. We had,
in the previous year, celebrated the Reserve Bank’s platinum jubilee which was
—I cannot fully capture this in writing—a very fulfilling experience for me. It
gave me a keen sense of the history, traditions and ethos of this great institution.
Leaving an institution that grew on me so much in the previous year would have
left me in an emotional vacuum.
Maybe at some level, I was not completely agnostic about an extension!
Because there was a nagging feeling at the back of my mind that not being given
an extension would have felt like a seal of disapproval on my performance. That
would have been difficult to countenance at any stage of my career, and would
have been even more so at the very end. But I had no illusions either. I was by
no means irreplaceable. I might miss the Reserve Bank, but the mighty Reserve
Bank would move on under a new leadership.

Under the Reserve Bank Act, the governor can be appointed ‘for a term not
exceeding five years’ and can be reappointed. Except in the case of Y.V. Reddy,
my immediate predecessor, who was given a straight five-year term, the normal
practice of the government had been to make the initial appointment for three
years and give an extension. This was the case with the two governors before
Reddy—Rangarajan and Bimal Jalan; my initial appointment for three years was
in accord with this practice.
Note also that contrary to popular perception, the law imposes no term limit;
in theory, it is possible therefore for someone to serve as governor for life. There
were several governors, especially in the early years after the Reserve Bank was
established in 1934, who served longer than five years. James Taylor, the second
governor (1937–43), served for nearly six years, and C.D. Deshmukh, the third
governor (1943–49) for close to seven years. Benegal Rama Rau (1949–57),
who succeeded Deshmukh, had the longest tenure—nearly eight years.
Most governors served out their terms of appointment although there were a
Most governors served out their terms of appointment although there were a
few exceptions. L.K. Jha (1967–70) resigned when he was appointed India’s
ambassador to the United States. K.R. Puri (1975–77) relinquished office
midway through his term when the Janata government came into office post-
emergency. Manmohan Singh (1982–85) resigned when he was appointed by
Rajiv Gandhi as deputy chairman of the now-defunct Planning Commission,
while Bimal Jalan (1997–2003) resigned a few months before the expiry of his
term when he was nominated to the Rajya Sabha.
Two governors resigned in protest and therein lie two interesting tales.
Sir Osborne Smith, the first governor of the Reserve Bank (1935–37), was an
Australian national and remains the only professional banker to date to have
been appointed to this high office. His tenure came at an interesting political-
economy juncture in our history when the colonial administration seemed open
to yielding to greater self-rule. Top officials in the British Indian bureaucracy,
already irked by this impending power shift, were upset by the Reserve Bank of
India Act which, far from making the governor play ‘second fiddle’ to the
government, had in fact, made him all too powerful.
Percy Grigg, the then finance member in the government, was particularly
upset with Governor Smith’s working style and had serious differences with him
on monetary policy issues, especially on lowering the bank rate. Their
relationship deteriorated so much that while Smith, then only an year into his
office, said he was ‘sick to death’ by the government’s desperation to dominate
the Reserve Bank, Grigg started suggesting that the governor was acting in
unison with ‘devaluationists and currency speculators’. The already antagonistic
relationship took an ugly turn when there were allegations that the government
was tapping the governor’s telephone and mail. And when no evidence came out
of these ‘interventions’, Grigg forced the issue by asking the government to
choose between him and Smith, and decide who stayed on and who moved out.
The government sided with Grigg, forcing Smith to resign, which he did on 1
November 1936. After proceeding on eight months’ leave, he laid down office
on 30 June 1937.
Sir Benegal Rama Rau, the fourth and also the longest-serving governor to
date, served as India’s ambassador to Japan and the United States before being
appointed to the Reserve Bank. His relationship with Finance Minister T.T.
Krishnamachari, popularly known as TTK, was frosty right from the time he
succeeded C.D. Deshmukh in July 1956.
succeeded C.D. Deshmukh in July 1956.
The first serious tussle between the two erupted when TTK introduced a
supplementary taxation proposal for hiking the stamp duty rate on bills, a ‘fiscal
measure with monetary intent’, as TTK himself described it, but which ran
counter to the Reserve Bank’s Bill Market Scheme. Taking umbrage at this
encroachment into monetary turf, Rama Rau took the issue to the board of the
bank which passed a resolution of protest. When requested by Rama Rau to
rethink his stance on the proposal, TTK responded with ‘professional
discourtesy’. As B.K. Nehru recollects in his autobiography, Nice Guys Finish
Second, the finance minister ‘let fly in no uncertain terms and in the loudest of
voices’ at Rama Rau.
Matters escalated further when Rama Rau’s memorandum expressing deep
concerns about the independence of the central bank and RBI’s ability to
exercise statutory responsibility for ‘monetary policies and other matters’ made
its way to Prime Minister Nehru. Nehru reportedly took serious exception to this
‘improper and agitational’ memorandum, which he saw as ‘practically an
indictment of Government’s policy’.2 Rama Rau stood his ground, and deeming
it not possible to continue under the circumstances, resigned on 14 January 1957.
The tussle between the government and the Reserve Bank has long historical
traditions, after all!

A few of the possible contenders, including some who did not figure in the
media’s speculation, came to see me to probe. My answers were straightforward.
No, the finance minister had not spoken to me about it. No, I had not raised the
issue with the finance minister. No, I did not intend to go and request the prime
minister. Yes, I would accept an extension were it to be offered. To remove any
awkwardness from the conversation, I also told them forthrightly that should
they be interested in the job, they should go and request the prime minister or the
finance minister, and I would not misunderstand.
It was more important for me to address the awkwardness and discomfort of
my staff with regard to this situation. I kept scheduling appointments, meetings
and travel, and accepting external speaking commitments as if I would continue
beyond the three-year term. This set the staff speculating on whether I might
have got an inside tip on an extension. I decided to lay my cards on the table and
have got an inside tip on an extension. I decided to lay my cards on the table and
levelled with the senior staff at one Top Management Group (TMG) meeting in
early July 2011. I told them the same thing that I had told the possible
contenders. I added that no inferences should be drawn from my accepting
commitments beyond my term; I was doing that only for maintaining continuity.
Should I be replaced, my successor could always rework the schedule. Managing
abrupt transitions has traditionally been one of the strengths of the Indian
bureaucracy, and this would be no exception.

The media did a comprehensive job of analysing why I might or might not get an
extension, which, of course, ran along predictable lines. Pro-extension
arguments were that I had steered the Reserve Bank through some very
challenging times, that my experience would be handy in managing the
continuing global uncertainty, and that a change in leadership would be
unwarranted at a time of persistent high inflation and stalling growth.
The case against my extension was stronger and centred around my record of
aggressively asserting the Reserve Bank’s autonomy, contrary to the expectation
when I was appointed that I would act as per the government’s bidding. I
botched up my chances, it was said, by differing with the government on the
criteria and timing for issue of new bank licences, openly questioning the
government’s attempts to encroach on the autonomy of the regulators—for
example, during the ULIP controversy, an issue I wrote about in an earlier
chapter—and by my strident criticism of the government’s fiscal laxity on the
ground that it was exacerbating inflation pressures, as well as my open
opposition to the establishment of FSDC. Most importantly, why would the
government reward me with an extension when I kept interest rates high,
completely unmindful of their pleas for a softer interest-rate regime?
An intelligent person would have surmised from the media reports that my
extension was certainly not assured, but neither did it seem impossible.
There was an interesting side story running alongside around the time my
extension came up for a decision, and that had to do with the unfolding 2G Scam
which embroiled the UPA government in charges of mammoth corruption. The
scam erupted when the CAG (comptroller and auditor general) pointed out in his
audit report of 2010, huge undercharging, massive irregularities and grave
audit report of 2010, huge undercharging, massive irregularities and grave
procedural manipulation by the Department of Telecommunication in giving
licences to telecom companies for 2G spectrum.
At the time the licences were given away in 2007–08, I was finance secretary
in the Central government and was an important player in the decision process. I
had written to the Department of Telecommunication in November 2007,
questioning their proposal to give away 2G spectrum licences in 2007–08 at a
price fixed in 2001 without any fresh effort to rediscover the price. I suggested
that the pricing issue, instead of being decided unilaterally by the Department of
Telecommunication, be brought before the Group of Ministers. This letter
received quite a lot of play in the media, with the suggestion that the UPA
leadership’s inaction in preventing the issue of licences at questionably low
prices despite its own finance secretary questioning the pricing formula, was
evidence of its complicity in this alleged wrongdoing.
It was not as if I was a completely unblemished hero in the 2G drama. Both
the PAC (Public Accounts Committee) and the JPC (Joint Parliamentary
Committee), while acknowledging my diligence in raising the pricing formula,
pulled me up for not sufficiently following up on my letter. But all that is a
different story and a deviation from my main narrative here. In the context of the
main story—my extension—the speculation was that the government would not
give me one because it was cut up with me for the embarrassment my letter had
caused to the UPA leadership.

I went to meet the prime minister at his official residence at 7 Race Course Road
on 21 July 2011 as part of my regular pre-policy briefing ahead of the quarterly
policy review scheduled for 26 July. This was roughly seven weeks before my
three-year term was to expire. After we finished the substantive business of the
meeting, he asked me if I had met the finance minister and briefed him on the
policy. I told him I had. He paused for a while and I remained quiet, as gaps of
silence were quite common in one-on-one conversations with Dr Manmohan
Singh. ‘Has the finance minister spoken to you about your extension?’ he then
asked me, and I said no. ‘You are doing well at RBI and there is no reason why
you should not serve a full five-year term like others.’ This was more of self-
musing rather than a question. After another awkward pause, I stood up to take
musing rather than a question. After another awkward pause, I stood up to take
leave, and then he said, ‘Let me know as soon as the finance minister speaks to
you.’
I returned to Mumbai and got caught up in the hurly-burly of the policy
review and follow-up tasks. It was not as if the uncertainty of an extension was
burdening my mind. There was still more than a month to go, and given the
government’s standard practice of eleventh-hour appointments, I knew it was too
early to feel at a loose end.
T.K.A. Nair, principal secretary to the prime minister, called me on 28 July to
check if the finance minister had spoken to me about my extension, and I told
him no. The prime minister wanted to know, he said, adding, ‘Let me know as
soon as the finance minister speaks to you.’ I knew Nair quite well as I used to
deal with him on a regular basis both when I was in the prime minister’s
Economic Advisory Council and later as finance secretary. He was a warm,
friendly and affable person, and I knew he regarded me highly and was my well-
wisher. He called me again, I think on 4 August, with the same inquiry. He
sounded a bit puzzled at what he thought was an impasse. The only signal I got
from these phone calls was that the government was actively engaged in a
decision on my extension or in identifying a successor. That was comforting, as
the last thing I wanted was for the issue to go to the wire.
On the morning of 9 August, at about elven, I was in my office working on a
speech that I was scheduled to deliver in Kathmandu later that week at a
conference organized by the Nepal Rastra Bank, when Susobhan Sinha, my
executive assistant, walked in to tell me that he had just seen a scroll on the TV,
saying: ‘Subbarao gets two-year extension’. We switched on the TV in my office
and saw it too. I dismissed that as a continuation of the ongoing media
speculation. My logic was that the finance minister, or at any rate, someone high
up in the government would call and give me the news before putting it out in
the public domain. Within fifteen minutes, Nair called to give me the news and
congratulated me on behalf of the prime minister and on his own behalf.
I tried to call the finance minister, Pranab Mukherjee, to thank him for the
reappointment, but managed to connect with him only late in the evening, at
about ten. I thanked him for the confidence reposed in me and he said something
to the effect of: ‘Oh, that was just a formality. You’ve earned the extension by
your performance. There was never any question of replacing you at this stage.
All the best.’
All the best.’
One issue in this whole process of reappointment that provided grist for the
media mill was the way in which the announcement came from the prime
minister’s office, on its website, rather than from the ministry of finance. Did
this indicate a tussle between the prime minister and the finance minister? Did
this suggest that the prime minister uncharacteristically pushed for my extension
overruling the finance minister’s reservations? If indeed Pranab Mukherjee was
against an extension for me, wouldn’t that impair the already fraught relationship
between the two of us?
I am no wiser than anyone else on the first question of whether the prime
minister prevailed over the finance minister’s opposition, but if it were true, it
would have marked another turnaround. Recall that I wrote earlier about how
Chidambaram may not have been inclined to take me in as finance secretary in
2007 but the prime minister had nudged him; and later in 2008, it was
Chidambaram who reportedly backed my candidature for the governor’s job
even as the prime minister was not too sure. And now it was a case of the prime
minister backing me against Pranab Mukherjee’s wishes. But all this is surely in
the realm of speculation.
On the second question, I must say that my relationship with Pranab
Mukherjee remained exactly as before. He continued to be friendly and gracious,
just as before, and he continued to be upset with my interest-rate policies just as
before.
The media and the financial sector endorsed the decision. The Economic
Times wrote that a fresh two-year term for Subbarao was a ‘reflection of the
confidence in the way he has handled the monetary policy and also signalling
continuity at a time of turmoil in global markets’. In an editorial titled, ‘Mr.
Crisis’, the Financial Express, while endorsing the extension, said that ‘few RBI
chiefs have handled two crises like Subbarao’. The Mint hailed the government’s
decision and complimented me for coming into my own as a central banker.
‘The July policy,’ it wrote, ‘demonstrated that Subbarao had graduated from
being a Finance Secretary sent to the RBI to take up the Government’s job, to
being a central banker.’
Those endorsements came with plenty of advice too. Analysts, asked for their
opinion by the media, said that I must move away from my ‘baby-step’ rate
action to a more aggressive interest rate-setting policy, that I must improve my
communication ‘to convince households and markets that my commitment to
inflation control stood above all else’. In its editorial, ‘Central Bank Rerun’, the
Indian Express, dated 10 August 2011, wrote: ‘In the next two years, apart from
negotiating through the expected global uncertainty, Subbarao’s biggest
challenge will be to reorient the multi-instrument, multi-objective, non-
accountable, non-transparent, RBI into a central bank that promises and delivers
price stability. He has now been given another chance to change the RBI and
help it fit the needs of a rapidly growing India.’
At the dinner table that evening, Urmila said to me, ‘Now that you’ve got an
extension, I suppose you can be more independent.’ I was surprised by this
statement-cum-question. I believed and continued to believe that standing by
your conviction and doing what you think is right is more a matter of personality
than opportunistic behaviour. I would be no less or no more independent, I told
Urmila, than I had been in the first three years of my term.

When I next ran into the media at some event, a reporter asked me: ‘Are you
reconciled to living in Mumbai for two more years?’ Both the question and the
way he phrased it surprised me. It struck me that the question was not the
expected one about my challenges and goals for the next two years; nor was it
about life in Mumbai. It was about being ‘reconciled to living in Mumbai’.
I figured out where he was coming from. In the early days of my shift from
Delhi to Mumbai, I had felt distinctly uncomfortable. That had nothing to do
with Mumbai, but with the sanitized life that the governor is expected to lead. I
had lived and worked in Delhi for several years. I had gone around by bus, by
auto and by car; I had walked the streets of Delhi. I was familiar with the city
and felt comfortable in it. Although I had visited Mumbai dozens of times in the
past, I had never lived there. Indeed, I couldn’t recall staying in Mumbai more
than three consecutive nights.
Early in my term, on my way back from office one evening, I asked the driver
to stop in Colaba, got off the car and walked around for about half an hour just to
get a feel of the place. The next morning, the protocol and security officer
attached to the governor’s office told me: ‘Sir, next time you want to go
anywhere on your way back home, let me know. I’ll come along with you.’
anywhere on your way back home, let me know. I’ll come along with you.’
Evidently, the driver was under instruction to keep the security officer informed
in real time about my movements, and he himself was uncomfortable with my
gallivanting on my own.
In conversations with colleagues and acquaintances, whenever the topic came
up, I would express my frustration at not being able to explore Mumbai on my
own. But somehow, that reaction took on life as ‘the governor doesn’t like
Mumbai’. Perhaps this is where ‘being reconciled to living in Mumbai’ came
from.
This is hardly the place to go into the usual Delhi–Mumbai squabble. There
are differences between the two, both subtle and striking, that I got to notice as I
spent time in Mumbai. Delhi is the nation’s capital and you can’t miss the very
essential political undertone in your everyday work life there. Its history and
grandeur—especially the Raisina complex where my office was—are
overpowering; its art and culture scene is lively. But Delhi is also guilty of an
exaggerated air of self-importance and an all-pervading sense of self-
righteousness.
Mumbai is different. The leafy streets and colonial buildings of South
Mumbai add to its charm. The city oozes energy and vitality from every nook
and corner. Mumbai is a city of stark contrasts—providing opportunities to
millionaires to pursue their riches and millions of poor to pursue a livelihood.
For many, Mumbai is a city where their dream begins; for many others, it marks
the end of a dream.
Contrary to the perception conveyed by the reporter’s question, I actually
came to like Mumbai—the allure of the city grew on me. There are many things
I recall with fondness and nostalgia—the Mumbai rains, walking along the Worli
Seaface, eating in the hole-in-the-wall vegetarian Maharashtrian eateries in
Tardeo, strolling in High Street Phoenix Mall, and watching plays in Prithvi
Theatre.
One of my most enduring memories of Mumbai is of the Walking Tour of
South Mumbai that Urmila and I took along with a few Reserve Bank colleagues
on a pleasant Sunday morning. The young, knowledgeable and enthusiastic
guide walked us along some of the historic precincts of Mumbai, telling us
enchanting stories about those magnificent buildings and the rich and sometimes
hidden tapestry of their cultural heritage. It was a wonderful lesson in history
hidden tapestry of their cultural heritage. It was a wonderful lesson in history
and a crash course on the evolution of architectural styles—neoclassical, neo-
Gothic, Indo-Saracenic, and of course, art deco—which you can’t miss along
Mumbai’s iconic Marine Drive.
And since this is also a ‘tell all’ book of sorts, I might as well add that on a
few occasions, although not too often, Urmila and I would tell the staff that we
were going for a walk, take a taxi from down the street and wander off to
explore the colours and sounds, and experience the hustle and bustle of Mumbai,
taking cover under the volume and crowds of this megapolis.

All directors on the board of the Reserve Bank, including the governor, sign an
official declaration of fidelity and secrecy as laid out in the Bank’s general
regulations. Earlier on, the declaration used to be taken in a register, but in time,
an elegant tradition has evolved—of signing on a scroll. The governor and
deputy governors sign when they assume office, while the part-time directors
sign before their first board meeting.
This reappointment meant that I was going to sign the scroll for a third time. I
signed it the first time when I was appointed to the Reserve Bank board in my
capacity as finance secretary, and the second time at the beginning of my first
term. Grace Koshie, the meticulous and diligent secretary to the board, took
great pride in maintaining and honouring the traditions of the Reserve Bank. She
suggested a small ceremony around my signing the scroll after the
reappointment, but she acceded to my request to keep it low key and I signed it
in the quiet of my office.
As I mentally prepared for two more years, I was hoping that the global
uncertainty would wind down, inflation would trend down and growth would
trend up, freeing me to focus on the longer-term agenda of the Reserve Bank.
But that was not to be. My interesting times continued, justifying the moniker of
‘Mr. Crisis’ that the Financial Express’s editorial had given me.
11
What Does Your Promise Mean, Governor?
Reflections on Currency Management

Most people associate the Reserve Bank with the printing of currency. When I
travelled around the country, especially on outreach visits, I used to be fond of
visiting primary schools. It was easy to make a connection with the children as
they recognized the visiting VIP as the one who signs on the currency notes.
Soon enough, the conversation with the children turned to currency matters.
Little children would ask if the reason we don’t have enough money is because
the governor is not able to sign fast enough! Slightly older children would give
these little ones a reproving look of ‘how can you be so dumb?’ and come up
with their own question: ‘Why doesn’t the Reserve Bank just print more money
so that everyone in the country can have more of it and India can become a rich
country?’ Explaining to the children that it does not work that way, what really
matters is not how much money we print but the value of goods and services we
produce in the country, and that if we just printed more money without
increasing production, all we would get is higher prices, is a pedagogical
challenge I have never successfully mastered.

The Governor’s Promise

Our currency notes1 carry a promise by the governor. For example, a ₹10 note
has a promise on it, saying: ‘I promise to pay the bearer a sum of ten rupees.’ A
woman actually having a ten-rupee note in her hand can be quite perplexed by
this promise. What does it mean for the governor of the Reserve Bank to
promise to pay you ten rupees when you actually have ten rupees in your hand?
Tautological as it might seem, it is simply an old-fashioned way of saying that
the currency note is legal tender and will be accepted as a medium of exchange
on the trust of the Reserve Bank.
The critical word here is ‘trust’, which is the core of any system of money.
Paper money originated on the basis of trust, trust that the holder of a note could
go to a bank and exchange the note for an equivalent value of gold or silver. If
that trust—that the bank would redeem its pledge without fail—held, the note
would circulate as a medium of exchange without anyone ever going to the bank
to exchange the note for precious metal.
Sure, that explanation of the evolution of money based on trust is persuasive
enough. But, is there a deeper meaning to the trust underlying the governor’s
promise on the currency note beyond the assurance that the note is legal tender?
Shouldn’t trust also extend to an assurance that the Reserve Bank will maintain
the purchasing power of the currency by keeping inflation under check? Isn’t
price stability, in fact, the reason why almost everywhere in the world, the power
to print currency is entrusted with unelected technocrats in a central bank rather
than with elected politicians in the government? Wouldn’t central banks forfeit
the trust of their people if they failed to maintain the purchasing power of their
currency?
These questions surrounding this broader interpretation of trust become all the
more meaningful if we note that the issuance of currency by central banks is no
longer governed by the theology of the gold standard—the belief that a central
bank must issue currency equivalent only to the value of the precious metal in its
vaults. The gold standard was abandoned during the Great Depression of the
1930s and what central banks issue today is fiat currency—that is, currency
which derives its value not from any gold or precious metal held by the central
bank but from a government decree.
The Reserve Bank too has been part of this global shift from the gold standard
to fiat currency. In fact, the original Reserve Bank Act which, coincidentally
dates back to 1934, the Great Depression era, prescribed a proportional reserve
system whereby, of the total value of notes issued by the Reserve Bank, at least
40 per cent was to be backed by gold bullion and sterling reserves. Subsequent
amendments to the Reserve Bank Act have relaxed that provision, and today
gold provides only a very small part of the asset-backing for the currency issued
by the Reserve Bank; the rest of the cover comes from the domestic and foreign
securities held by it.
securities held by it.
This breaking of the historical link between the issue of currency by a central
bank and its gold holding redefines the basis of public trust in a central bank.
The restraint on a central bank to issue currency without bounds is no longer its
gold holding but the obligation to preserve the value of the currency by keeping
inflation in check. All through my Reserve Bank tenure, I firmly believed that it
is this broader interpretation of trust that underlies the governor’s promise to pay
the bearer ‘the sum of ten rupees’.

