Duvvuri Subbarao: Frontier issues on the global agenda - need for
global cooperation
Inaugural address by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
Indian Council for Research on International Economic Relations/InWent/German
Development Institute (ICRIER/InWent/DIE) Conference on "Policies for growth and financial
stability beyond the crisis - the scope for global cooperation", Mumbai, 27 October 2010.
* * *
1. First of all, my thanks to the organizers of this conference - ICRIER, the German
Development Institute (DIE) and InWent - for inviting me to inaugurate this conference on:
"Policies for Growth and Financial Stability Beyond the Crisis - the Scope for Global
Cooperation". Having just returned from a meeting of G-20 Finance Ministers and Central
Bank Governors in Korea over this weekend, I am deeply sensitive to the value of generating
a wider debate on issues that the world has to grapple with as we emerge out of the crisis.
2. The focus of this conference on global cooperation is particularly relevant. Everyone
now has her/his list of lessons of the crisis, and one item common on almost every list is the
lesson that today's macroeconomic problems cannot be resolved without global cooperation.
The crisis has taught us that no country can be an island and that economic and financial
disruptions anywhere cause ripples, if not waves, everywhere. The crisis also taught us that
given the deepening integration of countries into the global economic and financial system,
uncoordinated responses will lead to worse outcomes for everyone.
3. When the history of this crisis is written, the London G-20 Summit in April 2009 will
be seen as a clear turning point when the leaders of the world showed extraordinary
determination and unity of purpose in combating the deepest economic crisis of our
generation. Sure there were differences, but they were debated and discussed and
compromises were made without eroding the end goal - that is to end the crisis.
4. The priority task today is to calibrate the exit from the crisis driven accommodative
policies and put the world on a sustainable growth path. Global cooperation is as vital for
managing this recovery as it was for managing the crisis. There is a growing apprehension
though that the vaunted unity that the G-20 had shown during the crisis is dissipating and
that its resolve to foster globally optimal solutions is weakening. When all the details are
distilled out, two main worries emerge: first, that countries are not able to resolve their
conflicts of interest, and second that at the world level we are bogged down by the tyranny of
the present and are not able to resolve the balance between medium term sustainability and
short term compulsions.
5. These concerns are valid, but the judgement on G-20 is perhaps harsh. The global
problems we are facing today are complex and not amenable to easy solutions. Many of
them require significant and often painful adjustments at the national level, and in a world
divided by nation-states, there is no natural constituency for the global economy. At the same
time, the global crisis has shown that the global economy as an entity is more important than
ever. We cannot afford a situation where decisions essential for global prosperity become
hostage to domestic concerns.
6. Against this background, and keeping in view the vast sweep of this conference
theme, what I propose to do in this inaugural address is to highlight the frontier issues on the
present day global agenda and emphasize how we cannot resolve them without global
cooperation.
Multi-speed recovery
7. By all accounts, the world has recovered from the financial meltdown and the follow
on recession much sooner than we had feared at the depth of the crisis. In its latest World
Economic Outlook (WEO - October 2010), the IMF projected global growth for 2010 of
4.8 per cent; this marks a surprising upward revision from its earlier projection of
4.6 per cent. This remarkable turnaround in outlook masks some significant geographical
variations in the recovery process. Emerging market economies (EMEs), contributing nearly
half of this growth, have clearly been the engine of this recovery. World trade which shrank
by 11 per cent in 2009, is projected to expand by 11.4 per cent in 2010, again powered by
import demand of EMEs which is rising twice as fast as that of advanced economies.
8. On the other hand, in advanced economies, there are growing concerns about the
slowing momentum of recovery, stubbornly high rates of unemployment and persistent
output gaps. Although specifics vary, the G-3 - America, Europe and Japan - are caught in
fierce policy debates on stimulus and exit strategies. At the heart of this debate are two
issues that pit the short-term against the medium term: first, whether additional fiscal
stimulus at this stage will jeopardize medium term fiscal sustainability; and second, whether
continued expansionary monetary stance - QE2 in popular jargon - will be an adequate
substitute for the waning fiscal stimulus, and what implications the ultra loose monetary
policy may have for medium term inflation trends.
9. A question often asked is whether EMEs will be able to sustain global growth even if
advanced economies continue to languish. People who put this question, I believe, are doing
so as a rhetoric - to encourage analytical thinking rather than to solicit an affirmative answer.
