06 October 2009

Financial crisis and central banking

Marc Faber in an interview recently praised the RBI for being amongst the best central banks in the world - mainly from the point of view of keeping an eye on financial stability:
The RBI has one of the best monetary policies in the world because they supervise the financial sector very closely. They have maintained relatively tight monetary policies and also they pay attention not only to core inflation which is not representative of the cost of living increases and is not representative of inflation in the system but the RBI also pays attention to rising and falling asset prices. So, I have to give them credit for being actually one of the best Central Banks in the world.


That's the view from the investment world, yet the RBI has often been criticised by economists for being ultra-conservative. Shankar Acharya talks of the good performance of the RBI in his article dealing with policy continuity at the RBI


But the conventional wisdom attributes this to an instinctively conservative and cautious approach of the RBI and its leadership, especially then governor Y V Reddy and deputy governor Rakesh Mohan. At best this is a partial truth and, at worst, it’s quite misleading. Let me explain. Reddy and Mohan should certainly get a lot of credit, but for much more than being instinctively conservative.

To begin with, maintaining a cautious stance in the boom years of 2003/4-2007/8 was itself quite a feat in those exuberant times when the financial community, the media and even the government were pressing for rapid progress on conventional, financial liberalisation. 

But the Reddy-Mohan RBI did much more than just preserve key elements of the policy/regulatory framework. Over the boom years, as the perceived scale and risks of global financial excesses mounted inexorably, the RBI evolved a diverse set of heterodox policy responses to deal with the problem. These included:

  • The inclusion of “financial stability” as an explicit objective of monetary policy;
  • Active management of surging and volatile capital inflows through partial “sterilisation” by market stabilisation scheme (MSS) security issues, cash reserve ratio (CRR) hikes and liquidity adjustment facility (LAF) operations, thus retaining substantial, discretionary control over monetary and exchange rate policies;
  • Moderation of bank exposure to asset bubble-prone sectors such as real estate and equity markets through countercyclical provisioning requirements and differentiated risk weights for bank lending to such “sensitive” sectors;
  • Extension of stronger regulation to systemically important non-bank finance companies;
  • Enhanced supervision of financial conglomerates;
  • Bringing bank exposure to non-banks within the prudential framework;
  • Tighter guidelines for securitisation and a sceptical stance towards complex financial products.
After a challenging year of crisis management, Governor Subbarao has explicitly endorsed the key elements of the Reddy-Mohan heterodoxy. It has probably helped that mainstream, international thinking on these issues has been driven much closer to the Reddy-Mohan positions by the global financial crisis. For those, like me, who backed the Reddy-Mohan approaches to monetary and regulatory policies, the continuity shown by Subbarao’s RBI is very heartening. For earlier critics of these approaches there may be some disappointment and discomfort.

So true! For those who are looking for a short roundup of the issues plaguing EMEs today, Subbarao's latest speech on the crisis and EMEs is worth reading. His conclusion:
It needs to be recognized that after a crisis, with the benefit of hindsight, all conservative policies appear justified. But excessive conservatism in order to be prepared to ride out a potential crisis could thwart growth and financial innovation. The question is what price are we willing to pay, in other words, what potential benefits are we willing to give up, in order to prevent a black swan event? Experience shows that managing this challenge, that is to determine how much to tighten and when, is more a question of good judgement rather than analytical skill. This judgement skill is the one that central banks, especially in developing countries such as India, need to hone as they simultaneously pursue the objectives of growth and financial stability.

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