Security Features of Our Currency

By far the most important facet of currency management is building in security


features to prevent counterfeiting.
There are several considerations that go into the design of a currency note,
such as reflection of the culture, history and ethos of the nation, a pleasing and
appealing look and feel, sensitivity to the needs of differently abled people,
particularly those with vision deficiencies, and amenability to mechanized
processing. An overriding consideration, of course, is to make counterfeiting
difficult and expensive. Keeping ahead of counterfeiters by constantly enhancing
the security features is the only way by which central banks can confront this
constant occupational hazard.
The most effective deterrent to counterfeiting is wide public awareness of the
security features so that people are able to tell a counterfeit note from a genuine
one. This is the motivation for the extensive awareness campaign that the
Reserve Bank runs in the media to educate people on the security features of the
currency. That shopkeepers routinely hold up high denomination notes to the
light with the confidence of people who know how to tell the true from the false
is everyday proof of the success of this scheme.
In managing this awareness campaign, the Reserve Bank faces two dilemmas.
The more straightforward dilemma is that the campaign has to educate people
without unduly alarming them, which is the reason why the Reserve Bank has
opted for a soft campaign rather than a hard-hitting one. We knew it would take
longer to create the necessary impact but it would be more lasting.
The second dilemma, and a more complex one, is that the awareness
campaign aimed at educating the public also provides handy information to the
counterfeiters. The Reserve Bank manages this tension by making the replication
counterfeiters. The Reserve Bank manages this tension by making the replication
of security features technically complex and prohibitively expensive, and also by
incorporating some additional security features that can be detected only by
sophisticated equipment.
On an issue like counterfeit currency, there can be nothing short of a zero-
tolerance policy but there is a gap, as always, between the policy and the reality.
The incidence of counterfeit notes has, of course, come down because of greater
awareness and improved systems for detection, but the problem is far from
totally eliminated. It shouldn’t be surprising also that the problem of counterfeit
notes is more acute in our states which have international borders.
Counterfeit currency is primarily a law-and-order and enforcement issue with
the responsibility for detection and prosecution lying with the police and security
forces. The Reserve Bank has the responsibility to ensure that counterfeit
currency does not circulate in the banking system; it does so by detecting and
eliminating it at the entry level itself. Importantly, the Reserve Bank has invoked
its regulatory power to instruct banks that all currency notes of ₹100 and higher
denomination should be checked for genuineness and fitness before they are
reissued into circulation. The Reserve Bank regularly trains commercial bank
staff and police personnel in detecting counterfeit notes.
The legal provisions governing prosecution for counterfeit currency are quite
comprehensive, but the underlying prescription regarding the procedure to be
followed distorts the incentives for enforcement. In particular, if a currency note
that a customer brings to a bank counter is suspected to be counterfeit, the bank
is mandated to file a First Information Report (FIR) with the police. This drags
both the customer and the bank into extensive paperwork, and in the case of the
customer, confirming that she was unaware of the counterfeit nature of the note
in her possession forms the first layer of investigation. This prima facie
suspicion and the associated paperwork deter reporting of counterfeit currency.
We tried our best to rectify this perverse incentive structure but met with only
limited success. Simplifying the process required amendments to the criminal
procedure code (CrPC). We proposed to the home ministry amendments to the
CrPC that will absolve the customer of prima facie responsibility, as that will
remove the fear and apprehension underlying the current provisions of the law.
The ministry, however, was unwilling to relax the process for fear that it would
compromise internal security. We did win some concessions though in the
matter of rationalizing the procedure for reporting of counterfeit currency. First,
matter of rationalizing the procedure for reporting of counterfeit currency. First,
in every district of the country, one police station was to be designated as a nodal
station for counterfeit currency cases so that the training and specialization could
be focused; second, the immediate filing of an FIR was required only if the
number of counterfeit notes detected in a single transaction exceeded four, or
else, banks could pool cases and file a combined FIR once in a month. This
rationalization has improved reporting and provided some relief to common
people who unknowingly come into possession of counterfeit notes.

Clean Note Policy

The Reserve Bank is committed to a ‘clean note’ policy. It exchanges soiled and
mutilated notes for clean ones. In pursuit of our clean note policy and also to
check counterfeiting, in 2011, we prescribed that all bank branches with cash
receipts of over ₹5 million per day be equipped with a note-sorting machine so
that every high-denomination currency note is checked for fitness and
genuineness before it is put back in circulation. Subsequently, the requirement of
machine-processing of cash has been extended to all bank branches, irrespective
of the value of receipts.
I noticed early on that there was an urban bias in the implementation of the
clean note policy. Urban areas get relatively clean notes and all the soiled notes
end up in the villages. The common complaint when I visited villages, more than
the absence of banking facilities, was about how they always got only soiled
notes. We tried to redress this grievance, at least partly, by including the
distribution of notes and coins in the scope of the activities of a banking
correspondent in addition to her regular tasks of cash remittances and
withdrawals, although I am not sure to what extent this initiative could mitigate
the problem. I must also admit that I did not pay as much attention to this issue
as I should have, but do hope that the Reserve Bank takes more active interest in
correcting the urban bias in its clean note policy.

Plastic Currency

Cost and longevity are important considerations in currency management. We


are a large cash economy; in fact, India is the second-largest producer and
consumer of currency in the world, next only to China. Producing such a large
consumer of currency in the world, next only to China. Producing such a large
amount of currency is expensive. One option for economizing is replacing paper
currency with plastic currency as some countries, such as Australia and
Singapore, have done. For some years, the Reserve Bank has been planning on
introducing plastic currency in India, starting with the ten-rupee note on a pilot
basis.
Plastic currency offers several advantages. It makes counterfeiting more
difficult, the notes stay clean and last longer, therefore entailing lower costs by
way of handling and replacement. As against these advantages, we had to test
the durability of plastic currency in India’s harsh and heterogeneous climatic
conditions. Whether they would get ‘cultural acceptance’ was also a question
mark.
I spoke about the Reserve Bank’s plans to introduce plastic currency in one of
my public speeches which was widely reported in the media. Within ten days
after that, I got a letter from an eighth-class girl from a remote village in
Jharkhand, asking me whether plastic currency was environmentally positive. I
was both touched and impressed. The Reserve Bank, of course, had already
taken care of that by commissioning a study by TERI (The Energy and
Resources Institute) on the carbon footprint of plastic currency. The TERI report
found that plastic currency would be about five times more environment friendly
than cotton fibre-based currency mainly because of the longevity of the notes
and low-resource consumption. During my term, we initiated a bid process for
outsourcing the production of plastic currency of ₹10 denomination. The
understanding was that if the pilot process succeeded, the initiative would be
mainstreamed.

India towards a Cashless Society?

India, as I have said earlier, is a large cash economy, which is to say that a
preponderant proportion of all financial transactions are conducted in cash as
opposed to electronic payments. Both the government and the Reserve Bank are
keen on moving India towards a less cash economy by encouraging people to
shift from cash to electronic payments for all transactions. This will not only
reduce the cost of printing and handling cash but also make transactions faster
and safer. Electronic payment systems also enable an audit trail of money, which
would help in the detection of money laundering and terrorist funding.
would help in the detection of money laundering and terrorist funding.
This shift from cash to electronic payments is a continuous process and is
happening all the time, but its scaling up will depend on some important factors.
The first is public acceptance, which is, in part, a question of removing the fear
of the unknown, and also a question of making it convenient for people to use
electronic payment systems. The second is a significant expansion of the
payment infrastructure, and in the nature of supply creating its own demand, this
expansion of the infrastructure may itself encourage more people to shift from
cash to electronic payments. In the ultimate analysis though, facilitating the shift
to a less cash economy is a question of meaningful financial inclusion.
There has been much talk recently in some rich countries of scrapping cash
altogether so that they can become ‘cashless societies’. In this futuristic world,
all payments will be made by contactless cards, mobile phone apps and other
electronic means, while notes and coins will stand abolished. Denmark is
reportedly in the forefront in this regard where, under a new proposal, paper
money transactions will be disallowed, except, for now, in places like hospitals.
The Danish central bank will stop printing currency, and banks will stop
carrying cash. In Sweden, it is common practice already for parents to pay
pocket money to their children electronically.
There are three main motivations behind this aspiration to a cashless society.
The first is the straightforward incentive of avoiding the cost of printing money
in the expectation that people will embrace electronic payments once they
discover how easy, convenient and efficient they are. Second, forcing people
into electronic payments will enable an audit trail of all financial transactions
and minimize tax evasion. Third, increasingly, an important motivation for
scrapping cash is to choke drug dealers and terrorist organizations who typically
use high-denomination notes for their financing.
The case for doing away with cash has gained currency in recent months in
the context of some advanced economy central banks, with the ECB and central
banks of Japan, Sweden and Switzerland embarking on negative interest rates. In
the midst of a contentious debate on the merits and demerits of negative interest
rates, an argument has been made that the way to make negative interest rates
effective is to ban cash altogether. The objective of negative interest rate is to
make people spend rather than save. But, as long as there is cash, people can
thwart negative interest rates by hoarding their savings in a safe or under the
thwart negative interest rates by hoarding their savings in a safe or under the
proverbial mattress. In the absence of cash, on the other hand, people will be
encouraged to spend, as the alternative is to lose value by saving in a bank.
Some people have even argued that abolishing cash will give traction to
monetary policy even in the normal world of positive interest rates. Since all
savings will be in the banking system, it is argued, central banks can manage the
business cycle more efficiently as its interest-rate calibration will have a bigger
impact. When the economy is slowing, it will cut interest rates to encourage
people to spend more; conversely, when the economy is overheating, it will raise
interest rates to discourage spending.
There is, of course, opposition to abolishing cash altogether and going
completely online. People apprehend invasion of privacy. The very audit trail
that allows the checking of illegal activities can turn into an Orwellian nightmare
where citizens’ every step is recorded in a Big Brother database for tax, financial
and monetary purposes. Worse still, should some hackers tap into the
information base, the consequences can be disruptive. People argue that the
anonymity of cash keeps them free from government snooping and that some
criminality is a price worth paying for this liberty.
The economic case for a cashless economy on the argument that it enables the
central bank to run a countercyclical policy more efficiently is also contested by
some experts who argue that it will deliver results no better than the
conventional monetary policy, and may in fact, do worse.
A debate such as this is far too premature for India. We are hardly ready to
contemplate the elimination of cash. Our objective is more limited—to shift
from a cash-intensive economy to a less cash-intensive economy since the
benefits of this shift, at our stage of development, unarguably, outweigh the
costs.
Meanwhile, physical currency with the governor’s promise will continue to be
around, reminding the governor of his dharma.
12
Goldfinger Governor
Foreign Exchange Reserve Management

I authorized the Reserve Bank’s purchase of 200 tonnes of gold from the IMF in
November 2009. There was deep irony in this for two reasons.

The Purchase of Gold from the IMF

First, back during the 1991 balance of payments crisis, it fell to my lot as a joint
secretary in the finance ministry to sign the agreement on behalf of the
government, authorizing the Reserve Bank to pledge our gold reserves to secure
foreign exchange for our rapidly depleting coffers. By sheer accident, this
purchase of gold in 2009 from the IMF to buffer our foreign exchange reserves
happened to take place on my watch as governor. The second irony surrounding
this transaction was that even as the Reserve Bank eagerly bought gold in 2009,
in the later years of my governorship, we were not only preaching to the public
to desist from buying gold, but had actually instituted regulations to discourage
the practice.
Well, the irony, if any, was superficial, and to understand why, I must tell the
full story. The Reserve Bank’s foreign exchange reserves comprise foreign
currency assets, gold and SDRs (Special Drawing Rights) issued by the IMF.1
When I took office as governor in September 2008, I inherited 357.7 tonnes of
gold, which was about 3.5 per cent of our total forex reserves of that time. There
was a view within the Reserve Bank that we must raise the proportion of gold in
the reserves as a risk-diversification measure since gold and dollar values move
in opposite directions in global markets. The counterargument was that gold, in
contrast to foreign currency holdings, is a non-income-generating asset and it
will be difficult to justify spending foreign currency to buy gold. Buttressing this
argument was the fact that during the global boom of 2002–06, the appeal of
gold as an asset had diminished even further.
Besides financial prudence, there were also logistic issues that inhibited the
purchase of gold. The problem of putting through a transaction in a transparent
manner is always a challenge. Not just the price of purchase, but the
counterparty risk involved, the quantity of gold that can be bought without
adversely tipping the price, due diligence, including the time gap between
paying for and receiving gold, could all be potentially controversial.
Both the economics and logistics changed in 2009, presenting us a ‘golden’
opportunity to bolster our gold reserves. Importantly, the global financial crisis
called into question the long-term health of the dollar as a stable asset,
reinforcing the argument for diversification away from the dollar. More
crucially, in September 2009, the IMF announced that it would be selling 403.3
tonnes of gold from its holdings to finance its lending to low-income countries
and partly also to defray its own operating expenses. The IMF also indicated that
before going for open market sales, it would make a preferential offer to official
reserve holders, including central banks, to buy the gold at the going market
price. The offer was on a first-come, first-served basis within a three-month
window.
Given the size of the transaction, we confronted the classic Hamletian
dilemma: ‘to buy or not to buy’ the gold on offer from the IMF. What made the
decision even more difficult was that all of this had to be done in great secrecy
since any leak would have moved the global price of gold, thereby exposing the
Reserve Bank to heavy pecuniary and reputation risk. This ruled out the
possibility of consulting any external expert. In fact, the initial discussion
involved just three of us—Deputy Governor Shyamala Gopinath, an epitome of
quiet competence and sturdy confidence, and Executive Director Harun Khan of
unquestionable integrity and discretion. The other deputy governors were
brought into the loop only after the three of us reached an ‘in principle’ view.
On the positive side was the rare opportunity to buy a significant quantity of
gold from an official international institution, a consideration that had to be
balanced against the potential censure we would attract should the price of gold
fall steeply in the future. Time was of the essence too since there could be
competition from other central banks. And how much should we buy? All 400
MT on offer? Or should we bid only for a part of it? It appeared from the
MT on offer? Or should we bid only for a part of it? It appeared from the
reaction when the news hit the market that I’d have pulled off a coup of sorts if
we had bid for the total quantity. But by then, over one year into my tenure as
governor, I had become enough of a central banker to take a conservative
approach. Considering all the pros and cons, I told Shyamala to go ahead and
place a bid for 200 tonnes of gold. In the next few days, I informed only the
prime minister and the finance minister, that too in person, when I happened to
meet them in some other context.
A small team in the Reserve Bank, led by the affable and intelligent Chief
General Manager Meena Hemachandra, worked on the logistics with the IMF.
The arrangement was that we would pay the IMF the average price in the
London bullion market over the following fifteen working days. Since secrecy
was critical, the whole operation had to be conducted on an entirely ‘need-to-
know’ basis. In fact, beyond me and the deputy governors, no more than half a
dozen Reserve Bank staff were involved in the transaction. The IMF too
instituted a similar code of diligence and secrecy on its side.
The transaction was completed on 3 November 2009, with 2 November being
the last of the fifteen working days. As per the agreement, we paid the IMF
through the US Federal Reserve by wire transfer at 6 p.m. IST that day, while
the Bank of England, the custodian of IMF holdings, transferred the gold to our
account by 9 p.m. the same day.
The contract with the IMF also included an agreement that both sides would
issue simultaneous press releases on completion of the deal, which meant that
the Reserve Bank release would be on 4 November. However, late evening on 2
November, our media spokesperson got a call from a press reporter saying that
he was releasing a story the next day, 3 November, on the Reserve Bank’s
purchase of gold unless we denied it. This report would not have had any impact
on the purchase price since the fifteen-day period was over. However, we needed
to ensure not only that the public heard it first from the Reserve Bank, but also
that they got accurate information, which made it imperative to advance the
press releases. Our staff coordinated overnight with the IMF and we issued press
releases simultaneously, in the early morning of 3 November in Mumbai, and
late evening 2 November in Washington.
This purchase of 200 tonnes of gold raised our gold holdings from 4.1 per cent
of our forex reserves on 30 October 2009 to 6.7 per cent on 6 November 2009.
The manner in which the entire transaction was conducted in extreme secrecy
and with utmost diligence, taking care at every step of the way to contractually
protect India’s interests, is a tribute to the competence, professionalism and
integrity of the Reserve Bank staff under the overall guidance of Shyamala
Gopinath. The Financial Times commended the Reserve Bank for putting
through the deal ‘like a hedge fund manager, leaving many countries red faced’.
For me personally, it felt good to have pulled off such a complicated piece of
theatre to conclude what some market experts labelled as the largest official deal
in history.
The commentariat welcomed the gold transaction with enthusiasm and saw it
as the Reserve Bank ‘redeeming the honour’ of the country nearly two decades
after we were pushed into the ignominy of pledging gold to raise money to pay
our foreign creditors. The Guardian of 4 November 2009 wrote: ‘The deal
underlines how India’s economy has been transformed since 1991 when a
financial crisis forced the country to take a loan from the IMF and ship its gold
reserves to London as security.’ And in an article titled ‘India flexes its foreign
reserve muscles’, the Financial Times of 3 November 2009 reported Finance
Minister Mukherjee describing the gold stock build-up as soothing the outrage
that Indians had felt when ‘we had to pledge gold to the Bank of England just for
borrowing to support our imports’.
I was pleased with all the praise for the Reserve Bank’s acumen but I was
discomfited by compliments for me at a personal level, tempting though it was to
believe that having signed away the pledge of gold back in 1991, I was now
having the opportunity of redeeming the honour of the country as the governor
of the Reserve Bank. But redeeming the honour of the country, an
unquestionably laudable objective, was not a consideration in the decision. The
only consideration that informed my decision was financial prudence. This was
exactly what I told the prime minister when, with glowing eyes, he
complimented me generously after the deal went public.
Reserve managers invest in gold for the long term. Even so, I am only too
conscious that should the price of gold drop significantly in the future from the
purchase price of $1041.80 per troy ounce, the very same people who praised me
would pan me. It is fortuitous that the price of gold has held so far!
What about the other irony that even as the Reserve Bank itself invested in
gold, we preached to the public not to invest in it? Some context is necessary to
gold, we preached to the public not to invest in it? Some context is necessary to
appreciate this apparent contradiction.
As I wrote earlier, the allure of gold for Indians is legendary. We absorbed
nearly a quarter of worldwide gold supplies in 2012. Changes in Indian demand,
therefore, have a significant impact on the world price of gold. During 2011–13,
our gold imports had increased abnormally, pushing the current account deficit
beyond the sustainable limit. The Reserve Bank investigations revealed that the
domestic demand for gold had gone up in part because people were investing in
gold as a hedge against inflation, and in part because the secular increase in the
world price of gold was encouraging speculators to invest in gold. It was
inevitable that we had to restrain the import of gold as part of our overall
strategy to manage the exchange rate during the taper tantrums in 2013, a topic I
wrote about earlier. Yes, it was ironic that I bought gold myself but stopped
others from doing so, but it was part of the dharma of the governor’s job.

Foreign Exchange Reserve Management

Although I have so far written only about gold, it is important to note that gold
is only a small proportion of our foreign exchange reserves. The bulk of the
reserves is foreign currency which the Reserve Bank invests as deposits with
other central banks, official international institutions and overseas branches of
commercial banks, driven by objectives of safety, liquidity and returns, in that
order. The broad strategy for investment is decided by a high-level committee
chaired by the governor and comprising the relevant deputy governor, the
secretary of economic affairs and the chief economic adviser from the finance
ministry. Within the broad strategy, the operational details are left to the staff of
the Reserve Bank.
A frequent question any governor confronts is whether our forex reserves are
sufficient. It’s also a tricky question because no matter how the governor replies,
it is bound to be overinterpreted to draw inferences on the rupee movement,
thereby fuelling speculation. If, for example, the governor answers that the
reserves are sufficient, the market would infer that the Reserve Bank would not
intervene in the forex market for the purpose of buffering the reserves. That
would bring the rupee under appreciation pressure. If, on the other hand, the
governor says that the reserves are not sufficient, there would be speculation
about the ability of the Reserve Bank to defend the exchange rate should it
about the ability of the Reserve Bank to defend the exchange rate should it
become volatile, thereby pushing the exchange rate down.
Back in the 1980s, the yardstick, in part enshrined by the IMF, used to be that
a country should have reserves sufficient to provide at least three months of
import cover. But that was when trade flows dominated the balance of payments
and determined the exchange rates. Today, global capital flows are several
multiples of trade flows, and floating exchange rates are more a function of the
capital account in the balance of payments rather than the current account. Any
measure of reserve adequacy in today’s world has to factor in not only the
current account balance, but also, at the minimum, debt with a residual maturity
of less than one year.
The economics literature has several models and formulae for estimating
reserve sufficiency. The time-tested truth on reserves, though, is that in good
times, no amount of reserves is too much, and in bad times, any amount of
reserves is too little.
Another FAQ that a governor faces is about why the Reserve Bank is not fully
transparent about its reserve holdings. In particular, why doesn’t the Reserve
Bank put out its reserve position in real time and why doesn’t it give out the
currency composition of its reserves?
Actually, the Reserve Bank puts out the data on foreign exchange reserves
every week with a lag of one week. It also publishes a half-yearly report on the
management of foreign exchange reserves indicating several details, including
the objectives of the reserve management strategy, and the adequacy of the
reserves as measured by several metrics, risk management practices and the like.
However, it does not disclose the currency composition of the reserves because,
as the forex reserves manager, the Reserve Bank is like any other commercial
entity in the market. The information is market sensitive and disclosure could
potentially impact our commercial interests adversely. Disclosure also has wider
implications for our international relations. Furthermore, market efficiency is in
no way affected by this non-disclosure. Indeed, non-disclosure is the norm
around the world; a majority of countries, particularly the large reserve holders,
do not disclose the composition of their foreign exchange reserves.
The Reserve Bank has, however, progressively moved towards a greater
degree of disclosure in line with international best practices. It is among sixty-
eight central banks from around the world to have adopted the Special Data
Dissemination Standards (SDDS) template for publication of detailed data on
Dissemination Standards (SDDS) template for publication of detailed data on
foreign exchange reserves, including some information on currency composition,
investment pattern and forward positions. These data are released on a monthly
basis on the Reserve Bank’s website. The Reserve Bank is also one of the very
few central banks which publish their market intervention numbers; it does so in
its monthly bulletin with a lag of two months.

