Duvvuri Subbarao: Financial crisis - some old questions and maybe
some new answers
Speech by Mr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the Tenth
C D Deshmukh Memorial Lecture, Council for Social Development, Southern Regional
Centre, Hyderabad, 5 August 2010.
* * *
1. It would be a privilege for anyone to deliver this lecture to honour the memory of
Sir Chintaman D. Deshmukh. The privilege is particularly special for a serving Governor of
the Reserve Bank of India. Everyday, as I go to work, I bask in the glory of serving a public
institution that is held in such high esteem.
2. I am deeply conscious that this high esteem owes a lot to the competence and
professionalism of the Reserve Bank's staff, its institutional values and culture, and
importantly, the outstanding leadership of former Governors. As the Governor of the Reserve
Bank in these exciting times, I am deeply humbled by the intellectual reputation of the
lineage of the Reserve Bank's Governors. Sir Chintaman stands out among them not only
because he was the first Indian Governor of the Reserve Bank, but because he laid the
ethical and intellectual foundations of central banking in India, and all of us, his successors
have stood on his giant shoulders.
3. A couple of months ago, I happened to visit the Reserve Bank's Archives in Pune,
and there I came across a letter from Prime Minister Nehru to Governor Deshmukh in 1948
expressing concern over the country's deteriorating economic situation and asking for his
analysis and guidance. That letter is a reflection not only of the intellectual stature of
Sir Chintaman but also evidence of his lasting legacy to the office of the Governor of the
Reserve Bank that has sustained the confidence and respect of successive Prime Ministers
for the Reserve Bank.
4. We owe a deep debt of gratitude to several of our early post independence leaders
- politicians, civil servants, public intellectuals, corporate heads and social activists - who all
contributed to building the institutional structure of independent India. Given the gigantic
scale of our democracy, the aspirations of Pandit Nehru for the country, and the low literacy
and awareness levels, this was by all accounts a formidable challenge. Sir Chintaman,
whose public career spanned over three decades, was a doyen among those early leaders.
Not just the Reserve Bank, but several of our institutions today are a testimony to
Sir Chintaman's commitment to the idea of India as a modern economy and an inclusive
society.
5. As Governor of the Reserve Bank during 1943-49, Sir Chintaman's intellectual
values, progressive outlook, meticulous planning and his ability to think outside the box
played a critical role in steering the economy through turbulent waters. I know from personal
experience that the job of a Governor, more than most other positions, involves managing
the tension between doing what is expedient in the short-term and what is good in the
medium to long run. By his actions, Sir Chintaman demonstrated that the dharma of a central
banker is always to defend long term sustainability against short term compulsions.
6. I struggled to determine how best to pay a tribute to a person of the intellectual
stature and social commitment of Sir Chintaman. As I read about him, I realized that he was
among those who believed in building a modern India based on reevaluating conventional
wisdom and finding fresh approaches to old problems, and new answers to old questions.
7. That has a resonance with the situation today as the world is trying to grasp the
aftermath of the most devastating financial crisis of our time. The global crisis has challenged
many of our ideas and reopened questions that we thought have been settled. In the spirit of
paying tribute to the memory of Shri Deshmukh and his remarkable intellectual traits, I want
to raise five old questions and see how the crisis has possibly thrown up new answers. The
five questions are:
(i) Have emerging market economies (EMEs) decoupled from the advanced
economies?
(ii) Should central banks persist with pure inflation targeting?
(iii) Should financial stability be an explicit mandate of central banks?
(iv) Are controls an appropriate mechanism for managing the capital account?
(v) Has fiscal dominance of monetary policy ended?
Question 1: Have emerging market economies (EMEs) decoupled from the advanced
economies?
8. The answer before the crisis was an increasingly assertive "yes". The decoupling
hypothesis held that even if advanced economies went into a downturn, EMEs would not be
affected because of their improved policy framework, robust external reserves and resilient
financial sectors. It is difficult to trace the precise origins of the decoupling hypothesis but it
would be fair to surmise that it was inspired by the superior growth performance of EMEs as
compared to advanced economies.
9. Clearly, differential growth performance by itself is not conclusive confirmation of the
decoupling hypothesis. But the decoupling hypothesis failed the first test which came during
the recent crisis. The banking sectors of the EMEs had relatively marginal exposure to toxic
assets and their off-balance sheet activities were limited. So, if decoupling worked, EMEs
should have been spared the crisis. Yet all EMEs were affected by the crisis, although to
different extents, as the crisis spread through finance, confidence and trade channels.
