NEW DELHI (Reuters) - The Reserve Bank of India (RBI) last week raised interest rates for the 12th time in 18 months and signalled it is not yet done with rate tightening as it struggles to control inflation that has run up a 13-month high.
Hours after the announcement, Kaushik Basu, the finance minister's chief economic advisor, said he had expressed reservations about a rate increase, suggesting there is pressure against further tightening from the government.
Meanwhile, India's headline inflation, at nearly 10 percent in August, remains way above the RBI comfort zone, and even Basu admitted that the country was facing a difficult inflationary situation.
So, the question is: How independent is the central bank?
WHAT DOES THE LAW SAY?
The RBI is not constitutionally independent, as the 1934 act governing its operation gives the government power to direct it. The government appoints the central bank governor and four deputies.
"The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest," the act says.
Technically, the government is also permitted by the act to supersede the central bank if it believes the RBI has failed to carry out its obligations.
HOW DOES IT WORK IN REALITY?
Over the last quarter century as India's economy was liberalised, the RBI has been more independent. However, there continues to be much consultation between the bank and the finance ministry, and the government has been known to exert its will, against the wishes of the central bank chief.
There is no legal act mandating autonomy of the RBI, but there is a growing convention that the RBI is allowed autonomy to do what it wants, analysts say.
Consultations between the central bank and the finance ministry are not unusual in India.
IS "CONSULT" JUST A POLITE WORD FOR "GOVERNMENT ORDER"?
Not necessarily. The RBI and government have clashed over monetary policy in the past, notably during the tenure of the previous governor, Y.V. Reddy, and then-Finance Minister Palaniappan Chidambaram.
In 2007, global interest rates were softening but the central bank under Reddy maintained a hawkish stance, citing inflationary risks stemming from high oil prices. The government favoured lower interest rates to help sustain high growth and bring relief to borrowers.
The RBI's view prevailed and it hiked policy rates. In June of the following year, however, Reddy was prodded by the finance ministry to raise rates against his wishes, he revealed in an interview after he left office.
More recently, government officials alarmed over slowing economic growth were advocating a pause in the central bank's 18 month long monetary tightening cycle.
However, the RBI persisted with a larger-than-expected rate hike in July, followed by another increase at its September policy review and said it was too soon to ease back from its anti-inflationary bias.
But the finance ministry and the RBI generally try and find common ground on issues concerning monetary policy.
SO WHAT GOVERNS THE RBI'S INDEPENDENCE?
Personalities to a very large extent. Reddy, for example, was seen as fiercely independent.
Mild mannered Subbarao is seen more open to consultations with the finance ministry, although he has demonstrated independence with criticism of the government's inability to rein in fiscal deficit.
He also aired his reservations over setting up a council headed by the finance minister to reconcile differences between regulators.
WHAT OTHER INFLUENCE CAN THE GOVERNMENT HAVE?
Appointments. The government appointed Subbarao, who was the top bureaucrat in the finance ministry, as central bank governor, bypassing Reddy's deputy Rakesh Mohan, who had been seen as a strong candidate.
This was a rare instance where the top bureaucrat in the finance ministry was appointed to the top job at the Indian central bank immediately after serving out his stint as finance secretary.
The government can also issue directives on non-monetary policy matters such as foreign investment rules in the banks.
WHO SHOULD INVESTORS BE WATCHING FOR POLICY CLUES?
Both the government and the central bank. Top officials, including Finance Minister Pranab Mukherjee and his chief economic adviser Kaushik Basu, and Planning Commission Deputy Chairman Montek Singh Ahluwalia speak frequently on matters of monetary policy, and their views are considered influential in policy decisions.
But it is the governor who has the final say. He decides the timing, means, and degree of policy moves.
Subbarao opted for a 50 basis points rate hike in July when the majority of the technical advisory panel members favoured a pause in monetary tightening or at the most a 25 basis points rise in rates.
Last week, he went ahead with the rate hike cycle even after Mukherjee's adviser Basu had suggested a pause.
(Editing by Ramya Venugopal)
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