Use of Reserves for Domestic Capital Expenditure

For a cash-strapped government like ours with huge and compelling expenditure
needs, there is a big temptation to dip into the foreign exchange reserves in the
custody of the Reserve Bank to finance capital expenditure. The idea was most
actively canvassed by Montek Singh Ahluwalia, deputy chairman of the
Planning Commission during 2004–14, who argued that we should design a
scheme for lending our forex reserves to public and private enterprises engaged
in infrastructure projects, as it was irrational for Indian entities to be borrowing
abroad at high cost while the Reserve Bank was earning such low returns on its
reserves. And if the Reserve Bank allowed its reserves to be put to use like this
for domestic capital expenditure, it would earn more by way of return, and the
borrowing entities would pay less by way of interest and we would have a win-
win situation.
The Reserve Bank did not see the cost-benefit calculus that way, and rightly
so, for several reasons. The most important concern was that India is a current-
account-deficit economy and our reserves, accumulated mainly through capital
flows, are actually in the nature of borrowing. This is in sharp contrast to China,
for example, whose reserves, earned through current account surpluses, are
unencumbered. Moreover, frittering away reserves like this would compromise
the Reserve Bank’s ability to defend the exchange rate in times of volatility and
also erode its external credit rating. There were also concerns that any relaxation
like this would, in fact, be the thin end of the wedge. Once the Reserve Bank lets
go of caution, there would be no end to similar proposals for spending away the
reserves, which could severely hurt our external sector viability.

Paying Iran for Oil Imports during the Sanctions

In the area of foreign exchange management, a sensitive task I had to handle as


In the area of foreign exchange management, a sensitive task I had to handle as
governor related to payments to Iran for the oil we imported from it while
remaining in compliance with the sanctions the country had come under. The
point to note is that the UN sanctions did not prohibit buying oil from Iran, but
payment for the imports became increasingly difficult as first the US, and later
Europe, tightened the use of their currencies for settling these transactions. Here
is how the situation developed.
Since India and Iran are both members of the Asian Clearing Union (ACU),
net trade settlements were generally routed through the ACU mechanism. The
ACU comprises nine countries—Bangladesh, Bhutan, India, Iran, Maldives,
Myanmar, Nepal, Pakistan and Sri Lanka—which have mutually agreed that
trade payments among them will be settled on a multilateral netting basis which
would help economize the use of foreign exchange reserves and transfer costs, as
also promote trade among the member countries. Import and export of oil was
brought under the ACU umbrella in 1985. The currency used for net settlement
under the ACU mechanism was originally only the US dollar, but the euro was
added as a settlement currency in January 2010.
Amidst misinformed and speculative news reports in America that the ACU
mechanism was being used as a conduit for payments on behalf of Iranian
companies that were blacklisted by the US for supporting nuclear proliferation
activities, starting 2008, the US authorities heightened their scrutiny of payments
under the ACU mechanism, gradually making it difficult and eventually
impossible to use the dollar as a settlement currency for Iranian transactions.
To get around this, the ACU shifted to using the euro to settle payments to
Iran. However, that channel too got choked in the wake of EU regulations issued
in 2010 that any bank in the euro area effecting a transfer to Iran on behalf of the
ACU had to obtain prior authorization from the euro area authorities by showing
that the proposed transfer would not contribute to Iran’s nuclear proliferation or
other sensitive and prohibited activities. With the dollar out of the ACU since
2008 and euro following suit in 2010, Iran’s continuation under the ACU
arrangement became virtually impossible. The inevitable consequence of taking
payments to Iran out of the ACU mechanism followed in December 2010.
Given India’s significant reliance on Iranian oil, the lack of a payment channel
landed us in a near-crisis situation. The challenge for us—the government and
the Reserve Bank—was to identify a payment mechanism that was in
the Reserve Bank—was to identify a payment mechanism that was in
compliance with the Iranian sanctions, but did not involve any American or
European bank. The Iranian authorities who were in constant touch with us
suggested several alternatives, but none of them materialized, as the parties
involved were wary of the consequences of getting hit themselves by sanctions.
Eventually, as a result of the joint efforts of the government and the Reserve
Bank, we zeroed in on two payment mechanisms. The first was to pay a part,
albeit a small part, in euros through a Turkish bank which came forward; and the
second was to pay the remaining amount owed to Iran in rupees. But where
would Iran keep the rupees and what will it do with them?
The straightforward option would have been for Iran to open an account with
one of our banks into which the rupee payments could be made, but that wasn’t
as simple as it seemed. Most of our banks were reluctant to accept this business,
not being sure of the impact of US sanctions on their overseas business,
particularly given the dominance of the dollar for trade settlements. After much
effort, we were able to persuade one of our public sector banks with minimal
overseas presence to take on this task.
But what was Iran to do with the rupees in its Indian account? It was agreed
that they would buy goods from India and use the rupees to pay for them; and
the balance, if any, would be remitted to them in hard currency once the
sanctions were lifted. Subsequent to the activation of the Rupee Payment
Mechanism by the Reserve Bank, India’s exports to Iran had increased from $2.4
billion in 2011/12 to $5.0 billion during 2013/14.
The resolution of the Iran oil payment impasse was a testimonial to the strong
friendship between our two countries as well to as the ingenuity of senior
officials of both the government and the Reserve Bank to find a solution to what
seemed like an impossible cul-de-sac situation.
13
‘Keep Your Ear Close to the Ground’
The Reserve Bank’s Outreach

When I went to call on Prime Minister Manmohan Singh in his South Block
office before assuming office as governor in September 2008, the meeting lasted
just about fifteen minutes. As I stood up to leave, he graciously walked me to the
door, and literally at the doorstop, gave his bit of advice: ‘Subbarao, you are
moving from long experience in the IAS to the Reserve Bank. That’s a big
change. Unlike in the civil service, in the Reserve Bank you risk losing touch
with reality. Your mind will be so full of numbers like inflation, interest rate and
credit growth that you will tend to forget how all this matters to people and their
livelihoods. Remember to keep your ear close to the ground.’

Tribal Indebtedness

I could relate very much to that advice. Let me give just one example to explain
why.
I have already written about how tribal welfare dominated my job chart in my
first posting as subcollector of Parvathipuram division in north coastal Andhra
Pradesh in the mid-1970s. The tribal people there suffered from a chronic curse
of indebtedness. It was far from uncommon for them to lose what little assets
they had to moneylenders and then end up as bonded labour.
How households living at a subsistence level end up in a debt trap is easy
enough to understand at a conceptual level. But why tribal people should suffer
this misery was initially a mystery to me. The reason is that since colonial times,
tribal people have been protected by a debt relief regulation. The regulation,
applicable to what were popularly called ‘agency areas’ in the erstwhile Madras
Presidency—hill tracts inhabited by tribal households and designated as
scheduled areas—was, by far, one of the most sympathetic laws that I had come
scheduled areas—was, by far, one of the most sympathetic laws that I had come
across. It provided that any and all debt owed by a tribal to a non-tribal stood
completely annulled. It was summary justice at its simplest. All it required for an
indebted tribal person to free himself of debt was to come forward and report
that he owed a non-tribal a certain amount of money, and I, as the subcollector,
could then issue an order that all that debt was cancelled. What was more, if the
non-tribal still pressed for repayment, he could be jailed. By way of affirmative
action, the debt relief regulation was remarkable for its extraordinary clarity of
purpose and simplicity of process.
The regulation was also most ineffective. My first instinct was to believe that
all tribal debt would have been written off since the regulation had been in force
since colonial times. But during my visits to villages, I realized that nothing had
changed. The moneylenders were still there, tribal households were still
borrowing from them, and generations of them were still going into bondage. I
thought maybe my predecessors didn’t pay attention to this task, and I would
make amends for past negligence.
In all my youthful enthusiasm, I went around tribal hamlets and encouraged
tribal households to report their debt so that I could then write it off and free
them from debt and bondage. I simply didn’t make a dent. Not one would come
forward. It took me several months to understand why. Their total silence had to
do with the dependence of the tribals on the non-tribals. Imagine a tribal actually
coming forward and getting his debt written off by the subcollector. From that
very moment, not only he, but his entire village, would be ostracized by the
moneylender community. The net result of my misguided heroism would have
been to cut off tribal households from their only source of loans.
Consider these scenarios. Where would the tribals go for an emergency loan if
they had a sick child who had to be taken to a doctor in the nearest town in the
middle of the night? Where would they go if their animals died in a drought or
their crop got washed away by floods? Where would they go for a loan to meet
lumpy expenditure on weddings and festivals? The moneylender, never mind his
usurious interest rate, was the tribal community’s safety net. It was vacuous on
the part of the government to believe that it could free the tribal people from the
clutches of the moneylenders without first instituting an alternative.

The Reserve Bank’s Outreach


This early experience with tribal indebtedness taught me an important lesson in
managing public policy. Competence and commitment are necessary to
successfully execute development policies and programmes, but not sufficient.
Those working at the field level, in particular, need to have a keen understanding
of the psychology of poverty and the sociology of village life.
The prime minister’s advice to keep my ear close to the ground, when
juxtaposed with my civil service experience, struck a deep chord in me. I made a
conscious effort to keep this in mind all through my tenure in the Reserve Bank.
I am by no means suggesting that the Reserve Bank is cut off from the real world
of everyday people. Far from it. Many, if not most, of the Reserve Bank staff
come, like me, from modest backgrounds and have grown up with middle-class
anxieties and aspirations. They are also intelligent enough to understand that
they must think through all the consequences of their actions, especially keeping
in view the levels of poverty and illiteracy in our country.
At the same time, there was also much truth to what the prime minister had
told me. The Reserve Bank is an insular institution with not much public
interface. In the normal course of their work, the staff do not have occasion to
travel into the hinterland of the country. Data and numbers on the economic and
financial sector are so much a part of everyday work that real-world perspectives
risk being pushed into the background.
It became quite clear to me, early in my term, that deepening the real-world
exposure of the Reserve Bank—the outreach—had to be one of my priorities.
The platinum jubilee celebrations of the Reserve Bank during 2009–10 provided
an opportunity to get started on this. At a meeting with the top management of
the bank where we were discussing the layout of the events and programme for
the whole year, we agreed that we should embark on something that would have
an enduring value extending beyond the platinum jubilee year. The outreach
programme emerged out of this brainstorming. The idea was that all of us in the
top management of the Reserve Bank would visit at least two villages each
during the year, spending a good part of the day there, connecting with ordinary
people and understanding their concerns, their problems and their way of life.
It was not as if we meticulously choreographed the outreach programme in all
its detail before rolling it out. On the contrary, the programme got off the block
with only a hazy structure and evolved over time, based on early experiences.
The twin objectives of the programme too crystallized more clearly only down
The twin objectives of the programme too crystallized more clearly only down
the line—first, to demystify the Reserve Bank which is to tell people what we do
and how it makes a difference to their lives in a language and idiom that they can
relate to; and second, to listen to them and understand their concerns so that
decision-making in the Reserve Bank gets to acquire a human face.
A picture, they say, is worth a thousand words. Similarly, visiting a village,
even if for half a day, and even if not seeing it in its everyday unrehearsed
setting, is more valuable than studying dozens of books and reports on village
life. It gives a perspective, a sense of reality, if also greater meaning to what the
Reserve Bank does. Imagine, for example, that the issue before a deputy
governor of the Reserve Bank is whether the area of operation of a banking
correspondent should be increased from a radius of ten kilometres around the
core village to fifteen kilometres. In the normal course, this issue would be
decided by studying an analysis on paper of the pros and cons of doing so. Now
imagine that the deputy governor actually sees a BC operate in a village and has
an understanding of how a transaction is carried out on a handheld machine, the
time it takes for each transaction, the volume and flow of work for the BC
through a workday and the logistics involved in moving from one village to
another. She would then have a much better sense of what it means to extend the
radius of operation of a BC. And if the deputy governor also visits villages in the
North-east, she will be able to appreciate why the area of operation there should
be different from that in the rest of the country.
Whenever I went to see the prime minister, I would often tell him about the
various initiatives of the Reserve Bank towards financial inclusion and how the
technology of a handheld machine was proving to be a game changer in barefoot
banking. I also used to urge him, during his travels across the country, to just
side step into a village, any village, to see a BC in operation. He and I, both
knew that this was not a practical idea. The prime minister’s travels are so well
choreographed and the security so intense that it is virtually impossible for him
to make an impromptu visit to a village. In the event, we settled for the second-
best alternative. I offered to bring a BC to his office and demonstrate the
operation to him.
Anyone who has seen a BC operating a handheld machine, which is just like a
credit card reader, would have noticed that the technology is far from robust.
Because the palms of villagers are typically soiled, it takes several attempts to
get the machine to respond to their fingerprints. In the manner of learning by
get the machine to respond to their fingerprints. In the manner of learning by
doing, BCs acquire rich experience in making these stubborn machines work.
Given this situation, it would have been best for us to choose a couple of BCs
from the vast hinterland of the country for the demonstration before the prime
minister. But that wasn’t to be. Demonstrating barefoot banking before the prime
minister was such a rare and prized opportunity that the chairmen of public
sector banks offered their own services.
So it transpired that one afternoon in September 2010, deputy governors Usha
Thorat and K.C. Chakrabarty, O.P. Bhat, chairman of State Bank of India, and
K.R. Kamath, chairman of Punjab National Bank, and I, along with three
villagers, appeared at the 7 Race Course Road residence of the prime minister to
give him a demonstration of the handheld mission. Imagine the situation. None
among the five of us had any prior experience of touching a handheld machine,
let alone operating it. I am sure both Bhat and Kamath were intensely tutored by
their staff and had practised on the machines for days on end for this impending
test before the prime minister.
But, of course, Murphy’s Law1 came into full play. The machines refused to
respond notwithstanding the villagers’ hands having being sanitized clean before
this demonstration. As his face and hands started sweating, Bhat even blurted out
light-heartedly that performing before the prime minister was making him
nervous. Only after much huffing and puffing did the machines oblige and save
our collective reputation. The prime minister, of course, was very pleased and
asked some very searching questions about financial inclusion before we all
trooped out triumphantly.

The Value of Getting Your Hands Dirty

Consider the following sample of questions. Can a bank branch operate out of a
village panchayat office? How popular or useful is the kisan credit card? How do
poor people with irregular incomes and lumpy expenditures manage their
finances? Is the interest rate charged by microfinance institutions usurious? If
yes, why are people still borrowing from them? If we make borrowing against
the pledge of gold more difficult, who gains and who loses? What do
schoolchildren learn about finance? Is that learning effective? Is it the case that
villages end up with only soiled currency? How big a grievance is that? Why and
how are poor people lured by Ponzi schemes?
These are just a sample of hundreds of questions over which the Reserve Bank
could take a more informed view by looking at things from the trenches, as it
were. Simply put, the outreach gave a real-life context and a human face to
Reserve Bank decision-making.
Personally, I had a lot of fun going on outreach visits to villages. I was always
touched by the warmth and affection of the villagers. In Lalpur Karauta village
of Uttar Pradesh, I went into a house with a newly built toilet and asked the
woman of the house how she felt. ‘Meri izzat vaapas aa gayi’—‘I have regained
my honour’—was what she told me. I visited the primary school in Jalanga, a
village near Bhadrak in Odisha, and chatted with the girls in the school. I was
impressed by how their aspirations had grown. One girl told me she wanted to be
an astronaut like Kalpana Chawla, another said she wanted to be like me—
become the governor of the Reserve Bank. I do hope that in not too distant a
future, the Reserve Bank will be headed by a female governor with a rural
background.
While the outreach programme was widely commended, there were a few
critics who said that an initiative like this was out of character for a central bank
which should remain in the background, and see and learn quietly. There was
criticism also that there was too much of show and festivity and that it was just a
vacuous attempt by the Reserve Bank to play to the gallery, and had little
learning value. I remained sensitive to this criticism and was concerned that the
outreach programme should not degenerate into an empty pageant; that it should
retain its freshness and spontaneity, and continue to enrich the Reserve Bank’s
collective understanding of the sociological context of our policies. Just to make
sure that we remained on track, I frequently did a reality check with the senior
management, both in formal meetings as well as informal conversations.

Town Hall Meetings

Although I have gone on at length on the outreach programme, this was only one
of the several initiatives that we launched during my tenure at the Reserve Bank
in order to keep our ears close to the ground.
The town hall meetings I wrote about earlier were a particularly rich hunting
ground for insights and understanding. I recall vividly the very first town hall
ground for insights and understanding. I recall vividly the very first town hall
meeting we held in Chennai, on the steps of the museum in Egmore, one
pleasant January evening, as part of the Reserve Bank’s platinum jubilee
celebration. This was shortly before Pongal in 2010, and Chennai was in a
festive mood, matching with the celebratory mood of the Reserve Bank’s
platinum jubilee. Vikram Chandra of NDTV was the moderator, and seated on
the dais along with me were the four deputy governors—Shyamala Gopinath,
Usha Thorat, K.C. Chakrabarty and Subir Gokarn. The audience for the show,
which was telecast live nationally, was entirely middle class comprising both the
young and the middle-aged.
As a warm-up for the questions from the audience, Vikram set the
conversation rolling by asking me to explain the basic functions of the Reserve
Bank, why we were in Chennai and why indeed were we doing a town hall
meeting on live TV. Thereafter, we fielded a variety of questions from the
audience centred expectedly on soaring prices, low interest rate on savings
accounts and fixed deposits, the myriad problems in getting loans from banks,
poor customer service, and vexatious KYC (know your customer) requirements.
Obviously, we tried our best to respond to all these questions in as simple and
direct a language as we could muster.
Midway through the show, I asked for an audience poll on how many thought
that the Reserve Bank should be supporting growth even if it risked higher
inflation as against those who thought that the Reserve Bank should firmly keep
prices under check even if that meant some sacrifice in growth in the short-term.
I was aware I was oversimplifying a complex dilemma but I wanted to get the
pulse of the public. The votes by show of hands were roughly even for either
option. But it struck me immediately, even through only a rough, visible check,
that the youngsters in the audience predominantly voted for growth—reflecting,
I thought, their concerns for job prospects and career opportunities—while the
middle-aged voted for the Reserve Bank giving priority to controlling inflation
over all else.
The town hall meetings were a rewarding learning opportunity; they were also
big mood elevators. Encouraged by our happy experience with the initial town
hall meetings, I started urging senior staff, both in our central office in Mumbai
as well as our regional offices spread across the country, to hold focus group
meetings in tier-2 cities and district towns with various categories of
stakeholders—pensioners, bank depositor associations, microfinance institutions,
stakeholders—pensioners, bank depositor associations, microfinance institutions,
banking correspondents and small and medium industries. I soon realized that I
didn’t need to coax the staff any more; they seemed to have embraced the idea
with energy and enthusiasm.

Financial Inclusion

We would often discuss the issue of financial inclusion with chairmen and CEOs
of commercial banks. These meetings were useful for understanding the major
challenges in deepening financial inclusion and for reaching a shared
understanding on the broad strategy forward. But these meetings lacked depth
because all of us operating at the top management of our institutions did not
have a full grasp of the problems at the front end. To fill this knowledge gap, we
embarked on what came to be called a ‘front-line bank managers conference’.
The format was to get together about fifty people—a dozen front-line bank
managers from branches in small towns and villages, banking correspondents,
MFIs (microfinance institutions), NGOs and some low-income households—in
an informal setting for a whole day to talk about financial inclusion. These
meetings were an eye-opener on the many gaps between policy and its
implementation at the field level: How long and how many visits does it take for
a low-income household to get a bank loan? How difficult is it for them to meet
all the documentation requirements for a loan? How much do they have to spend
out of pocket to secure a loan? Are the poor treated courteously and kindly in the
bank? These and other similar questions that came up in the front-line managers’
conference were pointers to what we from the Reserve Bank should be doing to
take banking services to the poor.
One of the things that used to impress me, both during outreach visits and
front-line managers’ meetings, was how confidently rural women would speak
up, not at all overawed by the occasion or the unfamiliar setting. At an outreach
visit to Chapro, a village in Himachal Pradesh, I recall one woman taking the
mike in front of maybe 2000 people to tell me that her local bank had introduced
a monthly recurring deposit scheme that would yield a lump sum at the end of
the year. She said she was attracted by the scheme as the lump sum return on
maturity would come in handy to pay the school fees of her children in June–
July. But the problem was that the bank had a rigid calendar for the recurring
deposit—it started in January and matured in December, whereas what she
deposit—it started in January and matured in December, whereas what she
wanted to do was to start in June so that the lump sum would be available the
following year in time for school reopening. All that was needed was a simple
fix that would have made a big difference to her and to the bank. But the bank
did not oblige her!
When in Ernakulam in November 2012 for a conference, I went for a morning
walk. I noticed that hundreds of labourers were gathered at the main street
corner. Just from their appearance, it was clear that they were not locals. On
inquiry, I found that they had come from the North-east for manual labour in
Kerala. I struck up a conversation with them and learnt about the work they do,
how much they earned, where they ate and lived in Ernakulam, and why indeed
they had travelled 3000 kilometres across the country for eking out a livelihood.
I was particularly curious to know how they were sending money back home
to their families. I gathered that out of hundreds of them, only a dozen or so
could meet the KYC requirement to open a bank account in Ernakulam, but they
got around that with some resourcefulness. Each of the dozen or so account
holders would service dozens of others, who did not have bank accounts. Each
of them would deposit the amount he wanted to send to his family back home
into a designated bank account, and the account holder would text his wife about
the respective shares. At the North-east end, his wife would withdraw the money
with her ATM card and disburse amounts to each family in accordance with the
remittances made in Kerala.
I was impressed by their enterprise. I was also embarrassed by my ignorance.
Here was big phenomenon—massive migration of labour across a 3000-
kilometre diagonal of the country—and I, as the governor of the Reserve Bank,
was not even aware of it.
I happened to go back to Ernakulam after stepping down from the Reserve
Bank. The regional director of the Reserve Bank there told me that they have
since started disseminating material on financial literacy in Bengali and
Assamese and that it would soon extend to other languages.

