Raghuram Rajan: Concerns about competitive monetary easing
Remarks by Dr Raghuram Rajan, Governor of the Reserve Bank of India, in the Policy Panel
Discussion, at the "2014 BOJ-IMES Conference on Monetary Policy in a Post-Financial
Crisis Era", organised by the Institute of Monetary and Economic Studies and Bank of Japan,
Tokyo, 28 May 2014.
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Good morning. The world seems to be struggling back to its feet after the great financial
crisis, and financial markets are buoyant. This is partly because central bankers are
collectively engaged in extreme monetary easing through unconventional policies.
I have two worries about this environment. First, unconventional policies tend to be feasible
when domestic commercial banks are willing to accumulate significant central bank reserves
without question. But those are typically situations where lending is unattractive - because of
debt overhang, structural problems, or simply weak demand. Of course, a hope is that when
commercial banks accumulate enough reserves, their behaviour will change. But this may be
a long time coming, if at all.
In the meantime, the consequences of these sustained unconventional policies pile up in the
financial markets, where risk taking increases, without necessarily increasing real investment
or consumption. And they spill over into foreign markets as capital flows lead to greater
leverage and stronger exchange rates in recipient countries, and a shift in demand away
from them.
The second worry I have is that such policies prompt a reaction by foreign central banks in
both competitor industrial countries and in emerging markets. These may espouse
unconventional policies once again in order to avoid exchange rate appreciation or capital
inflows. Even as each central bank does, what is most appropriate for its domestic
circumstances, aggregate world demand may be weaker and more distorted than it should
be, and financial risks higher.
The international rules of the game need to be revisited as the world has changed. Both
advanced economies and emerging economies need to adapt, else I fear we are about to
embark on the next leg of a wearisome cycle.
Unconventional policy
By unconventional monetary policies (UMP), I mean both policies that hold interest rates at
near zero for long, as well as balance sheet policies such as quantitative easing or exchange
intervention, that involve altering central bank balance sheets in order to affect certain market
prices.
Let me first say there is a role for unconventional policies - when markets are broken or
grossly dysfunctional or when deflationary expectations are strongly entrenched, as in Japan.
The key question is what happens when these policies are prolonged long beyond repairing
markets - and there the benefits are much less clear. Let me list 4 concerns:
1. Is UMP the right tool once the immediate crisis is over? Does it distort behavior and
activity so as to stand in the way of recovery?
2. Do such policies buy time or does the belief that the central bank is taking
responsibility prevent other, more appropriate, policies from being implemented? Put
differently, when central bankers say, however reluctantly, that they are the only
game in town, do they become the only game in town?
3. Will exit from unconventional policies be easy?
4. What are the spillovers from such policies to other countries?
For reasons of time, let me focus on the last two.
Exit
The macroeconomic argument for prolonged unconventional policy in industrial countries is
that it has low costs, provided inflation stays quiescent. Hence it is worth pursuing, even if
the benefits are uncertain. Central bankers such as Governor Stein have, however, raised
concerns about financial sector risks that may build with prolonged use of unconventional
policy.
One reason is that leverage may increase both in the financial sector and amongst borrowers
as policy stays accommodative. One channel seems to be that a boost to asset liquidity
leads lenders to believe that asset sales will backstop loan recovery, leading them to
increase loan to value ratios.
When liquidity tightens, though, too many lenders rely on asset sales, causing asset prices
and loan recovery to plummet. Because lenders do not account for the effects of their lending
on the "fire sale" price, and subsequently on lending by others, they may have an excessive
incentive to build leverage.
Leverage need not be the sole reason why exit may be volatile after prolonged
unconventional policy. As Feroli et. al. argue, investment managers may fear
underperforming relative to others. This means they will hold a risky asset only if it promises
a risk premium (over safe assets) that makes them confident they will not underperform
holding it.
A lower path of expected returns on the safe asset makes it easier for the risky asset to meet
the required risk premium, and indeed draws more investment managers to buy it - the more
credible the forward guidance on "low for long", the more the risk taking.
However, as investment managers crowd into the risky asset, the likelihood of possible fire
sales increases if the interest rate environment turns. Everyone may dump the risky asset at
that point in order to avoid being the last one holding it.
Ideally, market players would exit trades gradually, and asset prices would fall gently, as
probabilities of the interest rate environment turning increase. But a rise in long rates may
upset an incipient recovery. The central bank's attempt, however, to hold long rates down till
the last possible moment by reassuring markets that policy rate hikes are a long way away,
is not without danger. If economic data turn up strongly, its reassurance may not carry
credibility, and market players will exit trades en masse.
Leverage and investor crowding may therefore exacerbate the consequences of exit. The
consequences of exit, however, are not just felt domestically, they could be experienced
internationally.
Spillovers
Perhaps most vulnerable to the increased risk-taking in this integrated world are countries
across the border. When monetary policy in large countries is extremely and
unconventionally accommodative, capital flows into recipient countries tend to increase local
leverage; this is not just due to the direct effect of cross-border banking flows but also the
indirect effect, as the appreciating exchange rate and rising asset prices, especially of real
estate, make it seem that borrowers have more equity than they really have. Exchange rate
flexibility in recipient countries, in these circumstances, sometimes exacerbates booms
rather than slowing inflows.
