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What North Block needs: Reform of RBI and Ministry of Finance

The fistfight on the rupee is going badly. Such mistakes in macro and finance policy are increasingly expensive, as India comes into the ranks of emerging economies with an open capital account.

It is important to diagnose the sources of this failure and address them. Key problem areas are the organisation structure and staffing at the Ministry of Finance and RBI.

From 15 May to 16 August, the rupee lost 12.6% and Nifty lost 10.4%: one of the worst three-month periods in 20 years. If decision makers had envisioned how this was going to work out, they are unlikely to have gone down this route.

Things were much easier when India was a developing country, and a mostly closed economy. In those days, there were no business cycle fluctuations: all that mattered was the monsoon.

Closed vs Open

In a closed economy, the complexities of international macro and finance were absent. RBIran a central planning system where the government obtained cheap financing through distortions of the financial system and the inflation tax. In that old world, neither the Ministry of Finance nor RBI needed economics.

In the last 20 years, we have a sea change. Agriculture is now small enough to be irrelevant in macroeconomics. We have business cycles of the kind seen in market economies, rooted in fluctuations of inventory and investment of private firms. Financial markets have become important, and the capital account is mostly open.

Despite these changes, the role, organisation structure and staffing of MoF and RBI have not budged. How are good decisions obtained in public policy? A checklist of policy choices is drawn up. High quality staff work takes place, where the costs and benefits of each alternative are worked out.

A debate takes place, based on this work. The people in this debate have deep roots in understanding how macro and finance works in market economies, and in the gritty details of India. In most cases, tentative thinking goes to the public, for feedback, before decisions are made.

The work process is slow, thorough, and correct. It is absent in India. All too often, we shoot from the hip, without carefully thinking through the alternatives. Decisions are made by very few people, and adequate knowledge is not brought to bear on the decision process.

Stuck in a Rut

In the early 1990s, RBI was evolving towards becoming a modern central bank, towards a floating exchange rate, inflation targeting and an open capital account.

There was a gradual emergence of new thinking and new capabilities. Unfortunately, along the way, many things went wrong, and RBI retreated into the ethos of central planning.

From the early 1990s, the Department of Economic Affairs (DEA) built a institutional culture focused on the fiscal, financial and monetary institution building for a mature market economy. Some of India's best economists participated in building a bureaucratic consensus within DEA.

All finance ministers, and especially P Chidambaram, encouraged this trend. But unfortunately, in recent past, during Pranab Mukherjee's finance ministership, largescale staffing changes disrupted this institutional culture.

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