Duvvuri Subbarao: "Central banks must distill lessons from the global
crisis and make concrete reforms" - interview in Finance & Development
Interview with Mr Duvvuri Subbarao, Governor of the Reserve Bank of India, in Finance &
Development, 2 July 2010.
* * *
Central banks have been at the heart of the global financial crisis. They have been blamed
for policies and actions that got the world into the crisis; they have been praised for leading
the world out of it. Both are fair assessments. Central banks have been a part of the problem
and a part of the solution.
As the crisis unwinds and recovery takes hold, central banks face a number of issues, of
which I will address five.
Monetary policy in a globalizing environment
The crisis has demonstrated the difficulties of macroeconomic management in a globalizing
world. Even as governments and central banks acted with an unusual show of policy force,
they were unable to get the situation under control because of the interconnectedness of the
financial system and the effects, positive and negative, of external developments on
domestic policy actions. Most important, they found that sentiment and confidence were
remarkably correlated across countries.
External developments interact with the domestic economy in complex, uncertain, and even
capricious ways. Central banks have to deepen their understanding of these interactions.
Some of the channels through which cross-border transmission occurs are quite familiar -
global prices, including commodity price movements; synchronization of business cycles;
capital flows; strong comovement of asset prices; exchange rates of key international
currencies; and interest rate policies of major central banks. Some of the transmission
channels are less familiar. For example, the crisis has shown that even differences in
regulatory regimes can trigger arbitrage-based action and dilute the efficiency of domestic
policies.
Take managing capital flows. Emerging market economies experienced a sudden stop in
capital inflows during the crisis as well as capital outflows - the result of global deleveraging.
Now the situation has reversed and many emerging market economies again have net
inflows. Managing these flows, especially if they are volatile, will test the effectiveness of
central bank policies in semi-open emerging market economies. A country whose central
bank does not intervene in the foreign exchange market will incur the cost of currency
appreciation unrelated to fundamentals. If central banks intervene to prevent appreciation,
they will have to contend with additional liquidity and potential inflation pressures. If they
sterilize (soak up) the resulting liquidity, they run the risk of driving up interest rates, which
would hurt growth prospects.
Volatility in capital flows could also impair financial stability. How emerging market
economies manage the impossible trinity of an open capital account, a fixed exchange rate,
and an independent monetary policy will affect their prospects for growth and price and
financial stability.
Redefining the mandate of central banks
The crisis has triggered vigorous and wide-ranging debate on the role and responsibilities of
central banks and raises three big questions:
In the years before the crisis there
Should central banks persist with inflation targeting?
was a powerful intellectual consensus in favor of inflation targeting - that is, basing monetary
policy on achieving a target inflation rate, usually consumer prices. Even where central banks
did not target a precise inflation rate, their policy objectives were informed, if not dominated,
by price stability. This approach seemed successful. There was an extended period of price
stability accompanied by stable growth and low unemployment. In the world before the crisis,
central bankers were a triumphant lot. The unraveling of the Great Moderation has diluted, if
not dissolved, the consensus around solely targeting inflation. The mainstream view before
the crisis was that price stability and financial stability reinforce each other. The crisis has
proved that wrong: price stability does not necessarily ensure financial stability. The crisis
has given fresh impetus to the "new environment hypothesis" that pure inflation targeting is
inadvisable and that the mandate of central banks should extend beyond price stability to
include bank regulation and supervision, financial stability, and preventing asset price
bubbles.
The emerging view
What is the role of central banks in preventing asset price bubbles?
is that preventing an asset price buildup should be within the purview of a central bank.
Opinion is divided, however, on whether central banks should prevent asset bubbles through
monetary policy action or through regulatory action. What is indisputable, though, is that
central banks' efforts to check asset price bubbles demand not just analytical capability but
mature judgment of the nature of the risk.
