The Ministry of Finance in India recently released the Indian Financial Code (IFC) to streamline the prevailing financial regulatory structure which is full of overlapping laws and conflicting financial rules. Part of the chaotic architecture resulted from a rush to implement rules to accommodate the opening of the financial markets in the mid-1990s. The new code will consolidate the existing entities into the following seven agencies, as shown below. The overall structure is similar to that of the United States, some of which were mandated by the Dodd-Frank bill.

The revised proposal is open to comments till August 8, 2015. Most economists in India have expressed dismay over a missing feature, the veto power of the central bank governor. The news has created a stir in the Indian financial markets because the message from the government appears to be mixed; it is embarking on a policy of encouraging private investment but at the same time unwilling to stay away from dictating monetary policy.

For a better perspective on the financial code, a brief history is required. The proposal was initiated by the Ministry of Finance under the previous administration in March 2011. An independent commission, titled Financial Sector Legislative Reform Commission (FSLRC), was appointed to recommend a complete new framework to oversee the financial services sector. The commission undertook a thorough review process before issuing its final report in March 2013. Most of the recommendations were incorporated in a preliminary financial code but when the government changed hands in 2014, the old code was discarded and a revised financial code was submitted.

The independent commission had recommended that the monetary policy committee be made of seven members, of which four would be chosen by the government. The central bank governor would retain the power to override a majority vote under special circumstances. Specifically, it stated:

The central bank Chairperson would have the power to override the mpc (monetary policy committee) in exceptional circumstances. However, he/she would be required to release a rationale statement in public, explaining the reasons for disagreeing with the mpc.

This clause ensured that the RBI remains independent and not be subject to pressures from the legislative branch. In the revised proposal issued last week, this section was removed. It is a major revision and suggests an attempt to weaken the independence of the central bank. It goes against the pillar of modern corporate governance that central bank independence is essential in a free-market democracy.

From a historical perspective, central bank autonomy is a recent phenomenon – post World War II. Three countries, U.S., Germany and Switzerland, held the reputation of having the most independent central banks from 1950-1990. In the case of the U.S., even though the Fed became officially independent in 1933  when the Roosevelt administration removed the Secretary of the Treasury and the Comptroller of the Currency from the Board of Governors, its independence was institutionalized only by two later events, the Treasury-Fed Accord of 1951 and Paul Volcker’s actions in 1979 to target bank reserves. Both actions gave freedom to the Fed to increase interest rates even if resulted in deflation, as they did in 1980.

Other countries joined the bandwagon in the 1990s when financial markets were being liberalized globally. They include the Bank of New Zealand in 1989, and the Bank of Japan and Bank of England (BOE) in 1998. BOE’s autonomy is different from the others in that it is “operationally independent.” The inflation target rates are set by the Chancellor of the Exchequer while the BOE decides the appropriate actions to implement them.

The same “operational independence” model was adopted by the Reserve Bank of India last year. The current governor of RBI, Raghuram Rajan, a former University of Chicago professor and chief economist of the IMF, signed an agreement with the current government in February 2014 to reduce the inflation rate to 6% by 2016. The target rate thereafter was set at 4% with a band of +/- 2%. Similar to the Bank of England, the RBI will decide on the operational means to achieve the target rate. The agreement was considered an acceptance by the new government of central bank autonomy on monetary policy.

The about-face barely a year later is puzzling and raises questions on the motives of the government. Inflation rates have historically been unpredictable in India. Maintaining a 4% target may require the RBI to occasionally make large changes to interest rates. Future governments, especially during election years, may be tempted to ask its four appointed members to decrease rather than increase interest rates in an inflationary environment.

Criticism of this action presupposes that central bank independence is a condition for maintaining stable inflation rates. Academic research has generally supported the negative relationship between central bank independence and inflation rates. A recent paper by Dincer and Eichengreen (2015) find both transparency and central bank independence (CBI) have increased during the 1998-2000 period for over 100 countries. They also find lower inflation rates for countries with stronger CBI. The results of some other studies are a little more nuanced. Alpana and Honig (2013) find that central bank independence is not a prerequisite for low inflation. Rather, in their study of 66 countries during 1980-2006, they find countries that targeted inflation and reduced budgets fared better in managing inflation. Canova (2011) is a little more skeptical and cites many examples of low inflation even when central banks were not independent, including the U.S. in 1941-51, Latin America in the 1960s, and Japan in the 1990s.  On balance, however, the results provide strong support that countries with central bank independence have lower inflation rates.

Given the preponderance of evidence, we hope that the Indian government recognizes the risks of not having an independent central bank and restore the commission’s original recommendations. With net portfolio equity investments to India declining in the last two years, from $22.8 billion in 2012 to $12.3 billion in 2014, the government should consider the impact of its actions on investor confidence and geopolitical uncertainty.