Impact of Demonetization on Central Bank (RBI) Autonomy in India

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Topic: Demonetization Impact on Central Bank Autonomy


Central Bank Autonomy refers to the extent of freedom realised by the central bank in its functioning, independent of executive and legislative control. It implies operational freedom. A central bank is said to be independent or autonomous if it is free from any kind of political pressure or influence in formulation and implementation of monetary policies of a country.

have investigated the relationship between macroeconomic performance and the degree to which central banks are influenced from partisan politics. They Various economists have examined the legal and institutional framework within which central banks in different countries operate, and constructed indexes for the extent to which their central banks are independent known as central bank independence index (CBII). One of the major finding of these economists was that countries with independent central banks did not have higher unemployment, lower real GDP growth, or larger business cycles i.e. more independent central banks ensured lower average inflation and less variable inflation. Hence countries that had an independent central bank(High CBII), such as Germany, Switzerland, and the USA, tended to have low average inflation, while countries that had central banks with less independence(Low CBII), such as New Zealand and Spain, tended to have higher average inflation.

In India, the RBI is a government organisation like any other public sector unit. At present it does not enjoy the power to formulate and conduct an independent monetary policy. This is why control of inflation has become difficult throughout the planning period. The effectiveness of the RBI’s monetary policy is lost due to the present monetary fiscal link and because of an inherent inflation bias due to the short-term time horizon of politicians. Therefore, unless RBI is made an autonomous institution i.e. free from government intervention and control, it will not able to effectively control price and financial stability. The reason being that inflation is a sin, every government denounces it yet every government practices it.

Thus, autonomy in working enables central banks with a long term decision horizon to assert their authority, when facing a government with a short planning horizon.



RBI does not have complete autonomy, rather a relative freedom. The RBI, as the central bank, in India has the following 3 major functions:
i) Formulation of the monetary policy involving decision on money supply, credit supply and credit cost
ii) Management of the government debt
iii) Management and regulation of the banking sector

The RBI Act States that the Central government can give directions to RBI after consulting the Governor in larger public interest. The motive behind this clause is that RBI comprises of only bureaucrats and technocrats and who are not elected by the people and hence cannot be held accountable.

Therefore, in case of inflation targeting the government provides the target and RBI’s work is to achieve it. However, in this process the operational autonomy as to how to achieve that target lies with RBI. In case of loan disbursal from PSB’s government plays a significant role as it owns the bank and RBI is only a regulator, so government’s interference is justified in this case.

Autonomy of RBI as provided by RBI Act is fundamental and needs to be maintained but this does not mean complete separation of government’s control over RBI as in a democracy the government represents the people.

Autonomy is different from Independence. RBI is autonomous but not Independent as RBI board members are not elected and hence are not responsible to the public for their actions. Executives of the Government are the elected and hence are accountable to people.

The question of RBI autonomy has come up many a times in recent years on doubts about government interference in inflation targeting, policy rate decisions, setting up of a public debt management agency and recently on the issue of demonetization.

It is imperative to note here that RBI is not a sovereign institution but a player in the Indian economic management with the government and its fiscal policy.


The political dispensations always tend to have short-term, pro-growth view of the economy rather than long-term financial stability. Also, the governments are prone to use the banking system to push their populist objectives in order to appease the vote bank, even though the action may not be in the good interest of the banking system (examples are loan waivers and calls to restructure loans).

This is perhaps the reason why a clutch of former RBI officials, including Reddy, Manmohan Singh, Bimal Jalan have pitched for the independence in the operations of central bank.

Demonetization Impact on Central Bank Autonomy

On 8 November 2016, the Government of India announced the demonetisation of all ₹500 and ₹1,000 banknotes of the Mahatma Gandhi Series on the recommendation of the Reserve Bank of India (RBI). The government claimed that the action would curtail the shadow economy and crack down on the use of illicit and counterfeit cash to fund illegal activity and terrorism.

Overnight, Rs 15.44 lakh crore or 86 per cent of the currency in circulation was declared illegal. Norms were announced by the Prime Minister on how people could deal with such currency in their possession which was subsequently changed on an almost daily basis.

The government advised RBI to take the call on demonetization and the RBI board obliged the government without losing time. Is this something unprecedented? Does this violate the norms laid down by the RBI Act?