Portfolios of the Poor

By way of keeping my ear close to the ground, one book that impressed me was
Portfolios of the Poor2 where the authors tracked 100 poor rural households each
(living below the World Bank poverty norm of less than $2 a day) in three
countries—Bangladesh, India and South Africa—for one full year and
maintained a financial diary of each household’s daily income and expenditure.
The findings in the book are revealing and touching. One of the least
understood problems of poverty is that the poor have not only low incomes but
their income streams are irregular and unpredictable. Living on less than $2 per
day does not mean that you earn $2 every day. That is the average over time. At
the same time, the poor have to cope with loss of employment, illness and death
in the family and lumpy expenditure needs. One of the stereotypes about poverty
is that ‘the poor don’t save because they have no money to save’. That is a false
stereotype. The poor need to save precisely because, like the rest of us with a
present and a future, they too have to put aside a part of what they have today,
little as it might be, to provide for tomorrow. The sophisticated financial
planning that the poor adopt to smooth their incomes constitutes the fascinating
story of portfolios of the poor.
The reason I am referring to ‘portfolios of the poor’ is because of the powerful
way in which the book reinforces the importance of keeping one’s ear close to
the ground. Let me elaborate.
All through my tenure in the Reserve Bank, we would occasionally get reports
from banks as well as state governments that some districts have achieved 100
per cent financial inclusion. These claims would not, of course, stand scrutiny.
When you actually check, you would find that thousands of households had not
been covered. And even where they have a bank account, the accounts would not
be actively used. In other words, our financial inclusion programme was going
the way of all other target-driven programmes—compliance in letter but not in
spirit.
While visiting Vengoor village near Ernakulam, on an outreach trip in March
2011, I had thrown a challenge to Union Bank of India (UBI), the lead bank of
Ernakulam district, that they should make it the first district in the country to
achieve 100 per cent ‘meaningful’ financial inclusion—i.e. not only should
every household have a bank account, they should also be using the account
actively and regularly.
The choice of Ernakulam was significant. Ernakulam was the first district in
the country to have achieved 100 per cent family planning, in the 1970s; it was
the first district in the country to have achieved 100 per cent literacy, in the
the first district in the country to have achieved 100 per cent literacy, in the
1980s; achieving 100 per cent financial inclusion would therefore be a logical
sequel. UBI set about the task with impressive diligence, and working along with
the state government and the Unique Identification Authority of India (UIADI),
reported by mid-2012 that they had achieved 100 per cent ‘meaningful financial
inclusion’ in Ernakulam. We planned a big celebration, together with the state
government and UBI, to mark this achievement, in part to showcase Ernakulam
as an example for other districts in Kerala and indeed in the country. Chief
Minister Oomen Chandy, Nandan Nilekani of UIADI, Debabrata Sarkar, chief of
UBI, and I attended the celebration in November 2012.
Even as we were planning the celebration in Ernakulam, I had my own doubts
about the claim of 100 per cent ‘meaningful’ financial inclusion. So, three
months ahead of the launch, I asked our staff to commission a study in
Ernakulam district on the lines of ‘portfolios of the poor’.
We found that financial inclusion in Ernakulam was more meaningful than
elsewhere in the country, and since the launch of the drive, the banking habit had
certainly increased. Even so, there was a significant segment of households still
operating in the informal markets. They were still saving through chit funds, and
borrowing from moneylenders.
I realized that we were quite some way away from 100 per cent meaningful
financial inclusion. All that we need to do to achieve cent percent ‘meaningful’
financial inclusion remains an open question. Keeping our ear close to the
ground will take us closer to an answer.
14
Sleeping at the Wheel?
Regulation of Non-Banking Financial Companies

Since I left the Reserve Bank over two years ago, several people, especially from
the financial sectors of Hong Kong, London and Singapore, have asked me why
the Reserve Bank is institutionally biased against the non-banking financial
sector. This question has always surprised me, not only because there is no such
bias but, on the contrary, the Reserve Bank believes that non-banking financial
companies add to the financial intermediation function by reaching out to
borrower segments left out by banks. As governor, I myself have publicly
acknowledged several times that NBFCs perform a valuable function in the
financial space.
So, why the misperception? I can only conjecture that it probably arises from
the Reserve Bank gradually tightening the regulation of NBFCs over the years
for reasons of financial stability and consumer protection, which regulated
entities may have perceived as a systemic bias. It is important to understand the
context in which the Reserve Bank has moved in the direction of tighter
regulation of NBFCs.

Evolution of Regulation of NBFCs

NBFCs differ from banks in a number of important ways. Banks have access to
the Reserve Bank’s repo window for overnight liquidity management, whereas
NBFCs have to depend entirely on the regular financial markets and therefore
suffer higher cost of funding. NBFCs are not also entitled to access the ‘lender
of last resort’ facility of the Reserve Bank, and are therefore less able to protect
themselves against liquidity crunches in an emergency situation. NBFCs are not
part of the payment and settlement system, and cannot issue cheques drawn on
themselves. Unlike banks for whom retail deposits are the mainstay, NBFCs
themselves. Unlike banks for whom retail deposits are the mainstay, NBFCs
typically depend on borrowing wholesale from banks as also the money and
bond markets. Only a relatively small number of NBFCs are allowed to mobilize
deposits, and to the extent they do, those deposits are not covered by deposit
insurance unlike retail deposits with commercial banks.
The business models of NBFCs have evolved reflecting these constraints. As
their source of funding is narrower and costlier, NBFCs finance niche segments
where they have a comparative advantage in contrast to banks which maintain a
diversified portfolio of loans and investments. Because they pose less of a
systemic risk compared to banks, NBFCs have historically faced lighter
regulation than banks. That perspective has, however, changed over time
because of developments in the financial sector having implications for financial
stability and consumer protection, resulting in tighter regulation of NBFCs in
some respects.
Take financial stability first. We know from the experience of the crisis that
the interconnections in the financial system are by far the biggest threat to
financial stability. As NBFCs grew in number and size, their interconnection
with the rest of the financial sector, and with banks in particular, had not only
increased but had also become more complex. Being under lighter regulation,
NBFCs were becoming conduits for routing bank finance into risky activities
where the banks themselves were restrained from lending, such as real estate
development and stock market investment. The Harshad Mehta and Ketan
Parekh scams where bank finance had allegedly found its way into stock market
speculation are high-profile examples of this regulatory arbitrage. To prevent
this leakage of bank money into risky activities via NBFCs, the Reserve Bank
had tightened the leverage and reporting requirements for those NBFCs that
largely depend on bank financing for their business.
The second reason behind the gradual tightening of NBFC regulation was a
growing concern for consumer protection. Because they do not suffer bank-like
regulation, NBFCs are able to offer a higher interest rate on the deposits they
mobilize, thereby providing a saving option for people willing to accept higher
risk for higher reward.1 While the existence of such a saving avenue to cater to
higher-risk segments may be appropriate, it does pose problems in a country like
India with widespread poverty and low awareness levels. There have been
several cases where low-income households have been lured by the high returns
offered by NBFC deposits only to have lost all their money as the NBFC
defaulted on paying interest or even returning the principal. Besides, in the
absence of sufficient vigil, a number of ‘fly by night’ operators, masquerading as
NBFCs, have mobilized money from gullible people and run away with it.
As a measure of consumer protection therefore, the Reserve Bank has decided
that deposit mobilization by NBFCs should be gradually minimized and
eventually eliminated so that deposit-taking remains restricted to banks which
are more tightly regulated. The Reserve Bank has, in fact, not accorded
registration to any new NBFC for deposit mobilization since 1997, and has even
asked already licensed NBFCs to scale down deposit mobilization. To get a
perspective on the share of NBFCs in the retail deposit space, note that of over
12,000 NBFCs registered with the Reserve Bank as of May 2015, only about
220 were authorized to collect deposits. These deposit-taking NBFCs are also
subject to more stringent Reserve Bank regulation than their non-deposit-taking
counterparts.
The perception about the Reserve Bank’s alleged bias against NBFCs may
also have been shaped in part by the general antipathy at the global level towards
shadow banks in the aftermath of the global financial crisis. Shadow banks had a
sizeable role to play in abetting, if not actually causing, the crisis as banks
transferred their risky assets to these shadow banks, thereby freeing up space for
themselves for further lending which led to an unsustainable debt build-up and
the near-total implosion of the global financial system. Unsurprisingly, one of
the big post-crisis reform initiatives is to plug this loophole by bringing shadow
banks too under the regulatory purview, and thereby minimizing the chances of
contagion from shadow banks to regular banks.
Are NBFCs in India shadow banks? They are shadow banks in the sense that
they perform bank-like intermediation; but they are also not shadow banks
because, unlike shadow banks elsewhere which emerged and flourished beyond
regulatory oversight, India’s NBFC sector has always been regulated, although
less tightly than the banking sector.
Even though our NBFCs are not shadow banks, reflecting the global unease
about financial sector entities outside of the banking system, we too felt that
there was a need to review our regulatory approach to the NBFC sector in the
context of the shrinking difference between banks and non-banks, and their
increased interconnection. This was the motivation for my decision to appoint a
increased interconnection. This was the motivation for my decision to appoint a
working group under the chairmanship of retired Deputy Governor Usha Thorat
in November 2010 to advise on the broad principles that must underpin the
Reserve Bank’s regulatory approach to the NBFCs keeping in view the
economic role performed by them, their heterogeneity as well as recent
international experience.
The thrust of the Usha Thorat Working Group (UTWG) recommendations
was that the Reserve Bank must use its regulatory and supervisory resources
more efficiently by relaxing the regulation on smaller NBFCs and focusing more
on larger, systemically important NBFCs.
The UTWG recommendations were eminently rational and the Reserve Bank
subsequently accepted and implemented most of them. But one recommendation
that remains in abeyance has been the one regarding exempting smaller NBFCs
—those with asset sizes of less than ₹500 million—from the requirement of
registration with the Reserve Bank. Just to get a perspective on this, note that of
the 12,000 NBFCs registered with and regulated by the Reserve Bank, over
11,000 fall into this category of asset size below ₹500 million.
I would have thought that any relaxation like this which sought to exempt
over 90 per cent of the NBFCs from the requirement of registration would be
welcomed by the sector. On the contrary, they were quite agitated as they were
afraid of foregoing the credibility and reputation that came with registering with
the Reserve Bank. In any case, the public outcry following the Saradha scam
also turned opinion strongly in favour of more regulation rather than less
regulation of NBFCs.

The Jolt of the Saradha Scam

I was deeply distressed by the Saradha scam that erupted in West Bengal in
April 2013 in which hundreds of thousands of low-income households who had
invested their entire life savings in the Saradha Group of companies lost all of
that money when the operations of the companies collapsed.
Although the details of the various schemes run by the Saradha Group with
the money mobilized from the public and their legality are the subject matter of
criminal prosecution currently under way, media reports indicate that the group
collected around ₹200–300 billion from over 1.7 million depositors on the
promise of investing the pooled funds in collective investment schemes,
popularly but incorrectly called ‘chit funds’ in eastern India.2 The group
companies pooled the money they mobilized and invested it in a range of
enterprises—tourism packages, forward travel and time share credit transfer, real
estate, infrastructure finance and even motorcycle manufacturing. Reportedly,
investors were not properly informed about what use their money was being put
to, but were repeatedly assured that they would get handsome returns after a
fixed period.
Here is a report titled ‘Sen’s “bluff”, in a nutshell’ that appeared in the
Telegraph of Kolkata on 9 May 2013: ‘“Soon after the acquisition, Sen held an
agents’ meeting at the Science City auditorium to inform everyone how his
group was investing in the agro industry and hence, there should be no cause for
concern about the future of the investments,” said a senior officer of the
investigation team. “As with his other investments in industry, he knew from the
beginning that there would be no production from the company. The move was
aimed at encouraging his agents to bring in more funds. He would often tell the
agents that Saradha’s assets were ten times that of its liabilities,” the officer
said.’
The first signs of the impending collapse appeared in January 2013 when the
group’s cash flow was, for the first time, less than its cash payout, an inevitable
outcome in a Ponzi scheme that runs its full course. Sudipto Sen, the chairman of
the group, tried to raise additional funds but failed. In the face of the rapidly
intensifying investor agitation, he wrote an eighteen-page confessional letter to
the CBI admitting that he had paid large sums of money to several politicians
and was blackmailed into investing money mobilized from the public in dubious
and loss-making investments. Sen fled on 10 April after posting his confessional
letter, and in his absence, the Ponzi scheme unravelled. Despondency quickly
spread across Bengal, leading to massive street rallies and angry protests
targeting both the state government and Saradha agents. In a story titled
‘Banking on Lies’, the Business Standard of 26 April 2013 said: ‘While Sen is in
prison, it is left for his agents to face the ire of the depositors. Kalipada Naskar,
60, looks disturbed as he stands facing Saradha’s registered office in Salt Lake’s
Sector V. He became a Saradha agent a year ago after he was told that he could
earn up to ₹15,000 a month in commissions and also get retirement benefits.
Ever since Sen’s business went belly up, depositors have hounded Naskar and
3,00,000 other Saradha agents. Some call him names, others threaten him with
dire consequences. “I am helpless, I am sick,” says Naskar. A few blocks away,
about fifteen people have assembled outside another office of Saradha. These are
the depositors who have come to inquire about the fate of their investments. The
crowd includes old and young people, mostly poor. It’s a heart-wrenching
scene.’
An arrest warrant for Sudipto Sen was issued the next day. By 20 April, the
news of potentially the largest Ponzi scheme in India became front-page news
nationally. After evading the authorities for a week, Sudipto Sen and two of his
associated were arrested in Kashmir on 23 April 2013. On the same day, SEBI
announced that both chain marketing and forward contracts were forms of
collective investment schemes and officially asked the Saradha Group to
immediately stop raising any further capital and return all deposits within three
months.
Although Saradha was a high-profile implosion, it was by no means a stand-
alone episode. For many years, eastern India, particularly West Bengal, had been
a fertile ground for firms and outfits of questionable credentials luring
unsuspecting low-income households to part with their hard-earned savings by
promising enticing returns. No matter what the advertised business model, all
these were, at their core, pyramid schemes programmed to implode sooner rather
than later. ‘Why eastern India’ was an issue we used to discuss internally in the
Reserve Bank although a clear answer eluded us. Was it that there was
traditionally a culture of saving in eastern India among low-income households,
thus providing an opportunity for exploitation by clever operators? Did such
operators enjoy more political patronage than elsewhere? Was the lack of access
to the formal financial sector more egregious than elsewhere? Was it the relative
weakness of the cooperative structure?
As its name indicates, a pyramid scheme is structured like a pyramid. A
straightforward version typically starts with one person—the initial recruiter—
who is on top at the apex of the pyramid. This person then recruits a second who
is required to ‘invest’ a certain amount that is paid off to the initial recruiter. In
order to get his money back, this second recruit must now recruit two more
people; from the ‘investment’ made by these latest recruits, he pays himself off
first and the balance goes into a pot. The pyramid keeps building up, with money
first and the balance goes into a pot. The pyramid keeps building up, with money
brought in by fresh recruits used to pay off the recruiters above them such that
the entire stake, at any point of time, is borne by the bottom-most layer of the
pyramid.
The problem is that it is impossible to sustain this cycle. These operations
seldom involve any production of goods and services; no wealth is created and
no revenue is generated. Very soon, the only way a pyramid can survive is by
recruiting additional members. But that possibility hits a limit very soon—
remember the power of compounding—when people at the bottom of the
pyramid find themselves unable to recruit the next layer of investors to pay
themselves off, and the scheme closes in on itself. This kind of chain, pyramid or
Ponzi schemes, whatever name they are called by, are illegal in most countries
of the world. But fraudsters manage to get away by creating an illusionary
legality.
When the Saradha scam exploded spectacularly and made front-page news in
national newspapers, the Reserve Bank was on the block to explain how such
dubious schemes were allowed to not just operate, but even flourish, on its
regulatory watch. I was not surprised by being put in the dock as the Reserve
Bank is quite used to being the default defendant for any irregularity or
malpractice in the financial sector, no matter where the lapse lay and who was
responsible. We did a quick check and found that none of the companies of the
Saradha Group were registered with the Reserve Bank, nor indeed did the
advertised activities of these companies require them to register with the Reserve
Bank.
It would, of course, have been callous on the part of the Reserve Bank to wash
its hands off with the argument that the activities of the Saradha Group fell
outside its regulatory ambit when tens of thousands of poor households had lost
their financial lifeline. I was very sensitive to the fact that as a public policy
institution, the Reserve Bank has a larger responsibility, extending beyond the
letter of its regulatory remit, of protecting the public from dubious and
fraudulent schemes by spreading investor awareness and by working with other
regulators and state governments to tighten the policing of illegal activities.
I do not want to give the impression that the Reserve Bank woke up only after
the Saradha group imploded. For years, indeed even before I came in as the
governor, the Reserve Bank has been urging state governments to tighten laws to
protect depositors, enhance policing of fraudulent schemes, prosecute some of
protect depositors, enhance policing of fraudulent schemes, prosecute some of
the fraudsters and get stiff punishments for them so as to deter the mushrooming
of such schemes. In fact, this would be a standard item on my checklist
whenever I met the chief minister of a state.
When we were in Kolkata for the Reserve Bank’s board meeting in December
2012, in the media interaction that followed, I was asked about the alarming
increase in the incidence of pyramid schemes in West Bengal and what the
Reserve Bank was doing about it. Incidentally, this was just a few months before
Saradha exploded. I explained how such schemes operate below the regulatory
radar, and took the opportunity to urge the state government to increase its vigil
and take suo moto action against companies indulging in fraud and financial
malpractices.
The standing committee on finance of the Parliament had an exclusive
meeting on the Saradha case to understand what caused the collapse of the group
and what steps governments, both at the Centre and in the states, and financial
sector regulators must take to prevent a recurrence. They summoned officials
from several ministries of the government and all financial sector regulators,
including myself.
As I was preparing for my deposition before the standing committee, with
help from my staff, I noticed for the first time what an appallingly complex and
confusing regulatory web we had created in the non-banking financial sector.
There are several regulators operating in this sector—the Reserve Bank, SEBI,
IRDA, the National Housing Bank, the ministry of corporate affairs of
Government of India and state governments, each with compartmentalized
responsibility, each with its own set of complex rules and regulations, with no
one having a full picture, and with a whole lot of regulatory overlaps and gaps,
thereby providing a fertile ground for illegal and fraudulent schemes to flourish.
If I found it so difficult to comprehend the big picture and the small print, even
with my expert staff tutoring me, how could we expect non specialists, let alone
rural, semi-literate households, to understand what was legal and what was
illegal, what was safe and unsafe, and what to trust and what not to trust? Whom
could they turn to for advice? Whom could they turn to if they found themselves
defrauded?
I had faced the parliamentary standing committees in the past as finance
secretary, and several times as governor too, and in the process, developed
secretary, and several times as governor too, and in the process, developed
enormous respect for the knowledge, understanding and grass-root wisdom that
members of Parliament bring to bear on public policy issues through the
committee process. No matter how much I prepared, I always went into these
meetings with a great deal of trepidation. The meetings are invariably
adversarial; the members grill you to the point of exhaustion for lapse of
responsibility and dereliction of duty. To be sure, there was never anything
personal in this. Typically, when the meeting breaks up and the chairman of the
committee invites you to have tea with the members, the hostility just witnessed
in the formal meeting instantly melts away. There were several occasions when
individual members of Parliament even came and apologized to me for being so
harsh in the just concluded meeting and requesting me not to misconstrue their
questions and comments. I never failed to be amused by the members’
apparently high regard for me at an individual level and their eagerness to
criticize the Reserve Bank as an institution as if I had nothing to do with the
Reserve Bank’s decisions and actions.
When it came to the standing committee meeting on Saradha, I was, as
always, impressed by the concern shown by the members. I was even more
impressed by how they zeroed in on the root of the problem by juxtaposing the
regulatory gaps and confusion with the ignorance and poverty in Indian villages.
My session with the committee spanned a wide range of issues, but at its core,
the parliamentarians’ question to me was: ‘Why was the Reserve Bank sleeping
at the wheel and allowing such frauds to go unchecked?’
I admitted to the committee that our balkanized regulatory structure in the
non-bank financial space, straddling so many different regulators and
regulations, was bewilderingly complex and confusing with regulatory overlaps
and cracks. All of us regulators have a basic responsibility to protect the larger
public from malpractices and frauds. At the same time, I emphasized to the
committee that cases like Saradha were not so much the result of a regulatory
lapse but of a policing lapse. Ponzi and pyramid schemes, no matter how they
are camouflaged and marketed, are illegal. They operate below the regulatory
radar, in part by taking advantage of our complex regulatory maze. We can
comprehensively deter such frauds only by more stringent policing and
prosecution. National-level regulators like the Reserve Bank and SEBI do not
have the reach, penetration or the comparative advantage to effectively police
such activities in the financial space across the vast hinterland of the country. It
such activities in the financial space across the vast hinterland of the country. It
is state governments, with their local presence and vast police force, that have to
be the bulwark of surveillance and deterrence. Regulators such as the Reserve
Bank have a responsibility, of course, to work alongside state governments to
disseminate financial awareness and to train their police and other vigilance
personnel in detection and prosecution of financial frauds. As happens in such
meetings, we went back and forth several times, and even after nearly five hours,
I was not certain I had convincingly made my points to the committee.
As the meeting was closing, I told the committee that the ultimate defence
against malpractices and fraud was greater public awareness. I told them that I
would review the Reserve Bank’s approach to financial literacy and see how it
could be expanded and improved. I also told them that we would streamline our
training of grass-root police and bank personnel about frauds and malpractices.
Finally, I offered that the Reserve Bank would take the initiative to come out
with a comprehensive list of FAQs and put it up on our website. Some members
thought this response was too non-specific and inadequate compared to the
severity of the problem. One member even ridiculed my suggestion of FAQs by
asking whether it was realistic to expect semi-literate villagers to go to the
Reserve Bank’s website to understand the NBFC sector. I could relate to that
criticism. I assured the committee that we would translate all the material into
vernacular languages and work with state governments to disseminate that
knowledge widely and deeply.
The result of this assurance was a comprehensive and exhaustive list of FAQs
on the NBFC sector, the first of its kind for any sector or activity within the
Reserve Bank’s mandate. As per my assurance to the standing committee, we
also translated the material into local languages for dissemination across the
country. I must admit though that as all these developments took place in the
closing months of my tenure, I did not have the time or the mind space, given
my almost total preoccupation with rupee tantrums, to follow them through. But
I am happy to note that the Reserve Bank has carried the action plan forward in
all its dimensions.
In line with the ‘every cloud has a silver lining’ viewpoint, a positive outcome
of the Saradha scam has been the tightening of the vigil at the field level on
fraudulent schemes, fly-by-night operators and unauthorized deposit
mobilization. In fact, as far back as in 1999, the Reserve Bank enjoined state
governments to constitute state-level coordination committees (SLCCs)
governments to constitute state-level coordination committees (SLCCs)
comprising relevant government officials, police and regulators for regulatory
oversight. However, the SLCC meetings were irregular, and even when they did
meet, ineffective. The Saradha scam shook the authorities out of complacency.
As I write this more than two years after leaving the Reserve Bank, I checked
with my former colleagues, and they told me that SLCCs across most parts of
the country have been energized and are proactive in sharing economic
intelligence and expanding financial literacy and awareness.
Although the business model of Saradha was predominantly that of a
collective investment scheme, the scam nevertheless highlighted the issue of
regulatory oversight of chit funds. The basic point to note is that chit funds are
not illegal. However, and in some way adding to the confusion, even when chit
fund firms are incorporated as companies and are therefore NBFCs by definition,
they are not regulated by the Reserve Bank. As per a Central law, the power to
regulate the chit funds has been vested in the state governments. I can say from
my own experience as finance secretary in the Government of Andhra Pradesh
and also as governor of the Reserve Bank, that regulating chit funds is nowhere
near a priority for state governments. This neglect typically encourages
fraudulent and dubious schemes to project themselves as chit funds so as to
escape scrutiny. Indeed, a big lesson from the Saradha case for state
governments is not only to regulate chit funds more actively, but also to monitor
activities in the chit fund space closely to curb illegal activities masquerading as
chit funds.

