Urjit R Patel: Financial system and the macroeconomy
Opening remarks by Dr Urjit R Patel, Governor of the Reserve Bank of India, at the Centre for
Advanced Financial Research and Learning (CAFRAL) Conference on "Financial System and the
Macroeconomy", Mumbai, 7 December 2017.
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1. It gives me great pleasure to be here this morning to share some observations and thoughts.
The theme of this international conference: "Financial System and the Macroeconomy", and the
papers that are slated for presentation touch upon a number of issues that the Reserve Bank
has been grappling with. (Needless to say, some of the conference participants who follow the
Indian economy closely would already be aware of what I am about to briefly enunciate, but
others may not, and these remarks would, I hope, be helpful to them.)
2. For us in India, an eventful 2017 is drawing to a close with important transformations in place,
viz., a new monetary policy framework with decision making by a Monetary Policy Committee
(MPC); demonetisation of high value currency notes; introduction of a goods and services tax
(GST) regime; the Insolvency and Bankruptcy Code (IBC); promulgation of the Banking
Regulation (Amendment) Act and a recapitalisation plan for government-owned banks. As these
key changes mould India's financial sector landscape, let me take this opportunity to briefly
explain how they will shape the outlook.
3. Entrenching macroeconomic stability: Two significant developments have taken place in
the recent period. First, the primary objective of monetary policy in India has been defined
explicitly "to maintain price stability while keeping in mind the objective of growth". Second, an
MPC has been constituted with the task of setting the benchmark policy rate in pursuit of this
goal defined in the amended RBI Act (2016). The new monetary policy framework has been
playing an important role in shaping inflation expectations and outcomes. With some disinflation
underway, inflation expectations are, perhaps, getting re-anchored, indicative, in part, of the
credibility earned by the new framework; but these are early days, and hence considerable
caution and vigilance is warranted on the inflation front. Recent success in containing inflationary
pressures needs to be viewed in the broader context of entrenching macroeconomic stability in
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which the Government has played a crucial part.
4. Alongside, the current account deficit remains within sustainable levels, other indicators of
external viability such as the ratios of indebtedness to GDP and/or reserves are also reflecting a
healthy improvement. The Government has pursued the path of fiscal consolidation and the ratio
of public debt to GDP is gradually declining. International investors have warmed to where the
Indian economy is currently positioned and this is reflected in sizeable foreign investment inflows.
Meanwhile, domestic financial markets have shown resilience and stability in spite of escalation
of global geo-political uncertainty and heightened volatility in financial markets. These
developments have enabled the build-up of "buffers" against unforeseen shocks.
5. Taming the non-performing assets problem: A landmark development relating to resolution
of stressed assets is the Insolvency and Bankruptcy Code (IBC) 2016. From the Reserve Bank's
point of view, a great enabler in this context has been the Banking Regulation (Amendment)
Ordinance promulgated in May and subsequently enacted in August this year. By the authority it
conferred on the Reserve Bank to issue directions to banks to initiate resolution processes, it
scales up the ability of the Reserve Bank to deal decisively with stress in banks' balance sheets
and unclog the flow of credit to grease the wheels of growth. In the year ahead, we must seize
this opportunity to overcome the debilitating problem of corporate loan delinquency and get our
banks back into the mainstream of financial intermediation. The recently chalked out
recapitalisation plan of the Government for public sector banks will ensure that flows to
productive sectors (and credit-worthy borrowers) are not impeded and growth impulses are
nurtured. The Government has also proposed to take steps to improve the corporate governance
of PSBs by strengthening boards, bringing objectivity into management appointments, and
decentralising decisions to the professional board.
6. The risk-based supervisory process of the Reserve Bank keeps flagging the risks in the
balance sheet of banks which are taken up with the institutions concerned for remedy.
Previously, effective enforcement action on the specific violations/breaches has been a gap in
implementation. The new Enforcement Department was established in April this year for this
function; viz., concentrate on its mandate to develop a rule based, consistent framework to deal
with breaches of law, rules and directions. Effective deterrence enforced through such actions is
expected to contribute to strengthening the credit culture overall.
7. The Indian economy is at an important juncture. Our recent growth numbers may have
disappointed some in the first quarter of this fiscal year, but the second quarter has recorded an
uptick and the slowdown may well be bottoming out. If one sees far, structural changes that
come with temporary disruptions can be growth and efficiency-augmenting in the medium to long
term. This is what has happened, for instance, with the introduction of the GST. It should yield
gains that will mean better tax compliance and a more efficient tax system that in turn will impart
a permanent upward push to our growth. To add one more important reform to the list, there has
been substantial liberalisation of Foreign Direct Investment (FDI) policy, embraced by FDI
investors with record inflows to India.
