Our flawed inheritance
The Chamberlain Commission (1914) and the Hilton-Young Commission (1926) led to the drafting of the RBI Act. This was introduced in January 1927 and enacted in March 1934. The RBI Act does not state what the objective of RBI is. The authors of this Act were quite honest about what they were doing:
PREAMBLEFrom 1934 onwards, this `temporary provision' has been India's central bank. In the years of Indian socialism, this flawed beginning ossified into a full central planning system governing finance. Every detail of products and processes in finance is micro-managed. Alongside this, India got high and volatile inflation:
An Act to constitute a Reserve Bank of India. Whereas it is expedient to constitute a Reserve Bank for India to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in [India] and generally to operate the currency any credit system of the country to its advantage;
And whereas in the present disorganisation of the monetary systems of the world it is not possible to determine what will be suitable as a permanent basis for the Indian monetary system;
But whereas it is expedient to make temporary provision on the basis of the existing monetary system, and to leave the question of the monetary standard best suited to India to be considered when the international monetary position has be come sufficiently clear and stable to make it possible to frame permanent measures.
Fiat money made by RBI failed on the prime test: low and stable inflation.
It is easy to criticise RBI. It's like going into a time machine and making fun of what folks did not know in 1934. This is not a criticism of the individuals at RBI today. The problem lies right in the institutional DNA. What we have is not a central bank; it is a central planning agency for finance, with an improbable and conflicted set of objectives. Accountability mechanisms are absent. Good governance principles, and the rule of law, are missing. Even in the hands of good individuals, RBI has lurched from one mistake to another.
Figuring out the solution
I first saw the beginnings of clarifying what RBI was about at RBI. C. Rangarajan and S. S. Tarapore essentially understood that what made sense was a focused inflation targeting RBI + an open capital account. In the 1990s, open economy macroeconomics was not as well understood, and they did not quite get the fact that this inevitably meant a floating exchange rate. But they had intellectual leadership on the idea that low and stable inflation is the dharma of a central bank.
Similarly, in the late 1990s, intellectual leadership on reforming debt management arrangements came from RBI. By the early 2000s, RBI was saying that there is a conflict of interest between the objective of debt management (i.e. to borrow for the government at low rates of interest) and the objective of monetary policy (i.e. to deliver low and stable prices). To do a good job as debt manager would generate interest rates that are too low, and give an inflationary bias. The solution was for the government to find its own debt management arrangements, and unburden RBI of this conflict of interest.
While RBI fought inflation in the 1990s, this ethos did not turn into legal instruments, organisational reform, and lasting institutional change. By the early 2000s, RBI was back into hankering for exchange rate pegging and more capital account restrictions. On debt management, RBI's position shifted to defending turf. Intellectual leadership on RBI reform shifted outside RBI.
By the early 2000s, as the difficulties of exchange rate pegging became visible. RBI's pursuit of exchange rate objectives repeatedly led to the wrong decisions on monetary policy, and gave RBI a bias in favour of preventing the emergence of a capable financial system. When the Agent is given multiple objectives, he is accountable for none. The heart of the problem lay in putting an end to the temporary arrangement: in establishing a clear objective, removing conflicts of interest, and setting up accountability mechanisms.
The earliest sources that I am able to find on the Internet are a newspaper column by Ila Patnaik on 21 August 2006, Inflation targeting: Much ado about something by Deena Khatkhate in the EPW, December 9-15, 2006, and the Percy Mistry report (2007). By 2007, serious people in Indian macro/finance knew where India needed to go: Inflation target + Open capital account + Floating exchange rate. All the other expert committee reports supported this.
The long run answer
The Indian Financial Code, drafted by Justice Srikrishna's commission, is the full, coherent, internally consistent replacement for the menagerie of Indian financial laws. Once this is enacted, the RBI will have clarity of purpose, and will have sound governance. That is for some unstated date in the future. Does this mean that nothing can be done in the short run?
Some progress in the short run
In 1997, the Finance Secretary, Montek Ahluwalia, and the RBI Governor, C. Rangarajan, signed a `Ways and Means Agreement', which put an end to money creation for deficit financing. This was not in the law, but it was a step forward. The agreement, by and large, delivered.
In July 2014, the Budget speech announced that a monetary policy framework would be put into place. Ordinarily, one would think this is a combination of an inflation target and the machinery of an MPC.
Today, MOF has released a Monetary Policy Framework Agreement signed by RBI & MOF.
It establishes an inflation target. That is a good thing.
Oddly enough, there is no Monetary Policy Committee (MPC). The interest rate is decided by one person: the RBI Governor. This will lead to many infirmities. But this is progress, for the period until the IFC is enacted.
Like many of the other things in this year's budget speech, this is halfway there. Ideally, it should have been an inflation target + a properly constructed MPC. There is an odd loss of nerve.