10. Notwithstanding our sound banking system and relatively robust financial markets,
India felt the tremors of the tectonic shocks in the global financial system. The first round
effects came through the finance channel by way of sudden stop and then reversal of capital
flows consequent upon the global deleveraging process. This jolted our foreign exchange
markets as well as our equity markets. Almost simultaneously, our credit markets came
under pressure as corporates found that their external sources of funding had dried up
suddenly and turned to domestic bank and non-bank sources for funds.
11. By far the most contagious route for crisis transmission was the confidence channel.
For weeks after the Lehman collapse in mid-September 2008, everyday there was news of
yet another storied institution crashing. In this global scenario of uncertainty, the lack of
confidence in advanced country markets transmitted as hiccups to our markets too. The net
result was that all our financial markets - equity, debt, money, foreign exchange and the
government securities markets - came under varying degrees of pressure. Finally, the
transmission of the crisis through the real channel was quite straightforward as the global
recession that followed the financial crash resulted in a sharp decline in export demand for
our goods and services.
12. I have sketched the Indian situation in some detail but what we had experienced
here was typical of most EMEs, save for some differences in the degree of impact. The short
point is that the crisis resulted in a dissipation of the euphoria over decoupling.
13. So, have EMEs decoupled from the advanced economies? The new answer to this
old question is quite nuanced. It is that "strong" decoupling does not work. In a globalized
world, no country can be an island and what happens around the world affects every
economy, even as the extent of impact depends on the nature and depth of integration of the
economy. However, "soft" decoupling works. It is possible for economies to insulate
themselves against an external crisis, but to be able to do so, they need to diversify their
drivers of growth, institute automatic stabilizers and develop the fiscal space to
accommodate those stabilizers, regulate their financial systems effectively, and be swift and
nimble in economic management.
Question 2: Should central banks persist with pure inflation targeting?
14. The answer before the crisis was an increasingly confident "yes".
15. The years before the crisis saw a powerful intellectual consensus building around
inflation targetting. A growing number of central banks, starting with New Zealand in the late
1980s and currently numbering over twenty, embraced the principle of gearing monetary
policy almost exclusively to stabilizing inflation. 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 that existed before the
crisis, central bankers were a triumphant lot. They had discovered the holy grail.
16. The unravelling of the Great Moderation during the crisis has diluted, if not
dissolved, the consensus around the minimalist formula of inflation targetting. The
mainstream view before the crisis was that price stability and financial stability reinforce each
other. The crisis has proved that wrong. We have seen that price stability does not
necessarily ensure financial stability. Indeed there is an even stronger assertion - that there
is a trade-off between price stability and financial stability, and that the more successful a
central bank is with price stability, the more likely it is to imperil financial stability.
17. Where do we in India stand on this? The Reserve Bank is not an inflation targetter.
However, there is an influential view that our economy will be better served if the Reserve
Bank becomes a pure inflation targetter. The argument is that inflation hurts much more in a
country like India with hundreds of millions of poor people and that the Reserve Bank will be
more effective in combating inflation if it is not burdened with other objectives.
18. This argument is contestable. Inflation targetting is neither desirable nor practical in
India, and for several reasons.
(i) In an emerging economy like ours, it is not practical for the central bank to focus
exclusively on inflation oblivious of the larger development context. The Reserve
Bank needs to balance between growth, price stability and financial stability.
(ii) More often than not, the drivers of inflation in India emanate from the supply side.
Food items have a weight of 46 to 70 per cent in various CPIs and are notoriously
subject to supply shocks which are normally beyond the pale of monetary policy.
This dilutes our potential effectiveness as inflation targetters.
(iii) Which inflation index do we target? Our headline inflation index is the WPI and that
does not, by definition, reflect the consumer price situation. Getting a single
representative inflation rate for a large economy with 1.2 billion people, fragmented
markets and diverse geography is a formidable challenge.
(iv) A necessary condition for inflation targetting to work is effective monetary
transmission. Our monetary transmission mechanism is improving but is yet to reach
robust standards. It remains impeded because of administered interest rates, the
asymmetric contractual relationship between banks and their depositors, illiquid
bond markets and large government borrowings. These impediments to monetary
transmission diminish our effectiveness as inflation targetters.