Two sections of the RBI Act deal with this –

Section 26(2) of the Reserve Bank of India Act, 1934 says that on recommendation of the RBI’s central board, the government may, by notification in the Gazette of India, declare that with effect from a date specified in the notification, any series of bank notes of any denomination shall cease to be legal tender.

So, there is nothing illegal about the RBI board recommending withdrawal of Rs1,000 and Rs500 notes from the system.

And, Section 7 of the Act says “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”.

So, the government’s advice to the RBI on demonetization is in sync with the Act

Demonetization Impact on Central Bank Autonomy

under Section 7 of the Act, the government can “direct” the central bank. However, it could have fought against it—in private as well as in public—as the appearance of autonomy is as important as actual autonomy itself.

This has happened in the past, the former governor Y.V. Reddy fought hard against the government’s plan to create sovereign wealth funds and use of foreign exchange reserves for infrastructure development. The finance ministry went to the extent of reaching out to the board of the central bank, seeking help to convince Reddy but he did not budge an inch from his stance. In the end the governor made the finance ministry accept that RBI should have the last word on foreign investment in a holding company of a large private bank.


CLAIMS OF THREAT TO RBI AUTONOMY – Demonetization Impact on Central Bank Autonomy

  • It is well known that the government always put pressure on the RBI to push interest rates down to support growth, leading to open conflicts.
  • The manner in which the former RBI governor Raghuram Rajan took exit and Urjit Patel took ascension to/from the post of RBI governor in September and the subsequent demonetisation announcement by Prime Minister Narendra Modi in November, gives clue of rapid deterioration in the central bank’s independence in discharging its functions and government interferences.
  • The process of cutting the RBI’s wings began way back during the UPA days, when the Financial Sector Legislative Reforms Committee (FSLRC) had recommended taking away the debt management from the central bank to a separate entity, public debt management agency (PDMA) and creating a super regulator and shifting the power to set interest rates from the governor to a monetary policy committee (MPC). While both the proposals — creation of PDMA and MPC — have been welcomed largely to improve the existing framework and avoid conflict of interest, the plan to create a super regulator has been discarded outright.
  • The Demonetization Impact on Central Bank Autonomy further weakening the central bank continued during the NDA regime, when the government failed to fill the posts of a number of non-official directors on the board of the RBI (read here) at a time when the central bank was engaged in a credibility fight struggling to manage the massive demonetisation exercise in Asia’s third largest economy.
  • Former RBI deputy governor, K C Chakrabarty, said that the central bank, in the past, was not keen for demonetisation. “In the past, RBI has been uncomfortable with it, as rough estimates suggest only 6 percent to 8 percent of black money is in cash. And it does not make sense to hurt 90 percent people, especially the poor and underprivileged, for such a small percentage of black money,”
  • In a Report Mint stated that ‘RBI has been one of the least independent central banks in the world.’
  • Former FM P Chidambaram said that ‘‘the power offered by Section 7 has never been exercised in the 83 years of the RBI Act and a weakened central bank wouldn’t do any good for any aspiring economy like India, which is somewhat the situation at this stage’’.
  • While the RBI has not made public the deliberations of the November 8 board meeting, former Finance P. Chidambaram had questioned the sequence of events, suggesting that the short time intervals between the RBI board decision, the Union Cabinet’s meeting and the Prime Minister’s announcement seemed to indicate that the move was well orchestrated. Mr. Chidambaram is reported to have demanded that the central bank ought to share the minutes of the board meeting and let the public know that who were the directors? And who attended it?
  • Rating agencies like Standard & Poor’s have issued caution on a growing trust deficit in India when RBI’s autonomy is curbed and the global investors and economy watchers are looking at the country with an element of scepticism.
  • Deputy Governor K.C. Chakrabarty says ‘‘it is unclear in this whole exercise is how much say the country’s central bank had in the policy decision. RBI’s position has always been against demonetisation. That was the consistent view of the Reserve Bank in the past.’’
  • The RBI should have advised the government on the ground reality about withdrawing 86 per cent of the currency notes in circulation and the logistical issues. Note ban has hurt confidence in the central bank.
  • RBI insiders and some central bank watchers believe that RBI’s autonomy and its authority are indeed under siege, and that this dilution of powers preceded demonetization. The authority was being challenged due to attempts to create a separate debt management agency and an independent payments regulator. The autonomy is being challenged by the inflation targeting framework.
  • RBI governor Urjit Patel has been under the scanner as speculations are rife that he is just following orders and have no stand on his own. Former Governors like Dr. Manmohan Singh and Raghuram Rajan, were known to take their stand on which policies they believed in and took their own decisions.
  • Interestingly, the world order is no different. In many countries all over the world, one can witness a trend, in which there is a tussle between the government and central bank, and where the latter is becoming weaker by the day. After the 2008 economic recession, there has been an increasing trend in bad blood between governments and central banks.