Sure, multiple growth poles are a safety-net for the whole world, but to expect EMEs, by
themselves, to lift global growth will be unrealistic. Note that emerging and developing
countries account for less than half of world GDP even when measured at PPP valuations,
and only about a third of the world trade in goods and services. Notably, the much hyped
"decoupling" does not stand to strict scrutiny. On the contrary, there is evidence of powerful
coupling. Recent research within IMF shows that the detrended aggregate output growth of
EMEs has strong association with the aggregate output growth of advanced economies and
this "association" has in fact increased over time, evidencing not only that the coupling is
strong but that it is getting stronger. Sure, in recent years EMEs have been less affected by
recessions in advanced economies owing to improved policy framework and more effective
macroeconomic management. But over an entire cycle, the economic prospects of EMEs
remain firmly coupled with those of advanced economies.
Global adjustments - short term and medium term
10. All members of the G-20 are deeply conscious that purely national solutions do not
solve global problems and that they each need to make an adjustment to the post-crisis
global realities. It is in calibrating the exit in the short-term and sequencing the structural
reforms in the medium term that the differences arise, and that is where global cooperation is
most vital.
11. The post-crisis global scenario has thrown up three interrelated issues. The first is
the need for rebalancing across and within economies. In as much as global imbalances - no
matter whether they were caused by "a consumption binge" in advanced economies or a
"savings glut" in EMEs - were one of the root causes of the crisis, reducing imbalances is a
necessary condition for global financial stability. A second issue is the role of exchange rates
in redressing external imbalances. A third set of questions relates to capital flows into EMEs
raising the familiar challenge of managing the impossible trinity. Let me turn to these one by
one.
12. The first issue, rebalancing, is the focus of the latest (October 2010) World
Economic Outlook of the IMF. I can do no better than to quote from the foreword to the
Report.
"Achieving a "strong, balanced and sustained world recovery" - to quote from the
goal set in Pittsburgh by the G20 - was never going to be easy. .... It requires two
fundamental and difficult economic rebalancing acts.
First, internal rebalancing: When private demand collapsed, fiscal stimulus
helped alleviate the fall in output. But fiscal stimulus has to eventually give way to
fiscal consolidation, and private demand must be strong enough to take the lead
and sustain growth.
Second, external rebalancing: Many advanced economies, most notably the
United States, which relied excessively on domestic demand, must now rely more
on net exports. Many emerging market economies, most notably China, which
relied excessively on net exports, must now rely more on domestic demand.
These two rebalancing acts are taking place too slowly."
13. A prime lever for redressal of external imbalances is exchange rate flexibility, the
second issue that I listed. Rebalancing will require deficit economies to save more and
consume less. They need to depend for growth more on external demand which calls for a
real depreciation of their currencies. The surplus economies will need to mirror these efforts
- save less and spend more, and shift from external to domestic demand. They need to let
their currencies appreciate. Managing currency tensions will require a shared understanding
on keeping exchange rates aligned to economic fundamentals, and an agreement that
currency interventions should be resorted to not as an instrument of trade policy but only to
manage disruptions to macroeconomic stability.
14. That brings me to the third issue that I listed, return of lumpy and volatile capital
flows. Since capital flows have become such an emotive topic around the world in recent
months, it is important perhaps to recall a few realities. First, that emerging and developing
economies do need capital flows to augment their investible resources, but such flows should
meet two criteria: they should be stable and be roughly equal to the economy's absorptive
capacity. The second reality that we must remember is that capital flows are triggered by
both pull and push factors. The pull factors are the promising growth prospects of EMEs,
their declining trend rates of inflation, capital account liberalization and improved
governance. The push factors are the easy monetary policies of advanced economies which
create the capital that flows into the EMEs. What this says is that international capital flows
comprise a structural component and a cyclical component. It is the cyclical component that
typically causes all the adjustment problems for EMEs.
15. That said, the multi-speed recovery around the world and the consequent differential
exit from accommodative monetary policy has triggered speculative capital flows into EMEs.
The biggest problem thrown up by capital flows is currency appreciation which erodes export
competitiveness. Intervention in the forex market to prevent appreciation entails costs. If the
resultant liquidity is left unsterilized, it fuels inflationary pressures. If the resultant liquidity is
sterilized, it puts upward pressure on interest rates which, apart from hurting
competitiveness, also encourages further flows.
16. Currency appreciation is not the only problem arising from the ultra loose monetary
policy of advanced economies. Speculative flows on the lookout for quick returns can
potentially lead to asset price build up. The assurance of advanced economies to keep
interest rates "exceptionally low" for "an extended period" has also possibly triggered
financialization of commodities leading to a paradoxical situation of hardening of commodity
prices even as advanced economies continue to face demand recession. Hardening of
commodity prices has affected those EMEs which are net importers of commodities.