Should central banks also engage in bank regulation and supervision? In many
regulatory models the central bank is purely a monetary authority, with bank regulation and
supervision vested in another agency. The emerging view is that the crisis was caused, at
least in part, by a lack of coordination and communication between central banks and
supervisors and, in the interest of financial stability, it is optimal to entrust regulation and
supervision of banks to central banks. Admittedly, this is not a settled issue. There is no
onesize-fits-all answer, as is clear from the variety of regulatory models around. Each country
and each central bank will have to resolve this issue according to its specific circumstances.
Central banks and financial stability
While there is broad agreement that financial stability is neither automatic nor inevitable,
there is less agreement on whether it should be explicitly included in the mandate of central
banks. One argument is that explicit inclusion would be redundant, because financial stability
is a necessary - although not sufficient - condition for achieving the conventional central
bank objectives relating to inflation, output, and employment. On the other hand, there is a
growing view that unless financial stability is explicitly included in the mandate of central
banks, it is likely to fall through the cracks.
Complicating matters, defining financial stability in a precise, comprehensive, and
measurable manner is proving to be difficult. Nevertheless, we now know that there are two
attributes of financial instability:
 excessive volatility of macro variables such as interest rates and exchange rates
that have a direct impact on the real economy; and
 financial institutions and markets threatened by illiquidity to the extent of jeopardizing
systemic stability.
Do central banks have the instruments to address the mandate of financial stability? One
clear instrument for preserving financial stability is the lender-of-last-resort function. During
the crisis, central banks pumped in enormous amounts of liquidity to unfreeze the system
through the lender-of-lastresort window. While this made individual institutions liquid, the
market remained illiquid, thereby revealing the limitation of the window instrument in
combating illiquidity. A central bank can infuse liquidity, but it's hard to ensure that the
available cheap and abundant money is used to purchase assets whose value is rapidly
eroding. The only option may be for the central bank to buy the assets. This means that the
central bank must be not only the lender but also the market maker of last resort. These
issues have yet to be clearly defined, let alone resolved. But they must be resolved soon.
Managing the costs and benefits of regulation
To safeguard financial stability, the Reserve Bank of India used a variety of prudential
measures, including specification of exposure norms and preemptive tightening of the risk
weights attached to assets and the requirements for loss provisioning. But these measures
often carry a cost. For instance, tightening risk weights arguably tempers the flow of credit to
certain sectors, but excessive, premature, or unnecessary tightening can blunt growth.
Similarly, exposure norms offer protection against concentration risks; however, such limits
can restrict the availability of credit for important growth sectors. Thus, as in the case of price
stability, central banks face the challenge of managing the trade-off between financial
stability and growth.
After a crisis, with the benefit of hindsight, all conservative policies appear safe. But
excessive conservatism can thwart growth and stifle innovation. The question is, what price
are we willing to pay, or - conversely - what potential benefits are we willing to give up, to
cope with the unexpected, a black swan event? Experience shows that balancing the costs
and benefits of regulation is more a question of good judgment than analytical skill. Central
banks, especially those of developing countries, such as India, need to hone their judgment
skills as they pursue growth and financial stability.
Autonomy versus accountability
During the crisis, governments and central banks coordinated their efforts to launch
unprecedented expansionary fiscal and monetary policies. As countries contemplate exiting
these expansionary policies, the familiar tensions between monetary and fiscal policies are
showing up again. And a possible return of fiscal dominance could undermine the
independence of central banks.
Responsibility for financial stability must be shared by the government, the central bank, and
other regulators. Although that shared responsibility is not in itself a problem, there are two
related concerns. The first is that the rescue of financial institutions is an inherently political
act, and involvement in such decisions may compromise central banks' technocratic
credentials. The second concern is the risk that coordination with the government for the
purpose of financial stability may spill over into other areas within central banks' purview,
thereby undermining their independence.
The case for central bank independence is coming under increasing assault as a result of
crisis-spawned developments. Central banks must advocate for independence not with
weighty arguments but through more vigorous and voluntary efforts to be transparent,
responsive, and accountable.
This list of issues addressed here is by no means exhaustive, nor have all the nuances been
considered. But central banks must gain a better understanding of how to begin tackling
these issues, and on that basis adapt and change the way they function.