Y V Reddy: Financial sector reform and financial stability
Speech by Dr Y V Reddy, Governor of the Reserve Bank of India, at the 8th Global Conference of
Actuaries, Mumbai, 10 March 2006.
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Mr. President and distinguished friends,
It is a privilege and an honour to be invited for this 8th Global Conference of Actuaries. Dr. R. Kannan
has been a respected colleague of mine for several years in the Reserve Bank and I am thankful to
him for persuading me to join you. Also, Mr. C.S. Rao, Chairman, IRDA and Mr. D. Swarup, PFRDA
have been my friends and colleagues in the Government of Andhra Pradesh and Government of India.
Financial sector reform and financial stability are subjects of high priority to central bankers, are of
relevance to all financial regulators and may be of interest to a gathering of finance professionals like
actuaries. My address will, therefore, focus on the features of the financial sector reforms in India; the
initiatives taken to assure financial stability; the links between reforms and stability in the financial
sector and conclude with some observations in the current context.
Financial sector reform
The financial sector reforms in India, like almost all other countries, have some common and a few
unique features. They were undertaken early in the reform cycle, in early 1990s. They were designed
by eminent professionals in the country, and implemented pragmatically. This is evident from the
dynamic mix between public and private ownership and transition of Development Financial
Institutions as well as Unit Trust of India into their new incarnations. Fiscal support has not been
burdensome and legacy problems such as non-performing loans have been absorbed by banks and
not transferred to fisc. New regulatory bodies such as those for securities markets, insurance and
pension funds have been legislated or are underway. While prudential regulation of banks has been in
vogue for decades, independent regulatory framework for other entities has been a recent
phenomenon. Enhanced competition has been induced with the entry of private foreign entities and
foreign capital in financial sector. In brief, there has been progress in the three inter-related pillars of
financial sector, namely ownership, regulation and competition.
Let me illustrate the pragmatic nature of reforms in the fiscal-monetary policy interface. Reserve Bank
entered into a Memorandum of Understanding to limit the issuance of ad hoc Treasury Bills to the
central government and terminate automatic monetisation of the government's financial needs in 1994
and 1997, respectively.The Reserve Bank avoided participation in the primary issues in recent years
except to prepay external debt or as a transition measure, last week. These de facto arrangements,
proven to be workable, are coming into effect through legislative sanction only on April 1, 2006.
Financial stability
Financial Stability is difficult to define and thus difficult to measure. Basically, it refers to the smooth
functioning of the financial markets and institutions but it does not mean absence or avoidance of
crisis but presence of conditions conducive to efficient functioning without serious disruption. The
relevant legal, institutional and policy frameworks are wide ranging and policy instruments at the
disposal of authorities very varied. In a way, the financial stability objective is shared with a set of
public policy bodies and professional bodies like auditors and actuaries but the primary responsibility
for overall financial sector efficiency and stability generally rests with the central bank. The plausible
reasons for such a responsibility are the major elements contributing to financial stability, namely, the
oversight of the financial infrastructure, in particular payments systems; regulation and supervision of
financial institutions; crisis management and provision of liquidity; and macro financial stability
encompassing monitoring not only the behaviour of all important players in the financial sector but also
non-financial sector balance sheets as well as that of the governments.
Financial sector reforms and stability
National authorities have typically adapted the design of financial sector reforms - the pace,
sequencing direction and ambit - to country-specific situations, mindful of the threats to financial
stability. The relevant considerations may be summarized here.
First, there is substantial consensus, backed by some historical and cross-country evidence, that there
are strong complementarities between financial stability and macroeconomic stability.
Second, a key issue in the design of financial sector reforms is the pace of reforms in the context of
ensuring financial stability. Opinion remains sharply divided over the choice between a big-bang
approach or shock therapy and a cautious or gradualist strategy. On balance, it appears, the reforms
need to be introduced more as a process than as a short-lived event while the process moves fast
enough to produce reasonable results without running the risk of disruption in the short run.
Third, in case the gradualist approach is adopted, the question that arises is what should be the
optimal sequencing of reforms which secures financial stability. Such sequencing is crucial for
ensuring inter-sectoral balances and avoiding the chances of disproportionality.
Fourth, no reform process, however, paced and sequenced, can be consistent with financial stability if
it is widely perceived as temporary and lacking credibility. In a market-based environment, the
expectations of the economic agents are extremely important for economic decisions. The reform
process can succeed only if the economic agents, especially investors, believe that the reforms are
enduring. The issue of credibility is inter-related with the choice of the pace of reform. Our experience
has been that a graduated pace wins credibility since it avoids disruptions and roll-backs in the short
run while at the same time allowing the beneficiaries to build a consensus in favour of continuing
reforms. A key issue is that of managing expectations.
There is reason to believe that the financial reforms process in India has greatly aided in strengthening
and reinforcing financial stability. The financial sector has acquired the strength to absorb shocks,
largely facilitated by regulatory actions. The financial system is now robust and resilient, contributing to
public confidence and overall stability.
At this stage, the optimism generated by impressive macroeconomic performance and the modest
success in implementing financial sector reforms has intensified pressures for significantly
accelerating the pace of external financial liberalisation. It is essential to take into account the risks
associated with it while resetting an accelerated pace of a gradualist approach. It needs to be
emphasized that the existing international financial architecture is not adequate to prevent or mitigate
the domestic and external effects of a financial crisis in large economies like India. The impact of
instability in times of crisis appears largely to be borne by the home or domestic public sector rather
than the global private sector. The issue of setting the pace of financial liberalisation revisits the issue
of trade-off between sustained growth and a growth rate that could potentially turn volatile and
unstable. While it is necessary to add to the pace of growth, it is also equally important to minimize the
risks of instability, and the experience shows that more than desirable pace of financial liberalisation
was often followed by financial instability and crises. Avoiding crises is ultimately a national
responsibility. The approach to managing the financial sector, the choice of instruments and the timing
and sequencing of policies are matters of informed judgment, given the imponderables.
Current context
Some thoughts on the issue of financial stability in the current context, are perhaps in order. Low
growth accompanied by high inflation is a nightmare for a central banker. High growth coupled with
low inflation is indeed a central banker's dream. I have reason to be happy, considering the growth
and inflation numbers in India now. So are all my brother or sister central bankers who seem to have
similar positive trends. However, currently almost every central banker in this globalised world keeps
wondering whether the night ahead will continue the dream run and if so, when will it run out of steam.
The concerns of central bankers today arise out of what has been described as stable disequilibrium -
with every day adding to potential disequilibrium while continuing to be stable. The perceived risks
arise mainly out of global imbalances and outlook for oil prices, particularly in the light of emerging
geo-political situation. Most market participants seem to sense these risks but this sentiment does not
appear to be reflected in the pricing of risks. Risks do not disappear but they get transferred to another
part of the system. The macro policies in emerging markets in particular have to factor in these risks
while continuously balancing financial sector reform and stability considerations. More important, for
the regulators, monitoring where the risk lies has become very difficult due to emergence of large
conglomerates, sophisticated market instruments such as derivatives and presence of players like
hedge funds. The good news is that there is international cooperation among central bankers to
mitigate the impact of such risks. The Actuaries can certainly help the process of analysing the risks in
insurance sectors that do affect a large segment of population that in fact seeks to minimize such risks
through insurance.
Let me conclude by thanking the organisers for provoking me to think aloud and share my thoughts on
a subject of common interest to all of us assembled here. I wish the conference fruitful deliberations,
well balanced by pleasant stay and memories.