8. Let us now turn outward and situate the Indian economy in an international backdrop. Today
we are living in a world of ever increasing financial globalisation. The absolute size of capital
flows today is large and, worryingly for policymakers, also volatile. Globalisation has brought
about a rapid integration of markets across boundaries with swift and massive movements of
capital in search of returns (so called "alphas" and "betas" depending on the current fad!). In its
train have accrued tremendous gains in terms of global growth, trade and welfare, but it has also
amplified risks, and in particular, the vulnerability to financial crises of overwhelming magnitude
and speed. This begs the question: are we in an environment of excessive financialisation? Let
us reflect on a few numbers. Total global external liabilities have grown from 30 per cent to 190
per cent of global GDP between 1980 and 2015, far outpacing the growth in global trade (from 19
per cent to 28 per cent of GDP over the same period). The main vehicle of this new globalisation
has been cross-border banking flows, which constituted a third of global capital flows in the
decade prior to the financial crisis. In parallel, the global trade network has become increasingly
interconnected through supply chains that transcend national borders, and by the advent of new
players, especially from the developing world. Emerging market and developing countries taken
together contribute 37 per cent of global trade (up by about 15 percentage points since 2000).
India's cross border gross financial flows (both inflows and outflows) have also increased: to 47
per cent of GDP by 2016-17 from 12 per cent of GDP in 1990-91. Along with stable form of
capital flows such as FDI that come with relatively long-lasting interest in domestic entities,
foreign portfolio (both equity and debt) capital flows have also increased making the economy
(like that of other open emerging markets) susceptible to enhanced volatility and sudden stop
or reversal risks.
9. Therefore, as India - like other emerging markets - has undoubtedly benefited from
globalisation, we are also more exposed than before to vulnerabilities that come in its wake. Our
increasing dependence on the external world is reflected in outstanding external liabilities (both
debt and non-debt), which increased from about 30 per cent of GDP in March 2005 to 41 per
cent of GDP in March 2017. India's net international investment position (i.e., outstanding assets
minus liabilities) has moved over the period from about -7 per cent of GDP to -17 per cent of
GDP. This is consistent with a prolonged phase of running current account deficits which have
been financed by increasing net liabilities to the rest of the world. With easing of limits over the
years, there has been a rise in foreign portfolio capital flows. (Of course, this has to be
appreciated in the context of the obvious economic benefits from international financial flows into
capital scarce countries).
10. Movement of capital in and out of the country is often linked to policy cycles in other countries
which throw up the challenges of international policy spillovers. With every new tail event, the
churn becomes larger, the volatility ever higher, threatening to overwhelm the modest defences
that emerging markets are able to muster. How does one protect policy independence in such a
world? Do we need meaningful and deeper international policy coordination? Or, universal
financial safety nets rather than the asymmetric ones available at present only to a small
number of countries, which is more reminiscent of apartheid rather than universality.
Meanwhile, emerging markets that are at the receiving end of global financial turbulence, are
systematically denied access to such risk sharing. The time has come to end this sectarian
approach and to make the access to swap lines equally available rather than only for the
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privileged. While emerging markets have shown a degree of resilience to the turmoil of recent
years, they remain vulnerable to liquidity and bridge financing gaps that are debilitating even if
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transitory. Against this background, building up adequate buffers in the form of foreign exchange
reserves is a natural self-insurance to manage these risks better and thereby prevent the risks
from assuming systemic proportions, threatening financial stability. In the absence of a broader
swap network, the macroeconomic environment of each country will inform the choice of policy
instruments. In such a milieu, international financial stability is endangered when the inadequacy
of buffers precipitates a crisis in one country and assumes global proportions. Likewise, there
cannot be any common code or uniform approach to capital account liberalisation. Nimble capital
flows management needs to be intellectually mainstreamed (as also in practice) as
a conventional matter-of-fact component of the macro-prudential toolkit. Indeed, any attempts to
discourage the use of foreign exchange reserves as a macro-prudential tool would necessitate
that capital flows have to be managed more actively. Conference deliberations today and
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tomorrow could, perhaps, help shape the dialogue in this regard.
11. The conference may explore: How effective are such policies? Should we think of them as
short-term interventions or long-term policies?
12. Financial stability is also endangered by asset bubbles. Yield chasing investors - both
domestic and foreign - can catalyse (contribute to) frothiness in asset markets. How much
attention should central bankers be paying to such froth in asset markets in deciding monetary
policy?
13. The link between asset markets and the real economy is another area of continuing interest
for central banks. While the issue probably came to the fore during the global financial crisis, the
mechanisms and channels which link them qualitatively and quantitatively are of fundamental
importance for monetary policy.
14. A related source of concern for policymakers is about managing inflation. There is growing
global uncertainty regarding the determining factors of inflation, especially in advanced
economies. Do we need to rethink the monetary transmission mechanism itself or is the recent
weakening of the traditional link between policy and inflation just a temporary phenomenon?
15. A number of the papers in this conference will address some of these subjects. I look forward
to fruitful discussions which will not just push the debate forward on these issues but, hopefully,
also provide some enlightening policy insights.
16. Thank you.
follow policy that is sub-optimal from a global welfare perspective; in other words, is moral hazard perhaps
exacerbated?
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Real economy implications on account of Hysteresis can be deep and durable.
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There needs to be considerable rethinking around the practice of "naming and shaming" countries with terms
such as "currency manipulator", especially since the economic logic behind this is doubtful.