The Blow Up in the Microfinance Sector

The blow up in the microfinance sector in Andhra Pradesh in 2010 was the other
major episode in the non-bank sector during my tenure that has had significant
regulatory implications.
In some ways, the growth of the microfinance sector in India has been a
remarkable success story of recent years; in some other ways, that very rapid
growth had raised concerns about the quality of income-generation support that
microfinance institutions were offering. Although the microfinance sector had
presence across the country, it was particularly prominent in the southern states,
with the erstwhile combined state of Andhra Pradesh itself accounting for as
much as 40 per cent of the country’s microfinance activity.
In late 2010, Andhra Pradesh became the scene of a severe backlash against
the microfinance sector, with a flood of allegations about the usurious interest
rates charged by the MFIs, their coercive recovery practices and their
unscrupulous business practice of luring borrowers with multiple loans, in the
process pushing low-income households into the deep end of indebtedness.
There were reports too of some microfinance borrowers having committed
suicide to escape the debt trap. At around the same time, there were also exposés
of the grotesquely huge profits of some of the larger MFIs which was seen,
unsurprisingly, as exploitation of the poor.
The growing anger at the harassment by MFIs and resentment at their fat
profits at the expense of the poor, galvanized into a widespread public agitation
across Andhra Pradesh, prompting the state government to promulgate an
ordinance in October 2010,3 imposing stringent restraints on both the business
models and the business practices of MFIs operating in the state. All MFIs were
required to register with the state government on an annual basis. They were
barred from visiting the houses of borrowers; instead, they were required to
conduct their borrower meetings only in public places like the village panchayat
office or the village school. The recovery cycle was lengthened from one week
to one month. In an attempt to prevent household indebtedness, the law
stipulated that the total interest on a microfinance loan could not exceed the
principal. To restrain aggressive lending, MFIs were proscribed from lending to
self-help groups (SHGs) that were already covered by the formal banking
system, without the prior approval of the bank.
As a result of this clampdown, the microfinance activity in Andhra Pradesh
came to a grinding halt. Not only was there no fresh lending, but even recovery
of existing loans plummeted as word spread across villages that microfinance
loans need not be repaid. Both MFIs and the banks that loaned funds to MFIs
were agitated about this deepening default. And in the Reserve Bank, we were
getting inside track reports that several other states too were considering
following the Andhra Pradesh example to restrain microfinance activity, thereby
putting a big question mark on the future of the ₹250-billion ($5-billion)
microfinance industry across the country.
Once again, the Reserve Bank was in the dock for having acquiesced in these
excesses by MFIs. To be sure, what happened was a matter of deep concern and
excesses by MFIs. To be sure, what happened was a matter of deep concern and
consternation for all of us in the Reserve Bank. At the same time, we were also
worried about how the backlash might impact the future of the microfinance
industry. There were, of course, excesses and malpractices but we could not risk
throwing away the baby with the bath water. How we could get rid of the bad
and keep the good was the big challenge.
The Andhra Pradesh law also posed a legal dilemma for us. Under the Reserve
Bank Act, MFIs, incorporated as companies, were NBFCs falling within the
regulatory ambit of the Reserve Bank. By seeking to regulate MFIs, the Andhra
Pradesh law was encroaching into the Reserve Bank’s jurisdiction.
The prime minister called me to inquire about the imbroglio in the
microfinance sector. He, like me, believed that while we should come down
heavily on malpractices, we should not overreact by killing a sector which has
provided livelihood support to millions of households across the country. I also
explained to the prime minister the legal issue of the overlapping regulation
brought on by the Andhra Pradesh law and the possibility of this snowballing
across other states. The prime minister suggested that I speak to the chief
minister of Andhra Pradesh and resolve the legal complication.
Belonging to the Andhra Pradesh cadre of the IAS as I do, I had known chief
minister Konijeti Rosaiah for several years, in fact right from the time of my
early career in the late ’70s and early ’80s when I was holding field jobs in the
Government of Andhra Pradesh. He was already a senior politician by then.
More importantly, when I was posted as finance secretary to the Government of
Andhra Pradesh in September 1993, he was the finance minister in the then
Congress government. But that relationship lasted just about ten months, as NTR
won the subsequent election in mid-1994 and Rosaiah metamorphosed into a
feisty opposition leader.
Rosaiah is a seasoned politician; he is a warm and friendly person too. He is
also one of the most effective legislators that I had come across in my career.
There were several occasions during that ten-month period when we would be in
a meeting with him in his office in the assembly building when the legislative
assembly was in session. Even as he would be listening to us, he would have one
eye on the CCTV in his office, watching what was going on in the House. Once
in a while, he would abruptly get up, excuse himself, walk into the House,
reprimand the Opposition in chaste, firm Telugu with humorous overtones, and
tiptoe back to his office, all in a matter of minutes, to resume where we had left
tiptoe back to his office, all in a matter of minutes, to resume where we had left
off.
I spoke to Rosaiah and requested him to withdraw the microfinance ordinance
because of the several practical complications it would create. I levelled with
him on my apprehensions about how the Andhra Pradesh initiative might
snowball across the country and jeopardize the future of the entire microfinance
industry. I assured him that I would take action to comprehensively review the
situation in the microfinance sector and take appropriate remedial action that
would protect the borrowers, typically women who pursue an income-generating
activity, without killing the microfinance industry altogether. Rosaiah did not
budge though. I could understand his predicament. There was such deep rancour
against the microfinance sector that it wouldn’t have been possible for any
political leader, much less the chief minister of a state in a vigorous democracy
like ours, to backtrack on his action in such an emotionally charged atmosphere.
I took the microfinance issue to the Reserve Bank board at its meeting in
Kolkata in December 2010 where we decided to constitute a subcommittee
under the chairmanship of Y.H. Malegam, one of the board’s venerable
members, to study the issues in the microfinance sector, and recommend reforms
in order to prevent excesses and malpractices. The Malegam Committee did a
commendably thorough, competent and quick job and submitted its report in just
a little over a month with a comprehensive set of recommendations to bring
some discipline into the microfinance sector, covering both prudential and
regulatory dimensions.
The most important recommendation of the Malegam Committee was to cap
the interest rate that MFIs could charge their borrowers and also to limit the
margin (mark-up) they could have over their own cost of funds. Accepting this
recommendation posed a dilemma for the Reserve Bank, so once again it was up
to me to make a difficult judgement call.
Here was the issue. Before the 1991 reforms, odd as it might seem to the
‘children of reforms’, the Reserve Bank had in place an extensive regulatory
prescription on what interest rates could be charged on what type of loans and
what interest rate could be offered on what type of deposits. As part of the
reform process, the Reserve Bank had gradually dismantled this
micromanagement in the belief that the competitive impulses so generated would
enhance overall efficiency in the financial sector, and benefit both borrowers and
enhance overall efficiency in the financial sector, and benefit both borrowers and
savers. The dismantling started with the deregulation of interest rates on the
lending side and then moved to deregulation on the deposit side.
I have already written about my decision in October 2010 to free up the
interest rate that banks could offer on savings deposits and how that decision
brought this huge task of interest rate deregulation, which had been in progress
for nearly twenty years, to a logical closure. But here I was, with the Malegam
Committee recommendation, being called upon to reverse what was considered a
significant, if also a long-drawn-out reform, and that too, just within months
after I brought the curtain down on it. It wasn’t an ideological issue. My concern
was whether this reopening of the regulation of interest rates, no matter how
compelling, would turn out to be the thin end of a wedge and reopen the interest-
rate structure in the economy for regulatory tinkering.
I was also weighed down by another important dilemma. The charge against
MFIs was that they were charging usurious rates of interest. Is it possible for
anyone, including the Reserve Bank, to make an objective assessment of what is
usurious and what is not? Consider, just for illustration, a pushcart fruit vendor
who might borrow ₹10,000 in the morning, accepting to repay ₹10,200 at the
end of the day. That would be 2 per cent interest per day, or between 750–1000
per cent interest per year, depending on how you compound it. That sort of
interest rate certainly looks ultra-usurious, and also grotesquely iniquitous,
especially when you compare that with the interest rates rich corporates pay on
the loans they take from commercial banks. But that pushcart vendor, no matter
where in the country, hardly has a chance of getting a loan from a commercial
bank. He would only be too happy to pay that ‘usurious’ interest because access
to the loan, never mind the 1000 per cent interest rate, means livelihood to him.
By regulating the interest rate that the MFIs can charge, might we be driving
them out of business and running the risk of pushing impoverished households
once again into the laps of even more usurious moneylenders? That was my
concern.
Quite obviously, the internal discussion on the issue within the Reserve Bank
was quite intense and impassioned, with the dividing line between objectivity
and emotion often blurring. All through this process, I was holding no brief for
the MFIs, and there was enough reason to believe from the Malegam Committee
report that MFIs, especially the large and established ones, were enjoying
scandalously fat margins. I asked my staff to review the cost details in the
scandalously fat margins. I asked my staff to review the cost details in the
committee report once again, and after convincing myself that the risk of the
entire microfinance industry winding down as a result of any interest-rate
regulation was small, I decided to bite the bullet and clamped down on the
maximum interest rate that MFIs could charge their borrowers.
Meanwhile, the Andhra Pradesh law on microfinance was challenged in the
high court by some MFIs in which the Reserve Bank too was impleaded as a
party. By the time the case came up for arguments in 2012, we had already
implemented the Malegam Committee recommendation. In our submission to
the high court, we took a purely pragmatic position and pleaded that the state
law was in conflict with the Reserve Bank’s regulatory jurisdiction and would
cause a lot of confusion and disruption, eventually hurting larger public interest.
We also argued that by carving out MFIs into a separate category of NBFCs
(NBFC-MFI) for the purpose of regulation, we had removed the ambiguity, if
any, on the exclusive regulations applicable to the MFI sector. In the end, the
high court upheld the constitutional validity of the Andhra Pradesh law, but
asked the state government to review its statute in light of the comprehensive
national-level bill for the regulation of the microfinance sector which was then
under the consideration of Parliament.
Ironically, the standing committee of Parliament rejected the comprehensive
national-level microfinance bill in its report dated February 2014. It is not clear
if the Modi government wants to review the situation and introduce its own
version of a bill for a common national-level law to regulate the microfinance
sector.4
As I look back on the microfinance imbroglio from this distance of time, the
question of whether I did the right thing by capping the interest rate does
occasionally cross my mind. In the event, I believe that the Malegam Committee
recommendation was wise and mature. The microfinance industry did not die—
unlike what the opponents of the interest rate cap had argued. On the other hand,
the industry is back on track and is growing at a healthy clip. I hope, and I
believe too, that someday soon enough there will be sufficient competition in the
microfinance sector which itself will act as a check on the interest that MFIs are
able to charge so that the Reserve Bank can withdraw its regulation on the
interest rate.
Curbing the Excesses of Gold Loan Companies

The last topic I want to write about in regard to matters in the non-bank financial
sector is on the tightening of regulation on gold loan companies on my watch.
I’ve already written about the huge demand for gold in India not only because it
is an attractive saving option for households, but also because of its liquidity and
the ease of using gold as a collateral for borrowing. Companies that lend against
the pledge of gold are commonplace across the country although they are more
visible in some parts than others. In 2011 going into 2012, we found that the
gold loan business was expanding at an unusually rapid pace. The reason for this
was that for a few years before that, the price of gold was increasing steeply and
secularly which encouraged the all-too-familiar herd behaviour. Households
increased their purchase of gold and were raising loans against that gold to meet
their expenditure needs. This growing trend raised concerns for us in the Reserve
Bank from both financial-stability and consumer-protection dimensions.
If the price of gold was to correct sharply downwards, the gold collateral
available with the loan company would not be sufficient security for the amount
of loan. If indeed that happened, borrowers would be tempted to default on the
loan and the resulting loss to the gold loan company could potentially cascade
across the financial system, threatening financial stability. To safeguard against
this downside risk, we reduced the loan to value ratio (LTV) from 75 per cent to
60 per cent. What this meant was that a loan against gold could not exceed 60
per cent of the value of the gold pledged as collateral. We also reset the capital
requirements for loan companies primarily engaged in lending against the
collateral of gold jewellery so as to prevent contagion from them to the rest of
the financial system. As a measure of consumer protection, we imposed
regulations on where and how gold loan companies should store the gold
pledged with them, their obligation to make the gold available for inspection by
the borrowers and the procedure that the loan companies should follow for
selling the pledged gold in case of default by the borrower.

Financial Literacy—the Most Robust Defence

I started this story of mine on regulating the non-banking financial sector with
the question of whether the Reserve Bank has an institutional bias against the
sector and then meandered into talking about Ponzi schemes, MFIs and gold
loan companies. The common thread running through all this is my belief, as
indeed it is of the Reserve Bank too, that the non-bank financial sector plays a
vital role in financial intermediation by channelling money from savers to
borrowers, thereby contributing to growth, efficiency and equity in the economy.
To those who doubt the Reserve Bank’s commitment to the NBFC sector, here is
what the RBI says on its website regarding its role in non-banking regulation:
‘This role is, perhaps the most unheralded aspect of our activities, yet it remains
among the most critical. This includes ensuring credit availability to the
productive sectors of the economy, establishing institutions designed to build the
country’s financial infrastructure, expanding access to affordable financial
services and promoting financial education and literacy.’
That said, we certainly need to simplify the regulatory structure; but even
more importantly, we need to increase vigil against excesses, malpractices and
frauds. The ultimate, and certainly the most robust, defence against excesses,
malpractices and fraud is widespread financial literacy.
As of now, financial literacy remains a scarce commodity, even among people
who are supposed to be disseminators of financial literacy. Let me illustrate. The
legendary Ela Bhatt, founder of the Self Employed Women’s Association
(SEWA) and pioneering social activist, was on the board of the Reserve Bank
during my tenure and brought a tremendous amount of grass-root sensitivity to
bear on the Reserve Bank’s policies. She presented me a copy of her book, We
Are Poor but So Many: The Story of Self-Employed Women in India, which I
read avidly. One incident that Ela related in her book remains etched in my
memory. She took a vegetable vendor to a bank for a loan. The bank manager
quizzed both Ela and the applicant in several sessions over several days, but was
unable to make up his mind. Ela says that after all that vacuous and vexatious
interrogation, she realized that ‘financial literacy was on the other side of the
table’!
15
Footloose in the World of Central Banking
International Meetings and Global Policy Issues

The governor’s annual calendar contains a host of international commitments


round the year, much more than I had thought and much more than is possible to
cope with. Missed connections, security checks, jet lag, sleep disorder, frequent
flyer miles and airport lounge food, all a part of the job content.
The regular meetings on the governor’s annual calendar include the meetings
of the IMFC (the International Monetary and Financial Committee of the IMF),
the G20 meetings of finance ministers and central bank governors, the bimonthly
BIS meetings of central bank governors in Basel and at least one meeting each
year of the Asian Consultative Committee, the Asian Currency Union and
SAARC governors. There are also regular meetings of finance ministers and
central bank governors of BRICS (Brazil, Russia, India, China and South Africa)
that are typically held on the sidelines of the G20 or the IMFC meetings. An
incidental by-product of the crisis has been an increase in the number and
frequency of these meetings with the result that deciding which meetings to
attend and which ones to skip becomes a complex scheduling challenge.

Fund–Bank Meetings

The meetings of the World Bank and the IMF, Fund–Bank meetings, as they are
popularly called, are, as I mentioned at the beginning of this book, held twice a
year—the spring meetings in April and the annual meetings in October. The
meetings are held in Washington, the headquarters of these two Bretton Woods
institutions, except every third year when the annual meetings are held in
another country capital which is determined on the basis of some geographical
balancing formula. The finance minister is India’s nominee on the board of
governors of both the IMF and the World Bank; the governor of the Reserve
governors of both the IMF and the World Bank; the governor of the Reserve
Bank is the alternative governor on the IMF board while the finance secretary is
the alternative governor on the World Bank board.
Over the years, the Fund–Bank meetings have evolved into a nucleus for a
host of other multilateral and bilateral meetings, regional briefings, conferences
and seminars, some organized by the IMF and the World Bank, either jointly or
separately, and some organized by think tanks and global financial institutions
focused on the global economy, international development and world financial
markets. This ever-expanding activity brings to Washington during the meetings
week about 15,000 participants comprising finance ministers and central bank
governors, and their staffers, chief executives of banks and financial institutions,
investors and investment advisers, economists, corporates and consultants, and
many well-known and also not-so-well-known experts, all milling around the
Fund–Bank complex of office blocks and the numerous cafeterias around in the
Foggy Bottom area of downtown Washington DC, just a couple of blocks from
the White House. And, of course, the media from all around the world is present
in full force—with their mikes, cameras and lights—beaming images, filing
stories and reports, and eagerly chasing any minister or senior official in sight
for a sound bite.
The IMF has a membership of 188 countries, organized into twenty-four
constituencies, with each constituency represented by an executive director. Just
as owners of a company hold shares in it, countries hold ‘quotas’ in the IMF,
with each country’s quota based largely on its relative position in the global
economy. Quota subscriptions are a central part of the IMF’s financial resources.
A member country’s quota determines its maximum financial contribution to the
IMF, its voting power and its access to IMF financing. The five largest quota
holders—the US, Japan, Germany, the UK and France—as also China and
Russia are single-member constituencies with an exclusive executive director,
while the majority of the countries are grouped into multi-country
constituencies. India, for example, is the lead country in a constituency that also
includes Bangladesh, Bhutan and Sri Lanka.
The main official event for the congregated finance ministers and central bank
governors is the meeting of the IMFC which deliberates on the principal policy
issues facing the IMF, held over half a day in a large, harshly lit conference hall
in the IMF headquarters. Each executive director constituency is allowed a
delegation of ten people at the meeting. While the delegation leaders occupy the
delegation of ten people at the meeting. While the delegation leaders occupy the
front-row sofa seats, the rest of the delegation is seated in the rows behind.
Together with the IMF staff, there are typically around 350 people in the
meeting hall.
The IMFC is chaired by the finance minister or the central bank governor
from one of the member countries, elected typically for a three-year term.
During my tenure as governor, Youssef Boutros Ghali, the finance minister of
Egypt, was the chairman till he resigned in 2011 following the defeat of his party
in the elections in Egypt. He was succeeded by Tharman Shanmugaratnam, the
finance minister of Singapore. Tharman, who has since been elevated as the
deputy prime minister of Singapore, is intelligent, suave and articulate. I was
always impressed by the way he steered the discussions, and especially for the
special effort he made to bring emerging-market perspectives on to the issues,
and for the maturity and skill he showed in coalescing a consensus on what were
very divisive issues.
The format of the IMFC meeting has changed over time. Earlier, the meetings
used to be quite staid, with the leader of each delegation reading out a prepared
statement, with not much discussion or engagement with one another. That
format has since yielded to a new pattern. The statements are now taken as read
and are recorded. Under the new format, the meeting starts with a presentation
by the chief economist of the IMF on the global economic outlook and by its
financial counsellor on the global financial conditions. This is followed by a
briefing by the IMF’s managing director on policy issues that need to be
addressed by the IMF, such as global growth prospects, exchange rate
movements and financial conditions. Thereafter, there is a general discussion on
three or four topics identified in advance. Even as this format allows for a more
structured discussion, the sheer size of the meeting makes it unwieldy for active
engagement on any specific issue. Also, since the meeting proceedings are
recorded and its minutes are kept, it remains formal and somewhat
choreographed.
Partly to compensate for this, the IMF has introduced a new event on the
regular schedule—a breakfast meeting—bringing together finance ministers and
central bank governors from systemically important countries and large
economies, about thirty to thirty-five in all, along with the managing director of
the IMF, the president of the World Bank and their senior deputies, for a
the IMF, the president of the World Bank and their senior deputies, for a
freewheeling discussion on the global economic and financial situation. This
meeting is informal, more participative and engaging, and decidedly more
interesting than the formal IMFC meeting that follows this breakfast meeting.
While Chidambaram attended these meetings, Pranab Mukherjee usually chose
to skip them, and I often found myself to be the sole representative of India. I
profited from these breakfast meetings, both for the insights into global policy
issues and the opportunity to present emerging-market perspectives.
Neither the formal IMFC meeting nor the informal breakfast meeting was ever
acrimonious, but one could easily sense undercurrents of strain on certain issues.
In terms of these undercurrents, there was a clear distinction between the earlier
period (2008–10) when the global financial crisis dominated the agenda and the
later period (2011–12) when the eurozone sovereign debt crisis was the focus of
these meetings. In the earlier period, America was at the receiving end of the
blame for the economic and financial turmoil it foisted on the world because of
its poor policies and loose regulation. Except on QE, a topic to which I will
return later, on most other issues, the American tendency was generally not to
contest the blame. It was instead more pragmatic: ‘OK, let’s put that behind us
and see how we should move on.’ The Europeans, in contrast, were given to
vehemently pushing back on any suggestion of blame for the spillover impact of
their sovereign debt crisis or of their ineptitude in managing it. Nor did they
tolerate any advice on how they could improve their policy response to mitigate
the costs to them and to the rest of the world.