Recipient countries should adjust, of course, but credit and flows mask the magnitude and
timing of needed adjustment. For instance, higher collections from property taxes on new
houses and income taxes on a more prosperous financial sector may suggest a country's
fiscal house is in order, even while low risk premia on sovereign debt add to the sense of
calm. At the same time, an appreciating nominal exchange rate may also keep down
inflation.
So when source countries move to exit unconventional policies, some recipient countries are
leveraged, imbalanced, and vulnerable to capital outflows. Recipient countries are not being
irrational when they protest both the initiation of unconventional policy as well as an exit
whose pace is driven solely by conditions in the source country. Having become more
vulnerable because of leverage and crowding, recipient countries may call for an exit whose
pace and timing is responsive, at least in part, to conditions they face.
The case for international monetary policy coordination
Hence, my call for more coordination in monetary policy. I do not mean that central bankers
sit around a table and make policy collectively, nor do I mean that they call each other
regularly and coordinate actions. We certainly communicate with one another enough at the
BIS.
In its strong form, I propose that large country central banks, both in advanced countries and
emerging markets, internalize more of the spillovers from their policies in their mandate, and
are forced by new conventions on the "rules of the game", monitored by an impartial agency,
to avoid unconventional policies with large adverse spillovers and questionable domestic
benefits.
Given the difficulties of operationalizing the strong form, I suggest that, at the very least,
central banks reinterpret their domestic mandate to take into account other country reactions
over time (and not just the immediate feedback effects), and thus become more sensitive to
spillovers. This weak "coordination" could be supplemented with a re-examination of global
safety nets.
Let me be more specific. The key rationale for coordination and international monitoring is
adverse policy spill overs. Yet international agencies, with only a few notable exceptions,
have overwhelmingly endorsed the recent unconventional policies. Essentially, they argue, it
is OK to distort asset prices if there are other domestic constraints to reviving growth, such
as the zero-lower bound. But net spillovers, rather than fancy acronyms, should determine
internationally acceptable policy.
Otherwise, countries could legitimately practice what they might call quantitative external
easing or QEE, whereby they intervene to keep their exchange rate down and build huge
reserves. The reason we frowned on QEE in the past is because we believed the adverse
spillover effects for the rest of the world were significant.
But, if domestic demand is difficult to alter because of a variety of constraints, one could
argue QE works primarily through demand shifting, not unlike QEE. Therefore, if we are
unwilling to evaluate all policies based on their spillover effects, there is no legitimate way
multilateral institutions can declare that QEE contravenes the rules of the game.
The second danger is that a mismanaged exit will prompt fresh distortionary behaviour.
Indeed, the lesson some emerging markets will take away from the recent episode of turmoil
is: (i) don't expand domestic demand and run large deficits; (ii) maintain a competitive
exchange rate; and (iii) build large reserves, because when trouble comes, you are on your
own. In a world with deficient aggregate demand, is this the message the international
community wants to send?
Two obvious remedies suggest themselves: Less extreme monetary policies on all sides with
some thought given to adverse spillover effects when setting policy, and better global safety
nets to mitigate the need for countries to self-insure through reserve buffers.
Operationalizing coordination: some suggestions
In an ideal world, UMPs such as QE or QEE should be vetted by an independent multilateral
agency for their spillover effects. For instance, following a complaint by an impacted country,
the independent assessor could analyse the effects of such policies and come to a
judgement on whether they follow the rules of the game. Policies where the benefits are
largely domestic, while the costs fall largely abroad, would be especially carefully scrutinized.
And if the assessor deems the policy reduces global welfare, pressure should be applied to
stop such policies.
The problems with such an idealistic process are easy to see. Where is such an impartial
assessor to be found? And if a truly independent assessment came to the conclusion that
certain policies were in violation, how would such a judgement be enforced?
A more modest proposal
Perhaps then, it would be better to settle for a more modest proposal. Central banks should
not just worry about the immediate flows of capital to other countries from its policies, but the
longer run reaction such as competitive easing or sustained exchange intervention that this
would bring about. This would allow central banks to pay more attention to spillovers even
while staying within their domestic mandate.
At the same time, we should reduce the incentive for countries to engage in a repeat of
substantial reserve accumulation by building stronger international safety nets. An interesting
proposal from the IMF is a liquidity line from the IMF, where countries are pre-qualified by the
IMF and told (perhaps privately) how much of a line they would qualify for under current
policy - with access limits revised every year after the Article IV discussions and any
curtailment becoming effective 6 months later. Such a pushed line could overcome the
problem that no country wants to approach the Fund because of the associated stigma.
Conclusion
The current non-system in international monetary policy is, in my view, a source of
substantial risk, both to sustainable growth as well as to the financial sector. It is not an
industrial country problem, nor an emerging market problem, it is a problem of collective
action. The sooner we recognize that, the more sustainable world growth we will have.