17. Managing capital flows should not be treated as an exclusive problem of EMEs. In
as much as lumpy and volatile flows are a spillover from policy choices of advanced
economies, the burden of adjustment has to be shared. How this burden has to be measured
and shared raises both intellectual and practical policy challenges. The intellectual challenge
is that we do not have a good theory that explains the role of capital flows in the
determination of exchange rates. We, of course, have an established theory of current
account management and the role of exchange rate as a variable in that. What we now need
is a theory that encompasses both current and capital accounts and one that gives a better
understanding of what capital controls work and in what situations. That is the intellectual
challenge. What is the practical challenge? The practical challenge is that once we have
such a theory, we need to reach a shared understanding on two specific aspects: first, to
what extent are advanced economies responsible for the cross border spill over impact of
their domestic policies, and second, what is the framework of rules that should govern
currency interventions in the face of volatile capital flows.
Protectionism
18. In the post-crisis world, there may not actually be "deglobalization" but the earlier
orthodoxy that globalization is an unmixed blessing is being increasingly challenged. The
rationale behind globalization was, and hopefully is, that even as advanced countries may
see some low end jobs being outsourced, they will still benefit from globalization because for
every low end job gone, another high end job - that is more skill intensive, more productive -
will be created. If this does not happen rapidly enough or visibly enough, protectionist
pressures will arise, and rapidly become vociferous and politically compelling. The efforts of
several countries around the world to resist currency appreciation are a manifestation of
protectionist pressures.
19. There is concern in some quarters that while open protectionism has been resisted
relatively well during the current crisis, opaque protectionism has been on the rise. Opaque
protectionism takes the form of resorting to measures such as anti-dumping actions,
safeguards, preferential treatment of domestic firms in bailout packages and discriminatory
procurement practices. Experience shows that countries resort to restrictive trade practices
in areas not covered by multilateral rules or by exploiting the lack of specificity in certain
rules. To strengthen multilateral trade discipline, the need for a quick conclusion of the Doha
Round can hardly be overemphasized. In a world with growing worries about the debt
creating stimulus packages, a Doha Round agreement should be welcomed as a non-debt
creating stimulus to the global economy.
International monetary system
20. The global crisis has revived the familiar concerns about the robustness of the
international monetary system. The system we now have is that the US dollar is the world's
reserve currency by virtue of the dominant size of the US economy, its share in global trade,
the preponderant use of dollar in foreign trade and foreign exchange transactions and a host
of other intangible factors. The US has met the obligation of an issuer of reserve currency by
running fiscal and external deficits while enjoying the comfort of not having to make the
necessary adjustment to bridge the deficits. Such persistent deficits of a dominant economy
can potentially create imbalances at the global level as indeed happened in the build up to
the crisis. While the US took care of the supply side of the reserves, the demand side
impetus comes from several factors including the accumulation of reserve assets by EMEs
as a measure of self-insurance against external shocks.
21. The problem with the world having only a single reserve currency came to the fore
during the crisis as many countries faced dollar liquidity problems as a consequence of swift
deleveraging by foreign creditors and foreign investors. Paradoxically, even as the US
economy was in a downturn, the dollar strengthened as a result of flight to safety.
22. Based on the experience of the crisis, several reform proposals have been put
forward to address the problems arising from a single reserve currency. One is to have a
menu of alternative reserve currencies. But this cannot happen by fiat. An alternative
currency or currencies will take root as reserve currency/currencies only if those currencies
are fully convertible and acquire a dominant share in world trade. A second option is to
develop the SDR as a reserve currency. This does not seem to be a feasible option. For the
SDR to be a genuine reserve currency, it has to fulfil several conditions: the SDR has to be
accepted as a liability of the IMF, has to be automatically acceptable as a medium of
payment in cross-border transactions, be freely tradeable and its price has to be determined
by forces of demand and supply. A third suggested solution aims at reducing the need for
self-insurance and thereby the dependence on a reserve currency by supporting a
multilateral option of a prearranged line of credit that can be easily and quickly accessed.
Such a multilateral option is necessary as a complement to self-insurance but it cannot be a
substitute; some measure of self-insurance will continue to be the first line of defence.
23. None of the above solutions as you can see fully addresses the problems arising
from a single global reserve currency. What this underscores is that at the global level we
need to explore these and other options for protecting ourselves from the vulnerabilities that
we confront as a consequence of a single reserve currency.