Governance Reforms at the IMF

Governance reforms at the IMF came to be a standard item on the agenda of


virtually every IMFC meeting in the post-crisis period. Emerging markets and
developing countries (EMDCs) have long nursed a grievance that the Bretton
Woods twins—the IMF and the World Bank—are controlled and managed by
advanced economies to serve their own economic and political interests,
consistently denying EMDCs voice and representation commensurate with their
growing role in the global economy. The harsh, and often counterproductive,
conditions imposed by the IMF and the World Bank when extending aid to
EMDCs, it was believed, was a reflection of this asymmetric relationship. That
grievance went largely unheeded.
grievance went largely unheeded.
Until the crisis changed the dynamics of international economic power play.
The stereotypical view before the crisis was that EMDCs repeatedly brought on
financial crises on themselves because of their poor economic management and
venal governance. The crisis destroyed that stereotype. Here was America, the
largest and most advanced economy in the world, which was the epicentre of this
crisis, the deepest since the Great Depression. The causes of this America-
centred crisis were the same as those for which the EMDCs have historically
been reprimanded—inept economic management and poor governance. Post-
crisis, advanced economies found themselves in an unfamiliar and vulnerable
spot, of receiving a scolding rather than giving it, and depending on the EMDCs,
particularly China, for leading the world out of a potentially deep recession.
The changed dynamics presented an opportunity to the EMDCs to press for a
redressal of their grievances—for a bigger say in the running of the Bretton
Woods institutions. After protracted negotiations, extensive backroom
diplomacy and several iterations, the EMDCs extracted two concessions. First, it
was agreed that the historical monopoly of the US on the position of the
president of the World Bank and of Europe on the position of the managing
director of the IMF would be ended; instead of the traditional process so obscure
that it made a papal election process seem transparent by comparison, these two
pivotal positions would, in future, be filled through a merit-based international
selection process. The second concession, enshrined as the ‘2010 quota and
governance reform’, was that the quotas in the IMF would be adjusted to shift
the voting power in favour of dynamic EMDCs. In particular, the new formula
would push the BRIC countries to be among the top ten IMF shareholders, while
at the same time protecting the voting shares of the poorest 110 member
countries.
The first reform of opening up the selection of the chief executives of the two
institutions to global competition is yet to be tested. The second, the 2010 quota
and governance reform, was held up for over five years almost entirely because
the US Congress took that long to approve it. The problem was that as per the
IMF regulations, quota reforms require an 85 per cent majority of the total
voting strength. Even though most countries had approved the reform, that was
not sufficient for passing it, as the US had a voting share of 16 per cent and
therefore a virtual veto. The issue of US approval for the quota reform came up
unfailingly at every IMFC meeting. And all that US treasury secretary would
unfailingly at every IMFC meeting. And all that US treasury secretary would
offer each and every time was that it was yet to be approved by the Congress.
Evidently, an issue that was a clear priority for EMDCs remained low priority
for the US Congress for over five years. It was only in December 2015, as I
write this, that the US Congress is reported to have at last approved the IMF
quota reform.

As I wrote earlier, one big criticism of policymakers post-crisis was that they
remained indifferent to the incipient signals of financial instability in the markets
in the lead-up to the Lehman collapse. To remedy this, the IMF introduced
another regular meeting into the Fund–Bank meeting schedule—‘the early
warning exercise’—which is a briefing to select finance ministers and central
bank governors by the IMF and the BIS on potential threats to economic and
financial stability. The discussion in this ‘early warning exercise’ meeting
remains confidential and no record is maintained on the premise that disclosure
of what global policymakers think of as potential threats might actually trigger
those threats into materializing!
The Fund–Bank meetings provide a convenient venue for a variety of bilateral
meetings. Several people—from global financial institutions, especially large
investment banks, think tanks, the academia and the media—seek to meet the
Indian authorities. The finance minister and the governor meet them either
together or separately depending on the issue and their respective schedules.
Running in parallel with the formal meetings is a beehive of intellectual activity
—conferences, seminars and panel discussions. The finance minister and the
governor of the Reserve Bank are typically featured speakers at some of these
events.

BIS Bimonthly Meetings of Governors

The bimonthly meetings of central bank governors convened by the BIS in Basel
were among the most productive and interesting that I attended as governor. Set
up in 1930, originally to facilitate German World War I reparations, the BIS has
had a chequered history, and it has today transformed into a premier
organization to serve central banks in their pursuit of monetary and financial
organization to serve central banks in their pursuit of monetary and financial
stability, to foster international cooperation in those areas and to act as a bank
for central banks.
In all the uncertainty surrounding the governor’s work and travel schedule, the
BIS calendar of meetings was a rare item of certainty. The dates for the six
bimonthly meetings every year are determined a year in advance and are not
shuffled around. The two-day meetings are typically scheduled on Sunday and
Monday with the result that even for those of us who had to take a
transcontinental flight, the trip could be managed with an absence from the
office of just one workday.
The flagship event in the two-day choc-a-bloc schedule of BIS meetings is the
Global Economy Meeting (GEM) convened on Monday mornings, which brings
together about thirty governors from advanced and large emerging-market
economies to gather around a big circular table—indeed the biggest circular
table I have seen—discussing the global economic situation and exchanging
their own country perspectives.
The code of conduct governing the BIS meetings is that what is discussed
within the room stays within the room. No record or minutes are kept and no
attribution is to be made to anyone in any discussion beyond the meeting room.
This format allows for a frank expression of country situations and policy
dilemmas, and a freewheeling exchange of perspectives and ideas. The GEM
was an excellent forum to get a clear and candid briefing on the developments in
the advanced economies from their respective governors. This heads-up was
particularly useful during the global financial crisis as it helped those of us from
emerging markets to be better prepared to respond to those developments.
I feel quite nostalgic about this bimonthly trip to Basel on many counts; they
were also memorable for the efficiency with which the BIS ran the logistics of
the meeting—right from the time of receiving each governor at the airport on
arrival to dropping us back there at the end of the meetings, they demonstrated
the best practice for understated deference and unfailing courtesy.

G20 Meetings

Let me now turn to the G20 meetings of finance ministers and central bank
governors which I found useful but also taxing.
The G20 is an informal club with nineteen member countries and the
The G20 is an informal club with nineteen member countries and the
European Union that together represent 90 per cent of global GDP, 80 per cent
of global trade and two-thirds of the global population. Contrary to popular
perception, the G20 is not a new international grouping triggered by the global
financial crisis. It was, in fact, triggered by an earlier crisis, the Asian crisis of
1997.
The G20 has been meeting regularly since 1997, twice a year, at the level of
finance ministers and central bank governors. One important change brought on
by the crisis was to elevate the level of the meeting with the introduction of an
annual meeting of leaders—the Leaders’ Forum—which India’s prime minister
attends. The frequency of finance ministers and governors meetings went up to
four per year during the peak of the crisis in 2009 and 2010, but has since
reverted to the standard pattern of two meetings every year.
The chair of the G20 rotates every year from one member country to another.
All the G20 meetings are typically held in, and hosted by, the chair country. The
chair country takes the lead in formulating and driving the agenda and providing
logistic and secretarial support. The president of the World Bank and the
managing director of the IMF also attend the G20 meetings, thereby ensuring
that the activities of the G20 are integrated into the agenda of the Bretton Woods
institutions where necessary. There are also other invitees such as the OECD,
UNDP and the regional development banks like the Asian Development Bank.
The G20 was in the forefront of battling the global financial crisis of 2008–09.
Indeed, when the history of this crisis is written, the London G20 Summit in
April 2009 will be acknowledged as the clear turning point when world leaders
showed extraordinary determination and unity in addressing the biggest
economic and financial crisis of our time. There were differences, of course, but
they were debated and discussed, and compromises were made in order to attain
the shared goal of restoring market confidence. In fact, the entire range of crisis-
response measures—accommodative monetary stance, fiscal stimulus, debt and
deposit guarantees, capital injection, asset purchases, currency swaps—all
derived in varying degrees from G20 decisions.
The sense of purpose and vaunted unity that the G20 had shown in managing
the crisis all through 2009 and 2010 started dissipating in 2011 as the agenda
shifted from crisis response to agreeing on post-crisis reforms. The fault lines
ran along several dimensions: between advanced and emerging economies over
the responsibility of the former for the spillover impact of their policies that
the responsibility of the former for the spillover impact of their policies that
were adversely impacting the emerging markets; between America and Europe
on the management of the eurozone sovereign debt crisis; and largely between
America and the rest of the world on banking regulation reforms that eventually
led to the Basel III standards.
Managing these fault lines raised a contentious issue within the G20 about
how transparent it should be about these differences. A large majority of the G20
members felt that these differences, if exposed, would be exaggerated in the
global media which would dent the credibility of the G20, spook the markets and
undermine the as-yet fragile recovery from the crisis. They would contend that
these differences should remain within the conference room and we should all
present a picture of unity to the outside world, much like the code of conduct of
collective Cabinet responsibility in a parliamentary system. Ranged against this
was a minority view that any such cover-up attempt would be pretentious.
Differences, they argued, are inevitable in a world divided by nation states with
no natural constituency for the global economy. There was no need, therefore, to
be secretive about them. Besides, being upfront about differences of views
would help the G20 get larger public inputs into global policy issues and give us
a more informed basis for decision-making.

The G20 meetings typically started with an extended working dinner hosted
by the chair country which provided an informal, freewheeling discussion on the
global economy. That would be followed by the formal full-day meeting the
following day.
The last item on the agenda would be approving the communiqué of the
meeting. The communiqué process itself was quite interesting. It was not that
someone sitting in the meeting drafts the communiqué on the basis of the
discussion there. In fact, a draft communiqué, based on the agenda, is circulated
to the members in advance of the meeting. Even as the G20 meeting is in
progress, the deputies of the G20 delegations convene in a parallel session
negotiating the draft communiqué regularly, but informally, checking with their
respective principals on the content as well as the nuancing and messaging. This
process ensured that a pre-final draft of the communiqué was available to the
G20 delegates as soon as they completed the agenda of the meeting.
G20 delegates as soon as they completed the agenda of the meeting.
Sometimes, the communiqué approval used to go through quickly and easily.
But there were several occasions where it took much longer, often extending
beyond an hour, in order to arrive at the language and nuance that all members
felt comfortable with. It then became as much a test of English as of economic
diplomacy.
I often wondered if the G20 meeting was degenerating into a communiqué-
driven process with members focused more on messaging through the
communiqué rather than on discussing and resolving the underlying issues. But I
was in a minority. A majority seemed to feel that the prioritization was right:
that putting effort into the communiqué was a productive use of G20 time given
how crucial the communiqué was to shaping global sentiment.

Currency Wars

Two issues that regularly figured on the G20 agenda, either directly or
indirectly, were currency wars and the dollar as the global reserve currency.
Although ‘currency wars’, as a phrase, is of relatively recent origin, and
largely attributed to Guido Mantega, the former finance minister of Brazil, as a
phenomenon, they have been part of international trade and finance ever since
the 1980s when Japan had several run-ins with the US on the exchange rate of
the yen against the dollar. Currency wars represent a situation when countries
competitively depreciate their currencies against those of their trading partners
so as to boost their exports and restrain imports, in a classic beggar-thy-
neighbour attitude. Currency wars are ultimately self-defeating as they depress
trade and raise the costs for all trading partners involved.
The origin of the latest round of currency wars lay in the ultra-easy monetary
policies of advanced economies—zero-interest rates topped up by quantitative
easing—aimed at reducing interest rates, stimulating domestic demand and
helping economic recovery. In the event, this huge liquidity unleashed by QE
found its way into emerging markets in search of quick returns. But emerging
markets too did not have the capacity to absorb these large and volatile capital
inflows, with the result that their exchange rates appreciated out of line with
their economic fundamentals, eroding their export competitiveness and
threatening their financial stability.
The consistent refrain of emerging markets at the G20 meetings used to be
The consistent refrain of emerging markets at the G20 meetings used to be
that the unconventional monetary policies of advanced economies were taking a
heavy toll on their economies and that advanced economies must factor in this
spillover impact in formulating their domestic policies. They argued that these
cross-border capital flows were a consequence of globalization—maintaining
open borders for trade and finance. Both sides, advanced and emerging
economies, benefit from globalization and so both sides also must share the costs
of globalization; it is unfair to leave the entire burden of adjustment to emerging
markets. Although they did not bluntly make the allegation, emerging markets
would strongly suggest that the intent behind QE was for advanced economies to
debase their currencies for unfair trade advantage. Otherwise, why would they
persist with QE even after it became evident that it failed to deliver the intended
results?
Advanced economies, led by the United States, were largely dismissive of
these grievances. Their main response used to be that QE was driven entirely by
the need to stimulate their domestic economies, and the argument that it was a
cover for deliberately debasing their currencies for export advantage was
vacuous. They did not deny the existence of the spillover impact but would
argue that such spillover was an inevitable by-product of their policy effort to
revive their domestic economies. Moreover, the argument went, revival of
advanced economies is in international public good inasmuch as emerging
markets too benefit from that revival through increased demand for their exports.
They would add for good measure that emerging markets should set their own
houses in order to cope with the forces of globalization rather than find a
scapegoat in the domestic policies of advanced economies.
In the context of this debate, here is what Bernanke writes in his book The
Courage to Act on what he said at the G20 meeting in South Korea in October
2010: ‘I argued that because we are an important trading partner for many
countries, the rest of the world would benefit from a stronger US recovery. I said
that countries with sound monetary, budget and trade policies could better
withstand any short term disruptions from our easing.’
The asymmetry in this dialogue was best captured by the following poser from
an emerging-economy central bank governor to Bernanke in one of the G20
meetings. ‘You know, Ben, when we formulate our monetary policy, we review
not just our domestic macroeconomic situation, but also the global situation. In
not just our domestic macroeconomic situation, but also the global situation. In
our policy documents, there is a section on the global economy, and in
particular, on the outlook for advanced economies. Do you, when you make
monetary policy for the US, similarly review the economic situation in the
emerging world?’ The answer was a sheepish silence.
Currency wars is an issue where consensus remains elusive.

Dollar as the World’s Sole Reserve Currency

The second, almost regular, item on the G20 agenda was the position of the US
dollar as the world’s sole reserve currency. The risk to global financial stability
because of the world depending on a single reserve currency became starkly
evident during the global financial crisis.
As far as currency markets go, the aftermath of the crisis actually presented a
bizarre situation. The United States was the epicentre of this huge crisis; its
financial markets had seized up with deep anxiety and panic; several of its big-
name financial institutions were on the brink of collapse and the US economy
was headed into a deep recession. That should have sapped confidence in the
dollar and the dollar should have plunged in value vis-à-vis other currencies as a
consequence. Yet, exactly the opposite happened—the dollar actually
appreciated.
The reason for this counter-intuitive surge in the dollar was not far to seek. As
a result of the extreme uncertainty in financial markets following the Lehman
collapse in September 2008, dollar investors around the world began
withdrawing their investments to return to the safe haven of the US, in the
process pushing up the dollar exchange rate. The flip side of this capital exodus
was a severe dollar shortage everywhere outside the US which threatened the
smooth functioning of global payment systems, and exacerbated financial
vulnerability. The point is that every country in the world needs dollar reserves
just because the dollar is the underlying currency for a preponderant portion of
global trade and finance. The turmoil in the currency markets was a result of this
total dependence on the dollar as the world’s sole reserve currency.
To mitigate the risk of overseas dollar liquidity crunch, the US Federal
Reserve provided bilateral swap arrangements for some countries. The aim was
to improve liquidity conditions in the US as well as in foreign financial markets
by providing foreign central banks with the capacity to deliver US dollar funding
by providing foreign central banks with the capacity to deliver US dollar funding
to institutions in their respective jurisdictions in times of stress. But such an
accommodation was restricted to hard currencies, and largely to OECD
countries. We requested a similar rupee–dollar swap arrangement, but the
Federal Reserve did not respond positively. Although they never said it in so
many words, I believe their reluctance was either because the rupee is not a
freely convertible currency or because our financial markets were not important
from the US perspective.
Given the turmoil caused by this dependence on the dollar, it was not
surprising that when, in early 2009, Governor Zhou Xiaochuan of the People’s
Bank of China floated the idea that the SDR issued by the IMF could be an
alternative to the dollar, it created ripples in global policy circles and financial
markets.
The agitation about this excessive dependence on the dollar was not confined
to emerging markets. In fact, in 2011, when France was the chair of the G20,
President Nicolas Sarkozy had even appointed a task force with a mandate of
finding a solution to the sole reserve currency issue, with a not-too-unsubtle
message that the task force should explore ways in which the euro could become
an alternative reserve currency. As it happened, that task force lost its
momentum, as the eurozone sovereign debt crisis erupted in 2011 and continued
to convulse the global economy in the following years.
Can the yuan challenge the primacy of the greenback in the global system?
After listening to the Chinese authorities in the G20, IMFC, BRICS meetings
and indeed at several other international policy forums and conferences, I am not
certain if even the Chinese authorities are clear about whether they want to
position the yuan as an alternative global reserve currency. This is not to say
anything about their active efforts over the last several years to internationalize
the yuan, which the Chinese saw as a project quite distinct from positioning it as
a reserve currency.
The results of this internationalization effort are clearly evident. The yuan is
today second only to the dollar in its use in international trade and finance. Yuan
deposits outside China have multiplied more than tenfold in the last five years.
Every year, there are dozens of issuances of dim-sum—yuan-denominated—
bonds outside China.
What is also clear is that China has set a lot in store by way of the IMF,
including the yuan in the SDR basket, along with the dollar, euro, sterling and
including the yuan in the SDR basket, along with the dollar, euro, sterling and
yen. In November 2015, it achieved that aspiration when the IMF determined
that the yuan met its qualifying criterion of being ‘widely used and freely
usable’, and made it part of the SDR basket.
Opinion is divided on the significance of this imprimatur of respectability for
the yuan from the IMF, an institution with which China has often had a testy
relationship. One view is that this is only of symbolic value as the SDR is no
more than an accounting device; it is neither a true currency nor a claim even on
the IMF. True, central banks do hold SDRs, but they still have to convert them
back into the constituent currencies if they want to use them for intervention
purposes. Moreover, being in the SDR basket is neither a necessary nor a
sufficient condition for a currency to be widely held in official reserves.
Ranged against this is the view that being part of the SDR basket may make
central banks around the world more open to add yuan to their coffers. This
could be significant. Excluding China’s own pile, global foreign exchange
reserves are about $7.8 trillion. Shifting, say, even 10 per cent of this into yuan
over the next five years would require central banks to spend about $150 billion
a year on bonds and other assets denominated in the yuan. That could mean a
significant expansion of the internationalization of the yuan.
Even if this more positive perception about the future of the yuan bears out, it
might still be far from being accepted as a global reserve currency at par with the
dollar. For that to happen, China will have to meet some demanding
preconditions. In particular, the world must become confident that the Chinese
authorities will allow the yuan exchange rate to be freely market determined. It
will take at least a few years for the Chinese to establish credibility in this
regard. Further, the yuan should become fully convertible on the capital account
and it is still a far way from that. Also, the financial markets of China should
inspire the confidence of global investors about being open, deep, liquid, and
credibly and predictably regulated. This too will take time.
Beyond the above preconditions, there is another requirement too. For any
currency to be a global reserve, there should be ample amounts of it floating
around in global financial markets. The dollar meets this requirement, as the
Americans facilitate this by running a consistent trade deficit—a phenomenon
that textbook economics call ‘the Triffin Paradox’. This is the logic behind the
American claim that the dollar being the global reserve currency is not an
‘exorbitant privilege’, as it is made out to be but, in fact, an exorbitant obligation
on them. It is not clear that the Chinese are willing to take on a similar
obligation.
Money, as we know, has three functions: it is a unit of account; a medium of
exchange; and a store of wealth. A global reserve currency should meet these
three criteria at the international level. The yuan is surely a unit of account and a
medium of exchange, but far way yet from being a store of wealth.
My own view, from what I gathered from hearing the Chinese authorities both
in formal meetings and informal conversations, is that they will promote the use
of the yuan in international trade and finance, but are quite agnostic about
whether it will actually become a reserve currency.

Basel III Framework for Bank Regulation

Apart from currency wars and the reserve currency issues, the other contentious
issue in the post-reform period was banking regulation reform that eventually
took shape as the Basel III framework.
Although banking regulation is a domestic issue and every country can, in
theory, regulate its banks any way it wants, in practice, the flexibility is much
limited as countries perforce find that they have to conform to international
standards. Why so? Because in an era of globalization where trillions of dollars
cross international borders every day, it is just not possible for any country to
remain an outlier in terms of regulatory standards. Markets shun economies
which do not meet global standards. The choice in this regard is particularly
stark for emerging economies which are dependent on foreign capital for
investment.
The international standards for banking regulation are set by the Basel
Committee for Banking Standards, BCBS or Basel Committee for short, and for
non-banks by the Financial Stability Board (FSB).1 Before the crisis, both the
BCBS and the FSB comprised only advanced economies. In other words, these
exclusive clubs of advanced economies set the standards for bank and non-bank
regulation, and the rest of the world had to adhere to them. After the crisis,
emerging markets protested against being relegated to being hapless bystanders,
especially as it was the lax regulation by the advanced economies that was one
of the root causes of the crisis. The result was that the membership of these
forums was expanded to admit a few large emerging markets, including India.
As it turned out, this was not as substantive a victory as it looks. In some
sense, the advanced economies continue to run the show. Although emerging
markets were given a seat at the table, there was no real inclusion. Typically, the
advanced economies would stitch up a deal at a conclave ahead of the meeting,
and present that at the formal meeting for approval, almost as a fait accompli. In
other words, emerging markets had a vote, but not a voice.
The Basel III banking regulation standards emerged out of this ‘inclusive’
process. Shorn of a myriad of detail, at its heart, Basel III is a requirement for
banks to raise the quantum and quality of their capital so that they are better
prepared to withstand shocks, thereby bolstering both domestic and global
financial stability.
At a theoretical level, the requirement of higher capital standards on banks is
unexceptionable; the more fortified an institution, the better it is able to
withstand shocks. But bringing in additional capital entails costs, and these
additional costs will translate into higher interest rates on bank lending. In short,
the question is, how much are we willing to spend to buy insurance against a
shock to our banking system?
The cost-benefit calculus is different for advanced economies and for
emerging markets. Emerging markets, led by India, argued at the BCBS
meetings that the costs of additional capital to be raised by banks would hurt
their growth prospects, especially at a time when their growth prospects
depended more than before on the availability and cost of bank credit. However,
we failed to influence the final Basel III decision in any significant way.
For sure, the Basel III framework includes a ‘comply or explain’ provision,
meaning that if a country is unable to comply with the standards, it can choose to
deviate and then explain why it had to deviate. In practical terms though, this
choice is a no choice. In the ruthless world of globalization, deviating from
global standards, no matter how convincing the explanation, is not an option
open to emerging markets.
Going forward, I believe it is important for global-level reforms to factor in
emerging-market viewpoints. Emerging markets are undergoing significant
transformation, including in their banking and non-banking sectors, technology-
led financial inclusion and product development. These developments challenge
led financial inclusion and product development. These developments challenge
old banking models, present promising opportunities and pose new risks for
financial institutions and financial markets. Ignoring these EM perspectives in
global-level financial sector reforms will be collectively suboptimal for the
whole world.