ARGUMENTS AGAINST THE CLAIM – Demonetization Impact on Central Bank Autonomy

  • Ajay Shah, a professor at the National Institute of Public Finance and Policy, pointed out that Section 7 of the RBI Act empowers the government to give directions to the central bank governor in matters of public interest. According to Shah, the only areas where there is a need to keep the government out are when the regulator is issuing a licence, investigating someone or setting policy rates.
  • In a reply to Bloomberg, on a right-to-information query, the apex bank said that the decision to withdraw the legal tender character of the Rs 1,000 and Rs 500 notes was taken by the RBI board at 5.30 p.m. on November 8 less than three hours before Modi announced it to the country.
  • It is illogical to think that an institution like RBI, whose head is appointed by the elected government, not Parliament or by the people, can act completely independent of the ruling political dispensation.
  • Following the Centre’s decision to implement the recommendations of the committee headed by Dr. Patel, the RBI for the first time in its history, switched to a rule-based approach to monetary policy formulation with an explicit target set for inflation. A Monetary Policy Committee (MPC) has been setup and has started functioning with three representatives each from the government and the RBI, and the veto power with the Governor.
  • “Introduction of inflation targeting framework and a MPC-based approach, have increased the accountability and transparency of monetary policy making,” said Rupa Rege Nitsure, group chief economist, L&T Finance Holdings, who was a member of the Patel committee. ‘‘It ensures balanced representation of various sections of society and is hence more democratic in essence. The publication of the minutes informs general public about the actual thought processes supporting the decision. This helps create a good feedback mechanism.”
  • Finance Ministry said in a statement said that “The Government fully respects the independence and autonomy of the Reserve Bank of India.” And that “Consultations mandated by law or as evolved by practice should not be taken as infringement of autonomy of RBI.”
  • The government’s demonetization move has led to widespread adoption of online payment and is expected to have a positive long term impact on the economy, the report titled ‘India: Transforming through radical reforms’ by Assocham and EY observed that improved governance, favourable conditions to conduct business, transparency in government procedures and responsive policy making with an immediate focus on effective implementation of reforms will continue to evolve India into a preferred destination for foreign investment.



In the wake of recent Demonetization Impact on Central Bank Autonomy, the autonomy of the RBI is in question. RBI has 2 main roles in which it acts as an autonomous body free from the interference of the government –

  • On conducting the monetary policy in accordance with the inflation targets set by the Finance ministry.
  • Regulating the banking system, in which the government has a separate role as the owner of the public banks.

Due to the Demonetization Impact on Central Bank Autonomy, the autonomy is being questioned because it is being claimed that the government had advised the RBI to endorse the demonetisation and that it was not the other way round. Government directing the RBI on such matters and RBI acting accordingly without protest is being seen as an infringement on its autonomy, but the autonomy has not been affected as according to the RBI Act, the central government can issue directions to the bank after consultations with the RBI governor which it considers necessary in the public interest. This clause ensures that all major decisions are made by the government as they have been elected and hence are accountable to the people. The RBI board simply performed its duty by implementing the decision.

Government while demonetising the currency notes was acting within the norms of the law and did not assault the autonomy of the central bank. Increased coordination and cooperation between the two bodies would reinforce RBI’s autonomy in setting interest rates, regulation of banks or in other operational spheres.

The decision of the government to set up a debt management agency is motivated by the conflict of interest for RBI as a debt manager and policy rate decider. Further, it is the duty of and elected responsible government to decide the target for inflation and growth.

All this said, what RBI should be allowed is complete operational autonomy to set the monetary policy in achieving the targets set as it deems fit. Further, the government should not at all interfere in the management and regulation of the banking sector as it has vested interests on account of being the owner of all public sector banks.

The RBI and the Government are the two tyres of the Indian economic bicycle. Both must perform in order to move forward. The recent doubts appear more motivated by political interests rather than a genuine concern for RBI autonomy.






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