India at 75: The economic institutions have tended to over-regulate

For India's economic regulators, acquiring a better understanding of markets and acting accordingly will be the challenge for the next 25 years

This is the fifth in a six-part series in the run-up to the 75th Independence Day on August 15, 2022. It explores how institutions—Constitution, Legislature, Executive, Judiciary, Economic—have worked since independence.

Part 1 Part 2 Part 3 Part 4 

India's institutions can be divided into three categories - constitutional, statutory and, shall we say, whimsical, like the Planning Commission, now called NITI Aayog. The first lot, the constitutional ones, like Parliament, judiciary, election commission, comptroller and auditor general, and finance commission, to name a few, have generally performed well because the Constitution has guaranteed their independence. 

But the ones that the Constitution hasn’t created are servants of the sovereign, which the government represents. As a former governor of the RBI said, they are independent within the parameters set by the government. This is mainly because an old and persisting problem is that even when regulatory institutions are set up by Acts of Parliament, their heads are appointed by the government. This is not an Indian problem alone, but it creates a dilemma of primary loyalties and obligations. In India, this tendency is particularly pronounced.

Regulatory institutions in India present another problem: they are very new and also very old. The new ones are Sebi, Trai, Irdai etc. But the old ones, or one -because there is just one- is the RBI. It was created in 1935, which makes it 82 years old. The oldest amongst the rest, Sebi, is just 34 years old.

By and large, despite the criticism in the poorly informed media and by those economists who have never had to manage anything, these institutions have performed reasonably well. Their mandate is to keep the markets orderly and ensure fair treatment of customers. In this, they have mostly succeeded.

But it’s also fair to say that except for the RBI, the rest are still too new to arrive at definitive judgements about how well or poorly they have done. On the other hand, the RBI is quite long in the tooth and is, therefore, a better candidate for an assessment. 

In a nutshell, it’s done well in monetary policy and very badly in banking, not least because so many banks are owned by the government, which also owns the RBI. In fairness, though, it must be said that regulating banking isn’t the job of central banks. Their primary responsibility is monetary policy. 

The independence of a regulatory institution depends -to a large extent- on how the head views these. So far, all heads have generally regarded the government’s needs as paramount. But they have differed quite substantially in the degree. More often than not, the regulatory agencies have favoured governments in the ceaseless struggle between markets and governments. The left-wing philosophy permeates their actions.

Some of these institutions have also been subject to regulatory capture, which has led to some special interests being prioritised over the larger public interest. In India, the government has captured all regulatory institutions over the last 75 years on the grounds that it is the best judge of the public or national interest. But that’s open to question, and the matter has not been debated properly.

The worst consequence of such capture by the government is the way the RBI conducts monetary policy. It allows the government to borrow at very low rates, which means the price of money for others goes up. But it must also be said that since 1998 the two rates have come closer. That was when a sort of limit was placed on government borrowing that resulted in the printing of notes to pay off the loan.

If the RBI’s mandate is macro, Sebi’s is micro. That’s why it is often charged with seeking to micro-manage the functioning of market players. It’s also accused of hugely increasing compliance costs of market participants like brokers and mutual funds. But Sebi has to maintain a balance between protecting investor interests and developing the market. So investor protection remains a priority. The same is true of Irdai, too.

The manner in which the economic regulators function had also led to a debate on the merits of regulation by principle rather than rules. The former aimed to reduce the number of regulations and judge outcomes by whether or not the right principles were followed. This was given up by its most ardent adherents, the Financial Services Authority of the UK, after the crash of 2008. 

One of the strongest underpinnings of the argument to lower market regulations was that markets are efficient and rational. However, as the highly influential Adair Turner review pointed out, market efficiency does not imply market rationality. The review said that, even if an individual is rational, a collection of individuals was not. Hence the need for a strong regulator. 

India’s economic regulators have supported this wholeheartedly. But they have tended to over-regulate in the absence of proper knowledge of market practices. Acquiring a better understanding of markets and acting accordingly will be their challenge for the next 25 years.