Foreign Banks

Way back in1972, when I qualified for the civil service, I had an option to join
the foreign service, but I decided to choose the IAS for a number of reasons, one
of which was that I didn’t think I had the personality or skills to be a successful
diplomat. My self-assessment has not changed in the several decades since. But I
could not avoid diplomacy altogether; I was involved in economic diplomacy at
several points even in my IAS career, while dealing with multilateral institutions
like the IMF and the World Bank, and bilateral donors like Japan.
A successful diplomat, they say, is one who puts the interests of his country
above all else, consistency be damned. The truth behind this wisdom came
forcefully to me via a big policy issue pertaining to foreign banks that I had to
address as governor.
During the global financial crisis, emerging markets found that foreign banks
were largely fair-weather friends. A priority for emerging markets during the
crisis was to keep bank credit flowing for productive purposes. To persuade
banks to keep pumping credit was no easy task when they were seized with such
unprecedented fear and uncertainty. In general, emerging markets found that
their domestic banks heeded the call but foreign banks remained reticent, almost
all of them, in fact, retrenching credit.
The received wisdom among emerging markets in the post-crisis period was
that the best way to mitigate the risk of such self-centred behaviour by foreign
banks was to require all foreign banks to incorporate in the host country as a
subsidiary.
Just by way of explanation, commercial banks typically operate in a foreign
country either as a subsidiary or as a branch, and what form they choose depends
both on their business model as well as the regulations of the host country. In
India, the Reserve Bank allows both models of operation, leaving the choice of a
branch or a subsidiary mode to the foreign bank. Curiously, all foreign banks
that have come into India have chosen to operate as branches.
that have come into India have chosen to operate as branches.
We deliberated on the issue of whether the Reserve Bank too should mandate
all foreign banks to compulsorily operate only as subsidiaries. For sure, the issue
was not black and white, there were pros and cons on either side. To get a
broader opinion on the issue, we issued a discussion paper, listing the merits and
demerits of both models and calling for feedback. Foreign banks from almost
everywhere in the world endorsed the subsidiarization model and indicated their
readiness to incorporate in India should the Reserve Bank so regulate. The only
country that had a serious objection to this was the US, mainly on the ground
that mandatory subsidiarization of foreign banks would erode the efficiency of
capital use and therefore raise the costs of banking. International banks, they
contended, should be able to freely move capital from one country to another
swiftly, depending on the need. This, according to them, was good not only for
the bank but for the global financial system as a whole.
We raised the issue of mandatory subsidiarization of foreign banks with the
US authorities several times, including in the Indo-US economic dialogue in
Delhi in October 2012, when both Treasury Secretary Geithner and Federal
Reserve Chairman Bernanke were present. They reiterated their standard
position. We argued that they should not be judging the issue from the narrow
perspective of their self-interest but also factor in the risks and rewards of
emerging markets in determining the cost-benefit calculus. The impasse
persisted.
But the US opposition to our proposal for mandatory subsidiarization was not
a binding constraint. Considering all the pros and cons, including the fact of
broad endorsement from the foreign banking community, the Reserve Bank has
since issued fresh regulations on the subsidiarization of foreign banks operating
in India.
But that is not my main story. My main story is that the same US authorities
who argued against our proposal for mandatory subsidiarization of foreign banks
on grounds of efficient use of capital had jettisoned that principle while applying
Dodd Frank regulations to foreign banks operating in the US. In particular, the
Dodd Frank Act requires foreign bank subsidiaries in the US to hold higher
levels of capital at par with domestic US banks. This angered foreign banks and
their regulators for the same efficiency reason that the US argued with us—that
it amounts to ring-fencing capital and depriving them of the flexibility to move it
around as per need. The US authorities did not budge, evidently putting self-
around as per need. The US authorities did not budge, evidently putting self-
interest ahead of all else, inconsistency be damned.
A lesson in diplomacy for me at the end of my career!
16
Moving On
Stepping Down from the Office of Governor

In February 2012, I gave an interview to the online edition of the Wall Street
Journal. After covering a vast ground on the global and Indian economic
outlook, the last question Alex Fangos of the WSJ asked me was: ‘You were
recently reappointed to another two-year term, running out in September 2013.
Would you like to serve another term?’ My answer was a curt and crisp ‘no’.
I was very clear in my mind that not only did I not want to serve as governor
beyond the extended term of September 2013, in the very unlikely event of it
being offered, but also that I needed to move on from government service into
private life. I joined the IAS barely two months after finishing college and it has
been the government all the way since. It is where I learnt, matured and was
amply rewarded. After over forty years, I now wanted to live without the
crutches of the government.

The Succession Story

I first met Raghuram Rajan when I was finance secretary in the government and
he was leading a committee on financial sector reforms appointed by the
Planning Commission. We had lunch in my office, of idli and dosa, which my
staff had ordered from Saravana Bhavan. We also talked a little bit about
financial sector reforms.
The Rajan Committee submitted its report to the government in September
2008, shortly after I moved from North Block to Mint Street. I have already
written in an earlier chapter about that meeting with the prime minister where
the committee presented its report and the inconclusive discussion we had on
inflation targeting. Raghu and I kept in touch after that. We met in meetings and
conferences, and exchanged emails. As honorary adviser to the prime minister,
he used to send occasional notes to the prime minister on economic issues and
was always kind enough to share them with me. I also invited him to give a talk
in the Reserve Bank on his much-acclaimed book, Fault Lines, in May 2010.
In April 2012, Raghu, who was still in his academic job in Chicago, came to
see me in my office in Mumbai and asked about my plans, in particular, if I was
going to seek another extension of my term. Incidentally, he had been on the
probable list of candidates to succeed me in September 2011 if I was not given
an extension of two more years. Since that was behind us by the time of this
meeting, there was now occasional speculation that he would succeed me when
my extended term finished in September 2013. In response to his query, I told
him in no uncertain terms that I would not seek an extension, nor would I accept
one were it to be offered. I encouraged him to make his plans on that basis.
We met again three days later in Delhi where both of us were featured
speakers at a Festschrift for Dr Manmohan Singh, organized by Isher Judge
Ahluwalia, chairperson of the Indian Council for Research on International
Economic Relations (ICRIER) board, to celebrate twenty years of economic
reforms. I had a feeling, and I must emphasize this was just my gut feeling, that
Raghu was still doubtful about what I told him in Mumbai regarding my plans.
To put those doubts, if any, to rest, I told him in a quiet moment, when there
were just the two of us, that I didn’t intend to continue as governor beyond my
term.
In August 2012, Rajan was appointed as the chief economic adviser (CEA) to
the government. The speculation was that this was just a parking slot until he
moved to the Reserve Bank a year later, and that this experience as CEA would
give him the much-needed exposure to the functioning of the government from
within. That sounded very plausible but I am not sure if the government gave
him any assurance on the governor’s job, nor indeed if Raghu asked for one.
I don’t think either the prime minister or the finance minister had even
contemplated another extension for me. To make matters absolutely clear
though, I told Chidambaram as early as in January 2013 that he should begin
thinking about my successor. He passed it over saying it was more than six
months away. I reminded him again in March 2013, and also told him that the
government should announce my successor three months before the close of my
tenure so that the incumbent could understudy during that period. I had in mind
tenure so that the incumbent could understudy during that period. I had in mind
my own experience of the abrupt shift I had to make from Delhi to Mumbai and
how disruptive such unprepared transitions can be for both the institution and the
individual. On the other hand, understudying for the new position can add
enormous value to the change of guard.
I knew from working with Chidambaram that he was not only a reformer but
also a modernizer. I thought he would readily accept my suggestion, which
should mark a welcome departure from the standard, but antiquated, practice in
the government of making decisions on high-level appointments at the eleventh
hour. But he looked askance at me, surprised, I thought, at my readiness to
become a ‘lame-duck’ governor for a full three months. My own experience in
the civil service, however, gave me no reason to believe in the ‘lame-duck’
theory; in the Indian system, the incumbent prevails till he or she actually signs
off.
My term was finishing on 4 September 4 2013, but there was no decision from
the government even as we entered July. There was mounting speculation about
who my successor might be. Although Rajan was the overriding favourite, there
were other names being speculated about as well—Saumitra Choudhury,
member of the Planning Commission, and Arvind Mayaram, finance secretary,
among them.
The government announced Rajan’s appointment as the twenty-third governor
of the Reserve Bank on the afternoon of 6 August. Chidambaram, courteous and
correct as always, called me earlier that morning to inform me in advance not
only about the appointment but also about Rajan being an understudy for one
month. I thought he sounded a bit apologetic about the understudy bit even as it
was I who had encouraged him on such an arrangement.

The Governor’s Office

The governor’s office on the eighteenth floor of the Reserve Bank’s central
office in the Fort area of Mumbai is spacious and comfortable, elegant but not
luxurious. There was an ambitious greening project undertaken for the entire
tower structure of the central office in 2009–10 which doubled as an opportunity
to redesign the layout of the executive office floors of the building. The old
small, steel-frame windows were replaced by floor-to-lintel-level chrome and
glass windows which let in a lot of light but kept the heat out. You look out the
glass windows which let in a lot of light but kept the heat out. You look out the
window and you could see the Government Mint, the colonial era customs house
and the ships docked in the Bombay port. I used to joke with my staff that the
Reserve Bank must allow me the use of the governor’s office for at least three
months after I stepped down so that I could enjoy the comfort and elegance of
the beautiful office without the burdens of the job.
The eighteenth floor houses the governor and his front office; there is also a
large, handsomely appointed conference room, modernized as part of the
greening project. Across the aisle from the governor’s office is a private lounge
for meeting visitors, with a separate dining space should the governor be hosting
a small meal for friends or guests. On the wall adjacent to the dining table is the
governor’s gallery, portraits of all the past governors, seemingly keeping an eye
on the current incumbent who will, in course of time, join their club. You look
out the window on the lounge side and you can see several behemoths of the
Indian financial sector—SBI, UBI, BSE (Bombay Stock Exchange)—as well as
the high court, the naval base and the Mazagon Docks. From the air-conditioned
comfort and calm of the eighteenth floor, the hustle and bustle and the chaos and
confusion of Mumbai’s financial district looks orderly and organized!
There is an additional small office room on the eighteenth floor, behind the
governor’s office, which is allotted to visiting dignitaries. The Reserve Bank’s
housekeeping department arranged for this office to be used by Rajan during the
understudy period. He shuttled between Delhi and Mumbai during the month,
but I took care to keep him in the loop on all important developments, including
managing the exchange rate which dominated my agenda during that period.

What Would You Have Done Differently?

‘What would you have done differently?’ is a question that has crossed my mind
several times since stepping down. This is also one of the pointed questions that
Mythili Bhusnurmath of ETV hurled at me in the only formal, exclusive TV
interview that I had done since leaving the Reserve Bank. At one level, this is an
incomplete question. The full question, in my view, should be: ‘What would you
have done differently if you knew what you now know?’ With the benefit of
hindsight, one may, in fact, do many things differently. On the other hand, if the
question were ‘What would you have done differently if you were operating
within the universe of knowledge available at that time?’, the answer may be,
within the universe of knowledge available at that time?’, the answer may be,
‘Not very much.’
The writing of this book involved a lot of introspection into my time at the
Reserve Bank to identify in particular what I got right and what I didn’t get right.
Without getting into the logical fallacy outlined above, I tried to indicate,
wherever the context demanded, what I could have done better even with the
knowledge available in real time and what I would have done differently with
the benefit of hindsight. In one sentence, if indeed I had a second chance, I
would pay much greater attention to communicating more effectively.
I still have a fairly vivid recall of one of the topics that came up for discussion
when I appeared before the civil services interview board way back in 1972. I
wrote in my application that I was on the IIT debating team. ‘What was the latest
topic you debated on?’ a member asked me. That happened to be: ‘Man is
condemned to be free’, a statement from the existentialist philosophy of Jean
Paul Sartre. The interview board members pushed me into interpreting that
statement. Here is a precis of what I told them.
At the heart of the existentialist philosophy is the premise that all existence is
absurd. Life has no meaning and death is the ultimate absurdity. But in the
course of this absurd existence, man is forced to make choices, even if those
choices may be about absurd issues. But man abhors this freedom of choice, a
condition called ‘existential angst’. Until we reach a time when most of our life
lies behind us, we second-guess ourselves interminably. ‘What if I had done
this?’ ‘What if I had done that?’ ‘Could I have learnt from what others before me
have done?’ But that is a futile endeavour. It is just not possible to pass on the
burden of decision-making to someone else, nor is it possible to learn from
other’s experiences. Every man has to make choices by falling back on his own
experience. In short, man is condemned to be free.
I must admit it didn’t exactly go as fluently as that, and to this day I wonder if
the wise men (yes, all men, no woman!) on the board were impressed or put off
by a cocky twenty-two-year-old pontificating on what is arguably one of the
most abstract concepts in the history of ideas.
But why did this memory from over forty years ago come to me when I am
thinking about what I would have done differently as governor of the Reserve
Bank? Perhaps to remind me that every governor is a creature of the
circumstances in which he is called upon to perform. He has to make choices
and decisions based on his own learning and experiences. The governor is
condemned to be free!
If there was another chance, I could fall back on this experience to do things
differently. But then there are no second chances in life.

Looking Ahead

Another omnibus question that I have been asked both while on the job as
governor, and after I stepped down, is about the challenges for the Reserve Bank
on the way forward. I will highlight, but only briefly, four challenges that the
Reserve Bank will need to address in order to remain a premier policy
institution.
The first challenge on my list is for the Reserve Bank to learn to manage both
economic and regulatory policies in a globalizing world. The global financial
crisis, the eurozone sovereign debt crisis as well as the currency market volatility
during my tenure, have emphatically demonstrated how external developments
influence our domestic macroeconomic situation in complex, uncertain and often
capricious ways. In making policies, the Reserve Bank has to factor in external
developments, particularly the spillover impact of the policies of advanced
economies on our macroeconomy. This will become even more important as
India’s integration with the global economy deepens.
Even at the risk of sounding clichéd, let me say that the Reserve Bank needs
to ‘think global and act local’. The idea is not to fight globalization but to
manage it to the country’s best advantage. Mahatma Gandhi said: ‘I do not want
my house to be walled in on all sides, and my windows to be stuffed. I want the
cultures of all the lands to be blown about my house as freely as possible. But I
refuse to be blown off my feet by any.’ The Mahatma’s exhortation is even truer
today than when he said it.
Over the years, the Reserve Bank, as an institution, has learnt quite a lot about
managing policy in a globalizing world. Yet the learning curve ahead is steep.
My wish is that the Reserve Bank should take the lead in setting standards for
how an emerging-market central bank manages its policies in a globalizing
world. The Reserve Bank should become the best practice that other central
banks emulate.
The second on my list of challenges is that the Reserve Bank must position
The second on my list of challenges is that the Reserve Bank must position
itself as a knowledge institution. The crisis has shown that knowledge matters.
Those central banks which are at the frontiers of domain knowledge and are
pushing the envelope in terms of policies and actions will be better equipped to
deal with the complexities of macroeconomic management in an increasingly
dynamic and interconnected world.
There is obviously no template or manual for becoming a knowledge
institution, nor is there a comprehensive list of attributes. Becoming a
knowledge institution is a continuous process of learning from the best practices
in the world, oftentimes reinventing them to suit our home context, pushing the
envelope, asking questions, being open-minded, acting with professionalism and
integrity, and encouraging an institutional culture that cuts through hierarchies.
That takes me to the third big challenge for the Reserve Bank—to widen and
deepen financial inclusion. We all know from personal experience that economic
opportunity is strongly intertwined with financial access. Such access is
especially powerful for the poor as it provides them opportunities to build
savings, make investments, avail credit, and above all, insure themselves against
income shocks. At the aggregate level, financial inclusion provides an avenue
for bringing the huge savings of the poor into the formal financial intermediation
system, and for channelling them into much-needed investment. One of the big
takeaways from the outreach programme initiated on my watch has been that
financial inclusion is not just a public good; it is also a merit good. It empowers
poor people in diverse ways. If there is to be ‘inclusive growth’, financial
inclusion is the next big idea, as it will at once promote both growth and equity.
The final challenge for the Reserve Bank is to become a more transparent and
sensitive institution. As a public institution, it has an obligation to deliver quality
service at the cutting-edge level. The bank needs to listen to the people, be
sensitive to their concerns and responsive to their needs.

Release of RBI History Volume

The Reserve Bank initiated a project for recording its institutional history from
the time of its establishment in 1935, based on archives and oral interviews of
key players. The first three volumes covered the period up to 1981, and were
released before I became governor. The fourth volume, covering the period
1982–97, was ready for release by early 2013.
1982–97, was ready for release by early 2013.
All of us in the Reserve Bank were very keen that Prime Minister Manmohan
Singh release this volume because it would mark a very unique event. This
volume of history covers the period when Dr Manmohan Singh was governor of
the Reserve Bank and subsequently, the finance minister, and would be released
by him as the prime minister. I requested the prime minister several times but he
remained reticent. When I met him before the July 2013 policy review, I
reiterated my request, and to my surprise, he agreed, but on the condition that the
event should be low key and be held in his official residence at 7 Race Course
Road in Delhi. I got a feeling that he agreed just to oblige me since I would be
stepping down shortly, and I was grateful to him for that.
The event was finally scheduled for the morning of 17 August. I got a call that
morning from his office, saying that the prime minister wanted to see me fifteen
minutes ahead of the function. I wondered why, and got a bit anxious. We had
already sent the briefing material to his office earlier. Was he annoyed about
some misrepresentation of his period of history? Did he just want a personal
briefing? Was he upset that the function was not as low key as he had asked it to
be? I went to see him with much trepidation because I had not read the full
volume myself. I had neither the time nor the mind space in the midst of
managing the rupee tantrums. I depended on the same briefing material that we
sent him.
The meeting turned out to be for a completely different reason. He said he just
wanted to compliment me for the way I led the Reserve Bank during a period of
enormous economic and political challenges. Once again, I was touched by his
graciousness. He inquired about my future plans. I told him I would be
relocating to Hyderabad and that I wanted to take about six months off to decide
what I would do next. ‘Do let me know if you want anything in the government.
I will be happy to consider that,’ he added kindly. Thinking that it would be
discourteous to tell him that I had decided to keep away from the government
and live completely as a private citizen, I thanked and took leave of him.

Subbarao’s Mixed Record

Quite expectedly, there was extensive media evaluation of my five years at the
Reserve Bank. The general verdict was that my record was a mixed one. Here
are some excerpts:
are some excerpts:
‘Had Subbarao stepped down in May [2013], his legacy would have been
different. In September 2008, when he took up the assignment, India was one of
the many countries hit by the global credit crunch. But the currency crisis is
mostly India specific and tackling it has been Subbarao’s biggest challenge in his
entire career. He hasn’t met the challenge with aplomb. Does that mean his has
been the worst tenure at RBI? As they say, a governor should be judged over a
cycle and not when he leaves.’ (‘D. Subbarao: The government insider who
turned rebel’ by Tamal Bandyopadhyay, Mint, 3 September 2013)
‘The true legacy of Dr Subbarao will be realized . . . down the line. But this
much needs to be said: over the years the grand old lady of Mint Street has been
wooed by several powerful suitors from Delhi. And she turned them all down.
Dr Subbarao sustained that legacy even if at times it required him to tell some of
those suitors to take a walk, all alone. That shall remain his biggest
accomplishment.’ (‘Not his master’s voice’, The Hindu, 4 September 2013)
‘Fiscal dominance means that fiscal policy dominates monetary policy in
terms of its impact. Monetary policy actions lose traction and effectiveness
because, even if the central bank raised interest rates, if it was forced to buy
government debt because of excess government spending, the effectiveness of
rate hikes is lost. That is what happened to poor Dr Subbarao. He was more a
victim than a villain of India’s inflation and currency problems as many made
him out to be then and still think so.’ (V. Anantha Nageswaran in a blogpost on
the gold standard site:
https://thegoldstandardsite.wordpress.com/2015/03/04/indias-inflation-targeting-
regime/)
‘How will history judge Subbarao? As a governor who fought fiercely for the
central bank’s independence, one who had a mind of his own and honestly did
what was right for the economy? Or will the verdict be less favourable?’ (‘The
man who dared to disagree’, Business Today, 4 September 2013)
‘Subbarao has been in charge at a very difficult time, with global instability as
well as growing domestic and economic problems. Our view is that his record
has been a mixed one and has to be understood against the complicated times in
which he was managing the monetary affairs of the nation.’ (‘Subbarao’s mixed
record at RBI’, Mint, 4 September 2103)
‘He bequeaths a good tradition to his successor. The RBI and the country have
been well served by this scholarly, thoughtful, modest and dignified man.
Posterity will be kinder to him.’ (‘Subbarao—End of a turbulent tenure’, The
Hindu BusinessLine, 3 September 2013)

Change of Guard

Real-life events do not respect leadership transitions. The last couple of months
of my tenure went completely off script. I thought this would be the time when I
would travel around and visit many of the Reserve Bank’s regional offices and
also meet the staff of the central office departments to reminisce and rejoice over
our time together. I particularly wanted to reach out to middle-and junior-level
professionals of the Reserve Bank whose ideas, insights and perspectives
influenced me more than they realized. In the event, I was so fully preoccupied
with the rupee tantrums that my last day in office, 4 September 2013, seemed to
have arrived almost as abruptly as my first day as governor.
At eleven that morning, I spoke to the entire Reserve Bank staff across the
country via a video link-up and told them that I would carry many, many
pleasant memories of my association with the Reserve Bank. The challenges and
anxieties we went through together and the joy and fun we had together would
be enduring memories. I pointed out that in a full-length feature article on the
Reserve Bank in 2012, the Economist had said: ‘The RBI is a role model for the
kind of full service central bank that is back in fashion world wide.’1 I hoped, I
added, that in a few years’ time from then, everyone watching and evaluating the
Reserve Bank would say: ‘The RBI is a role model for the kind of knowledge
and ethical institution that a central bank should be.’
There was a lunch that afternoon to bid me farewell and welcome Governor
Rajan. Gathered there were the directors on the board of the Reserve Bank,
serving senior management and retired senior officers of the Reserve Bank,
CEOs of banks and financial Institutions, other financial sector regulators—
about 200 in all. There was the expected round of speeches—nostalgic,
emotional and touching.
I kept my own remarks deliberately quite light-hearted. I told the gathering
that there are many things I will miss about being governor, but most of all I will
miss being important. Once I step down, I will enjoy the freedom to open my
mouth without the pressure of having to say something profound every time I
spoke, that I look forward to spending time with my ninety-plus-year-old
mother-in-law and that I will freak out on going to a matinee show of Chennai
Express. I gave some advice to Raghu. He could, I told him, comfortably
delegate to his senior staff less important decisions like interest-rate changes and
to whom to issue bank licences, but that he ought to retain with himself
important decisions like the menu for lunches to be hosted by the governor, gifts
to be given to visiting dignitaries and seating arrangements at meetings.
At a brief ceremony at three that afternoon, I signed off and Governor Rajan
signed on. Minutes later, I walked out of the office, went down the elevator—
with hundreds of Reserve Bank staff present on the ground floor to see me off,
and cameras of assembled press photographers clicking away—got into the car
and drove away into life after the Reserve Bank.