Governance of Bretton Woods institutions
24. The global crisis has underscored the importance of reforming the governance
structures of Bretton Woods institutions - the IMF and the World Bank, so as to give
representation to EMEs commensurate with their growing share in the global economy.
These reforms are central to the legitimacy and effectiveness of these global institutions.
There has been significant progress in respect of World Bank capital and voice reforms.
Quota reform in the IMF is also expected to be completed soon. Countries which have not
been traditional creditors, including India, have entered into sizeable credit arrangements
with the Fund. This strengthens the case for quota shifts in their favour as a group, and in
particular to dynamic EMDCs, to better reflect current global economic realities. These shifts
need to be followed up by continuing the dynamic process aimed at enhancing the voice and
representation of the poorest through a comprehensive review of the quota formula by
July 2013. Here the need for cooperation among countries will be crucial.
Financial sector reforms
25. In September 2010, the Basel Committee on Banking Supervision (BCBS) put out a
comprehensive paper indicating the broad agreement reached on the Basel III proposals.
Broadly, these reforms will require banks to hold more and better quality capital and to carry
more liquid assets, will limit their leverage and mandate them to build up capital buffers in
good times that can be drawn down in periods of stress. The Basel III process is not yet
complete. Some aspects of Basel III, such as common equity and tier I capital have been
firmed up; others such as the new global liquidity standards and the leverage ratio have yet
to be precisely specified. This will be done after a further assessment of the reasonableness
of these measures and their impact on banks' balance sheets as well as the national
economies. Though this would allow time for further calibration and refinement, it could on
the other hand contribute to regulatory uncertainty. Moreover, there are several issues such
as capital conservation buffer and countercyclical buffer which are fraught with severe
definitional and implementation complexities and challenges.
26. Another crisis driven initiative has been to expand the erstwhile Financial Stability
Forum into a Financial Stability Board (FSB) by giving representation to EMEs. The FSB has
been working on a number of initiatives including managing the moral hazard associated with
systemically important financial institutions (SIFIs) through more stringent regulatory and
supervisory norms, principles to guide compensation of bank managements, a single set of
accounting standards and regulation of OTC derivatives, credit rating agencies and hedge
funds. There are also several areas where substantial work needs to be done including in
improving resolution regimes for cross-border banks and systemically important nonbank
financial companies, addressing the procyclicality of the financial system, and
macroprudential surveillance. More work also needs to be done to extend the prudential norms on
the lines of Basel III to the shadow financial system which lay at the heart of the recent
financial crisis.
27. Within a common set of agreed-upon global standards, each jurisdiction may have
to tailor some of its rules and supervisory practices to national conditions and preferences.
The big challenge going forward will be to implement global standards with national
differentiation but without giving any scope for the market to interpret national deviations from
the standards as regulatory looseness.
Conclusion
28. Let me now summarize. In my remarks today, I covered what I believe are the
frontier issues on the present day global agenda. In particular, I gave a picture of the
multispeed recovery and its implications for global adjustments in the short term and in the
medium term. These adjustments need to cover three inter-related issues: redressing
imbalances, exchange rate flexibility and management of capital flows. I emphasized how
global cooperation is vital to reach a shared understanding on all the three issues. I then
raised the possibility of a post crisis world which will be less welcoming of globalization and
how this may trigger protectionist pressures. I moved on to emphasize how global
cooperation is vital for reforming the international monetary system and the need for a
comprehensive quota and representation reform in the Bretton Woods Institutions
commensurate with the growing contribution of EMEs to global growth and global trade.
Finally, I gave a brief status of the reforms in the financial sector, and how again restoring
financial stability at the national and international levels requires global cooperation.
29. The common thread running through all the issues that I raised is the need for global
cooperation in solving our most pressing problems of today. Given the strength and pace of
globalization, purely national solutions are not only inadequate but may indeed be
counterproductive.
30. I realise I have raised several issues without providing complete solutions. I believe
that is the privilege of the inaugural speaker. The burden of identifying solutions and debating
their pros and cons belongs to the conference proper.
31. The global crisis has taken a devastating toll on global growth and welfare. In their
painstakingly researched book, "This Time is Different: Eight Centuries of Financial Folly",
Kenneth Rogoff and Carmen Reinhart show how over eight hundred years, all financial
crises can be traced to the same fundamental causes as if we learnt nothing from one crisis
to the next. Each time, experts have chimed that "this time is different" claiming that the old
rules do not apply and the new situation is dissimilar to the previous one. It will be too costly
for the world not to heed this lesson. We should cooperate not only to firmly exit from the
crisis, but also to ensure that in resolving this crisis, we do not sow the seeds of the next
crisis.