Summing Up

In the five years that I was governor, I ran into thousands of strangers who
recognized me, complimented me and were generous in their appreciation of
what I was doing at the Reserve Bank. Every such meeting was a heart-warming
experience as their compliments were so genuine. The most touching experience
of all was when a young woman approached me in Mumbai airport, while I was
awaiting a flight, and said: ‘Sir, you are an inspiration for people like me
because you’ve proved that it is possible for someone from a middle-class,
underprivileged background to rise to the top.’
As I conclude this book on my five years at the Reserve Bank, I must
acknowledge that I was fortunate to have served in a central bank during a
remarkable period. From a central-banking perspective, history will mark that
period for two distinct developments. The first is the extraordinary show of
policy force with which central banks responded to the global financial crisis.
This has generated a vigorous debate on the short-term and long-term
implications of unconventional monetary policies, as also on the responsibility
of central banks for the cross-border spillover impact of their policies. The
second historical marker will be the manner in which, reflecting the lessons of
the crisis, the mandate, autonomy and accountability of central banks are being
the crisis, the mandate, autonomy and accountability of central banks are being
redefined in several countries around the world.
Notwithstanding all the tensions and anxieties of policy management during
an admittedly challenging period, I consider myself enormously privileged to
have led one of the finest central banks in the world during such an intellectually
vigorous period. There were taxing times, testing times, anxious times. But at all
times, I moved on with the confidence that there is a great institution behind me
that will steer me in the right direction. I was deeply impressed by the
professionalism, intellectual agility and commitment of the staff and officers of
the Reserve Bank. This is an institution that has served the country with dignity
and distinction, and will continue to set exemplary standards for professional
integrity and work ethic.
Finally, how would I like to be remembered? As a governor whose every
decision and action was motivated by one and only one consideration—the
larger public interest; as someone who never swerved from the Reserve Bank’s
dharma.
Author’s Note
I stepped down from the office of governor of the Reserve Bank of India (RBI)
on 4 September 2013. In the months before I left the RBI and for long
afterwards, several people have asked me if I planned to write a book on my
time as governor. I remained dismissive of the suggestion if only because I
found the idea of writing a book very daunting.
In mid-2014, I took up a position as a Distinguished Visiting Fellow at the
National University of Singapore (NUS). I was employed primarily by the
business school although my appointment was also partly supported by the
Institute of South Asian Studies and the Monetary Authority of Singapore. The
job involved giving occasional lectures on issues in central banking, the financial
sector and the global economy. Many faculty and students who heard the
lectures urged me to put those ideas, thoughts and experiences together in a
book.
Encouraged by all this urging, I decided to bite the bullet and started on the
book in earnest in mid-2015. This book is an account of my term as governor
during 2008–13. This was, by all accounts, an unusually turbulent period for the
world and for India. The global financial crisis erupted in full blast within a
week of my stepping into the Reserve Bank. Just as India started recovering
from the impact of the crisis, the action shifted to combating a decade-high,
stubborn inflation during 2009–11 which segued into a battle against a sharp
depreciation of the rupee from mid-2012 up until the close of my tenure in
September 2013. At its heart, the book is about the dilemmas I confronted in
leading the Reserve Bank through a period of extraordinary economic and
political challenges.
This book is not an attempt to defend my decisions as governor, so much as to
explain the circumstances in which I acted. It is not an effort to reshape the
narrative of that period but to convey my perspectives on the issues and
challenges which shaped that narrative in the first place.
My five years at the Reserve Bank also marked an intellectually vigorous
period for central banking around the world. Not only has the global financial
crisis tested the policy force of central banks but it has also raised several
questions about the tools of their trade, their forays into communication, the
questions about the tools of their trade, their forays into communication, the
limits of their autonomy and the limitations of the manner in which they render
accountability. Much of the debate surrounding these issues has been set in the
advanced economy context. I have endeavoured to place some of these issues
and debates in an Indian and emerging-market perspective.
The book is more than just about my challenges and dilemmas. It is also an
attempt to demystify the Reserve Bank. Although monetary policy is the
glamorous stuff that grabs the headlines, the Reserve Bank is much more than a
narrow monetary authority. It has a broad mandate and a wide array of
responsibilities. Yet the vast majority of people in India only have a scanty
understanding of what the Reserve Bank does and how that affects their
everyday lives. I have endeavoured to bridge that knowledge gap; a wider
awareness of the functions and responsibilities of the RBI should help the larger
public hold the Reserve Bank to account for results. Or that, at least, is my hope.
I did not keep any notes while serving as governor which ruled out a
conventional memoir organized chronologically. Besides, I was more attracted
to the idea of telling my stories and recounting my challenges thematically. The
ordering of the chapters has, however, been informed by a rough chronological
sequencing.
As I started on the book, I was apprehensive about whether I could recall the
relevant details and reconstruct my experiences after a gap of over two years in
the absence of any notes whatsoever. In the event, it did not prove to be as big a
handicap as I feared. I depended almost entirely on press clippings, my speeches
and the Reserve Bank publications of my period which helped me put together a
narrative in as much detail as I wanted. Besides, the Internet was a handy and
efficient resource for research and fact–checking.
Virtually, the first question that colleagues at NUS, many of them experienced
authors themselves, have asked me when I told them about the book was, ‘Who
is your target reader?’ A straightforward answer eluded me. There are
economists, analysts and commentators who know the Reserve Bank but are
keen on understanding how the Reserve Bank’s mind operates. Then there are
several times that number of educated and intelligent people who do not know
much about the Reserve Bank but are eager to understand how its policies affect
them. Both those groups are my target readers. To paraphrase Einstein, I have
tried to make the book as simple as possible, but no simpler.
tried to make the book as simple as possible, but no simpler.
It is customary for a preface to end with a vote of thanks. If I do so now, it is
not so much to pay homage to a tradition but to acknowledge many people who
encouraged and supported me in this project. First and foremost, my thanks to
the NUS authorities for generously allowing me the time and space to write the
book in the intellectually stimulating university environment. A special thanks to
Dean Bernard Yeung at the business school who attached so much value to the
scholarly pursuit of a book that he kindly agreed to free me of other obligations
so that I could focus on writing.
I needed specific information on certain topics from the Reserve Bank.
Deputy governors Harun Khan and R. Gandhi, under advice from Governor
Raghuram Rajan, supplied me notes on such topics, always on the mutual
understanding that the notes they gave me could be put out in the public domain.
My sincere thanks go to them and their support staff who serviced me with the
quiet efficiency that is the hallmark of the Reserve Bank. Susobhan Sinha, my
former executive assistant at RBI, went way beyond the call of duty to act as an
intermediary between me and the notes suppliers at the RBI, with his
characteristic efficiency and energy that I have so taken for granted. Alpana
Killawala, chief of the Reserve Bank’s communications department, kindly
provided me a CD of the press clippings which were of invaluable help in
constructing the basic narrative on each topic.
Indira Rajaraman read through every chapter and Anantha Nageswaran
through most chapters. I profited immensely from their insightful feedback and
suggestions, and was deeply touched by their generosity, patience and
enthusiasm. I owe them more than they realize.
At the Reserve Bank, Janak Raj and Muneesh Kapur peer-reviewed several
chapters with the same diligence and critical eye as they would have were I still
the serving governor. I was deeply touched by their earnestness and enthusiasm.
Others at RBI, serving and retired, who provided me thoughtful inputs or
reviewed one or more chapters were, in alphabetical order: Vivek Aggarwal,
S.K. Bal, Surajit Bose, Madhumita Deb, Suddhasattwa Ghosh, Meena
Hemachandra, Gunjeet Kaur, Grace Koshie, G. Mahalingam, A.K. Misra,
Deepak Mohanty, Gopalraman Padmanabhan, Suman Ray, Mridul Saggar, Uma
Shankar and Susobhan Sinha. Being thoroughbred Reserve Bank professionals,
they did not endorse all of what I said or the way I said it. My apologies to all
those who I may have inadvertently missed out, and my sincere thanks to them
those who I may have inadvertently missed out, and my sincere thanks to them
as well as to all those who helped from behind the scenes.
I felt free to use retired deputy governors of RBI—Shyamala Gopinath, Usha
Thorat, Subir Gokarn and Anand Sinha—as my sounding board on a number of
issues, and they indulged me as before with their wise counsel and advice. It felt
very nostalgic.
Outside the Reserve Bank, those who reviewed one or more chapters and gave
constructive feedback were, again in alphabetical order: Gita Bhat, Mythili
Bhusnurmath, Kalpana Kochhar, K.P. Krishnan, Amitendu Palit, V.G.S. Rajan,
Alok Sheel, Venky Venkatesan and Jumana Zahalka. My thanks to Rinisha Dutt
for her research assistance.
The improvement from my first drafts to the final versions that you see owes
to the comments and contributions of all the above reviewers. The standard
caveat that I remain responsible for the final version applies.
I am grateful to the team at Penguin—Meru Gokhale, Ranjana Sengupta, V.C.
Shanuj and Anushree Kaushal, and indeed all their teammates—for leading me
through the mysterious realm of book publishing with passion and
professionalism.
Many authors say that their families have been their harshest and also most
helpful critics. I can now vouch for that. My wife, Urmila, sons, Mallik and
Raghav, and daughters-in-law, Rachita and Aditi, who have grown to be more
than the daughters we didn’t have, have all been my most discerning and caring
critics. Their love and care is my most prized blessing.
1 As of now, this methodology is still the second best. I understand the Reserve
Bank is still having to interpolate the new series into the past using the CPI for
industrial workers.
1 This report has since been restructured as Monetary Policy Report on
Governor Rajan’s watch, and is released simultaneously with the governor’s
policy statement.
2 Incidentally, I don’t recall having a one-on-one meeting with Pranab
Mukherjee except on two occasions—the first when I had expressly requested
an exclusive meeting with him to discuss Usha Thorat’s reappointment as
deputy governor, and the second time when he invited me to his office to
explain the amendment to the RBI Act in the context of the ULIP (Unit
Linked Insurance Plans) controversy, both of which I will write about later.
1 I would learn only much later that ‘RBI restriction’ is a popular excuse that
banks invoke when they don’t want to do something.
1 The exchange rate, or more appropriately the nominal exchange rate, defines
the number of units of domestic currency that is needed to buy one unit of
foreign currency; for example, ₹60 is needed to buy one dollar. A decrease in
this number denotes nominal appreciation of the domestic currency while an
increase in the number denotes nominal depreciation. Thus, if the rupee
moves from ₹60 to a dollar to ₹50 to a dollar, it is said to have appreciated in
nominal terms and vice versa.
2 The actual CAD in 2013–14 was 1.7 per cent of GDP.
3 The real exchange rate defines the purchasing power of two currencies
relative to each other. While two currencies may have a nominal exchange
rate in the forex market, it does not mean that the goods and services
purchased in one currency cost an equivalent amount in the other currency
converted at the nominal exchange rate. This straightforward calculation will
change if the two jurisdictions have different inflation rates. The real
exchange rate is thus the nominal exchange rate adjusted for the differing rates
of inflation. For example, if India has higher inflation than the US, the rupee
can get ‘strong’ relative to the dollar in real terms even if the nominal
exchange rate does not move.
4 The Reserve Bank does, however, disclose its monthly total interventions with

a lag of a month.
5 Drawn from an article by Vivek Kaul in the DNA of 7 August 2013.
6 Indeed, the public expects policymakers to respond to every situation even

though there are situations when the most sensible thing, from a long-term
perspective, for policymakers to do is not to do anything at all. This dilemma
was illustrated very lucidly in a creative video presentation on the differing
ideologies of Keynesian and Austrian prescriptions for the global crisis. In
the video, featuring a boxing match between Keynes and Hayek, Keynes asks
Hayek about what he would do when unemployment is rising. Hayek trots
out a few long-term prescriptions. But in the short-term, he would like the
government to be a standstill goalkeeper. Sensible maybe, but virtually
impossible in the shrill democracies of today.
1 The other one-on-one meeting was in the context of the ordinance on ULIPs
which I will come to a little later.
1 Grace Koshie, the secretary to the Reserve Bank board, used to reprimand
anyone who used the phrase ‘extension of the governor’s term’. Technically,
the governor’s term is not extended; she or he is reappointed. I am resorting
to the more common phraseology for ease of communication. Grace, since
retired like me, will, I hope, pardon the liberty I am taking.
2 History of the Reserve Bank of India, vol. 2 (Mumbai: RBI, 1998).
1 The technical phrase for currency issued by central banks is ‘bank notes’. I am
using the phrase ‘currency notes’ since it is more easily understood.
1 Included in the SDRs is also the Reserve Tranche position of India with the
IMF.
1 Murphy’s Law: If anything can go wrong, it will.
2 Darryl Collins, Jonathan Morduch, Stuart Rutherford and Orianda Ruthven,

Portfolios of the Poor: How the World’s Poor Live on $2 a Day (New Jersey:
Princeton University Press, 2010).
1 The Reserve Bank imposes a ceiling on the interest rate that NBFCs can offer
on the deposits they mobilize, but this ceiling is typically higher than the
maximum interest that banks offer.
2 According to the definition given by Chit Funds Act 1982, ‘chit’ means a
transaction whether called ‘chit’, ‘chit fund’, ‘chitty’, ‘kuri’ or by any other
name by or under which a person enters into an agreement with a specified
number of persons that every one of them shall subscribe a certain sum of
money (or a certain quantity of grain instead) by way of periodical
instalments over a definite period and that each such subscriber shall, in his
turn, as determined by lot or by auction or by tender or in such other manner
as may be specified in the chit agreement, be entitled to the prize amount.
(See more at: http://business.mapsofindia.com/investment-industry/chit-
funds.html#sthash.ONkcMyph.dpuf.) 3 Converted into law with the approval
of the state legislature in December 2010.
4 The Modi government has since established MUDRA (Micro Units

Development and Reform Agency) as an agency to refinance and supervise


microfinance operations.
1 Before the crisis, the Financial Stability Board was known as the Financial
Stability Forum.
1 ‘The Reserve Bank of India: Pulling every lever’, the Economist, 4 February
2012.
THE BEGINNING

Let the conversation begin…


Follow the Penguin Twitter.com@penguinbooks
Keep up-to-date with all our stories YouTube.com/penguinbooks
Pin ‘Penguin Books’ to your Pinterest
Like ‘Penguin Books’ on Facebook.com/penguinbooks
Find out more about the author and
discover more stories like this at Penguin.co.uk
VIKING
Published by the Penguin Group
Penguin Books India Pvt. Ltd, 7th Floor, Infinity Tower C, DLF Cyber City, Gurgaon 122 002, Haryana,
India
Penguin Group (USA) Inc., 375 Hudson Street, New York, New York 10014, USA
Penguin Group (Canada), 90 Eglinton Avenue East, Suite 700, Toronto, Ontario, M4P 2Y3, Canada
Penguin Books Ltd, 80 Strand, London WC2R 0RL, England
Penguin Ireland, 25 St Stephen’s Green, Dublin 2, Ireland (a division of Penguin Books Ltd)
Penguin Group (Australia), 707 Collins Street, Melbourne, Victoria 3008, Australia
Penguin Group (NZ), 67 Apollo Drive, Rosedale, Auckland 0632, New Zealand
Penguin Books (South Africa) (Pty) Ltd, Block D, Rosebank Office Park, 181 Jan Smuts Avenue, Parktown
North, Johannesburg 2193, South Africa
Penguin Books Ltd, Registered Offices: 80 Strand, London WC2R 0RL, England
First published in Viking by Penguin Books India 2016
www.penguinbooksindia.com
Copyright © Duvvuri Subbarao 2016
All photographs courtesy the Reserve Bank of India.
Cover design by Ahlawat Gunjan
All rights reserved
The views and opinions expressed in this book are the author’s own and the facts are as reported by him,
which have been verified to the extent possible, and the publishers are not in any way liable for the same.
ISBN: 978-0-670-08892-8
This digital edition published in 2016.
e-ISBN: 978-9-386-05745-7
This book is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, resold, hired
out, or otherwise circulated without the publisher’s prior consent in any form of binding or cover other than
that in which it is published and without a similar condition including this condition being imposed on the
subsequent purchaser.

Common questions

Powered by AI

The governor’s interactions with international financial institutions played a significant role in providing insights and developing perspectives on global financial conditions during his tenure. Regular involvement in IMF, BIS, and G20 meetings offered platforms for exchanging views and learning about policy responses to global economic challenges. These interactions were particularly valuable during crises, enhancing the Reserve Bank’s ability to effectively navigate complex international financial landscapes and implement responsive monetary policies .

Internal and external challenges significantly influenced the Reserve Bank's policy decisions during the crisis. Internally, the Reserve Bank had to communicate effectively to restore market confidence and provide targeted liquidity support to non-banking financial companies (NBFCs) and mutual funds under redemption pressure, an unconventional move that was crucial to stabilizing the markets . Externally, the global financial integration and the crises in advanced economies necessitated cooperation and careful monitoring of international developments. The Reserve Bank participated in regular briefings from the US Treasury, Federal Reserve, and the European Central Bank to understand global market dynamics and coordinate responses . This coordination was vital given the dual challenges of managing domestic market stability while responding to ripple effects from global economic policies, such as quantitative easing in advanced economies . Furthermore, the Reserve Bank implemented forward guidance to manage expectations effectively and communicated openly to demystify its operations and reassure stakeholders ."}

Global interactions significantly influenced the Reserve Bank of India's response to the financial crisis by demonstrating the impact of global economic conditions on domestic markets and necessitating swift, unconventional actions to restore confidence. The financial crisis of 2008–09 highlighted the interconnectedness of global economies, making it clear that India could not remain insulated from global economic turmoil due to its deep trade and financial integration, which saw external transactions ratio rise to 111% of GDP by 2008–09 . This necessitated India's acknowledgment that globalization poses both opportunities and challenges, influencing the Reserve Bank's crisis management strategies . Additionally, the Reserve Bank adopted bold measures atypical in normal circumstances, such as instituting exclusive lines of credit for NBFCs and mutual funds under redemption pressure, a move aimed at bolstering market confidence during the crisis . The rapid evolution of the situation required the Reserve Bank to adapt quickly, without the luxury of prolonged deliberation typical in non-crisis times, indicating a high degree of responsiveness prompted by global economic shifts . The international coordination through forums like the G20 also influenced the Reserve Bank's approach. The global sense of urgency and coordinated actions, such as those derived from G20 decisions, underscored the necessity for swift, varied response measures, including monetary and liquidity support, to maintain financial stability and market confidence . These interactions and collective global strategies shaped India’s response to manage the crisis effectively.

The relationship between the government and the Reserve Bank of India (RBI) remained complex with the appointment of a new governor. The government frequently exerted pressure on the RBI, such as urging higher payments to the government and expecting the RBI to adopt government-friendly economic forecasts, which often led to tension between the two entities . Despite these pressures, the RBI maintained its stance on issues like fiscal deficit and inflation, emphasizing its role in preserving monetary stability and autonomy . Additionally, suggestions were made to improve accountability by having the governor testify regularly before a parliamentary committee, which could help shield the RBI from political pressures and protect its autonomy . However, certain accountability mechanisms were viewed as insufficient and skewed towards a one-way communication, failing to cover the full range of the RBI's functions beyond inflation targeting .

Criticisms of the Reserve Bank's exchange rate management focused on two main issues: a hands-off approach and lack of credibility in defending the rupee. Critics argued that the Reserve Bank did not build sufficient forex reserves during high capital inflows in 2010 and 2011, which left the country vulnerable during the 2013 currency crisis . The governor's hesitancy in defending the rupee and failure to project confidence further undermined efforts to stabilize the exchange rate . The governor addressed these criticisms by explaining that intervention during stable conditions would have violated the policy of not targeting a specific exchange rate level and could have led to moral hazard, where market participants relied on the Reserve Bank to manage exchange risks . He also admitted that while communication could have been more assertive, the Reserve Bank's actions were intended to manage volatility, not defend a predetermined exchange rate .

The decision to use monetary policy measures for exchange rate defense was seen as one of the toughest by the governor due to its unusual nature and the significant implications for the economy. Raising the marginal standing facility rate by 2% and imposing restrictions on bank access to the repo window were extreme steps designed to curb speculation and send a strong signal about the Reserve Bank's resolve to maintain currency stability . These measures, intended to manage pressures on the rupee, contradict traditional uses of monetary policy, which typically focus on inflation and growth . Furthermore, intervention in the forex market can be complex, involving potential moral hazards and risk of misinterpretation by the market as trying to target a specific exchange rate . The decision was also met with external challenges and varying perspectives within the financial community and government, further complicating its implementation . Thus, it was a finely balanced but necessary decision to address the speculative attack on the rupee in midst of external economic pressures and domestic vulnerabilities ."}

The governor's decision to use monetary policy to defend the exchange rate was driven by the need to curb speculative activities that were exacerbating the pressure on the rupee. With the system liquidity being relatively comfortable, speculation was thriving, especially in the overseas non-deliverable forwards (NDF) market. Tightening domestic liquidity was essential to make it costlier to borrow in rupees for dollar positions, signaling a strong resolve to stem rupee volatility and consistent with inflation management objectives, given that rupee depreciation was inflationary . The Reserve Bank's actions were also influenced by high inflation, the fiscal deficit, and low reserves, which made an exchange rate defense imperative in a fragile economic context, exacerbated by external pressures from the U.S. Fed's tapering announcement . Additionally, this approach aimed to address market expectations and send a clear message about the bank's determination to handle the currency issues despite concerns about growth .

Concerns about the Reserve Bank's autonomy in pursuing inflation-targeting centered around the potential conflict with government priorities. The central bank’s ability to maintain credibility while managing inflation expectations could be undermined if the government set conflicting short-term growth objectives. The draft Indian Financial Code suggested an implicit requirement for the Reserve Bank to balance price stability with government growth targets, potentially compromising its autonomy in strictly adhering to inflation targets .

The Reserve Bank faced several challenges in implementing an inflation-targeting policy, such as dealing with an economy where short-term inflation is driven by supply shocks like food and energy, rather than demand-side pressures. The effectiveness of inflation-targeting was hindered by large fiscal deficits and administered interest rates. The Reserve Bank also struggled with the absence of a single representative inflation index for the economy. Additionally, the policy risked either stifling growth by tightening interest rates or losing credibility if inflation targets were consistently missed .

The shift to an inflation-targeting regime under Governor Rajan was considered a well-advised move because the multiple-indicator, multiple-target approach previously followed was criticized for creating confusion and diluting the Reserve Bank’s accountability. With the development of a composite all-India consumer price index and improvements in policy conditions such as fiscal responsibility and monetary transmission channels, the Reserve Bank was better positioned to adopt inflation-targeting. This approach was expected to provide more consistency and credibility to monetary policy decisions .

You might also like