(v) Finally, large and volatile capital flows will continue to be an important feature of our
external sector. Managing these flows will mean managing what has come to be
called "the impossible trinity" - balancing between the objectives of a fixed
exchange rate, open capital account and independent monetary policy. Inflation
targetting is clearly not possible in an impossible trinity situation.
19. The burden of my argument is that the Reserve Bank cannot be, and indeed should
not be, a pure inflation targetter. Post-crisis, the dominant view around the world is shaped
by the "new environment hypothesis" which says that flexible inflation targetting, rather than
pure inflation targeting, is more efficient. According to this hypothesis, if inflation is way off
target, a central bank's first call is to bring it within acceptable range, and if inflation is within
the range, the central bank should focus on other objectives.
20. To summarize, the answer to the old question, "should central banks be pure
inflation targetters?" has shifted from an increasingly confident "yes" to an increasingly
qualified "yes".
Question 3: Should financial stability be an explicit mandate of central banks?
21. Before the crisis, there was no answer to this question - not because there was an
intellectual vacuum but because no one really asked the question so pointedly.
22. Post-crisis, financial stability has come centre stage. One of the big lessons of this
crisis is that financial stability can be jeopardized even in an environment of price stability
and macroeconomic stability. It is even possible to make a stronger argument, based on the
experience of this crisis, that extended periods of price stability and macroeconomic stability
may indeed blindside policy makers to financial instability brewing in the underbelly. These
lessons from the crisis have triggered a vigorous debate on whether financial stability should
be made an explicit mandate of central banks.
23. There are powerful arguments for why central banks should be in the centre of the
financial stability function. Let me list a few important ones.
(i) Generally, monetary policy and financial stability are mutually supportive. This
interdependency between the two dimensions suggests that the central bank, with
inherent responsibility for monetary policy, should also be the systemic regulator in
charge of financial stability so that it can take a holistic view of policy options by
factoring in costs and benefits in both dimensions.
(ii) The responsibility of central banks for monetary policy is unquestioned. Because
banks are the conduits through which monetary policy decisions are transmitted to
the real economy, it is synergistic to entrust responsibility for prudential regulation of
banks also to the central bank. And if the central bank is the prudential regulator,
there is a strong case for it to be the systemic regulator.
(iii) By far the strongest argument in favour of entrusting the financial stability
responsibility to the central bank is that it is unquestionably the lender of last resort
(LOLR) for the financial system. A central bank can discharge its LOLR function
more efficiently if its mandate extends beyond merely monitoring financial
institutions to taking preventive action. This becomes possible if the central bank is
also the systemic regulator.
24. Developments around the world over the last few months reflect two clear
trends. - first, a decisive shift towards giving increased responsibility for both systemic
oversight and prudential regulation to central banks; and second, institutionalisation of
collegial arrangements involving the central bank, other regulators and the government, with
the primary responsibility of identifying threats to financial stability. The councils can make
recommendations for heightened prudential standards in the interest of the safety of the
financial system, but notably, not for forbearance or relaxations. The two seemingly
paradoxical trends make eminent sense and supplement each other.
25. A brief review of the situation around the world will be instructive in this regard. In
the US, the proposed Financial Stability Oversight Council is to be headed by the Treasury
Secretary and comprises the heads of the central bank and all the regulatory agencies.
However, the Act entrusts the Federal Reserve with powers of supervision over all bank
holding companies as well as any non-bank financial entity that can be a threat to financial
stability regardless of whether they are bank holding companies or not, and to oversee the
payment, clearing and settlement system. In Europe, recognizing the need for a specific
body responsible for macroprudential supervision across the EU financial system, it is
proposed to constitute a European Systemic Risk Council (ESRC) chaired by the President
of the ECB with central bank governors of the 27 member states, chairpersons of the three
European Supervisory authorities, and a member of the European Commission. The
chairperson of the Economic and Financial Committee (EFC) representing the finance
ministries will participate as an observer.
26. In the UK, there is a paradigm shift underway in terms of the institutional
arrangements for microprudential as well as macroprudential regulation. The new
Government has announced plans to: (i) shift the responsibility for prudential oversight from
the Financial Services Authority (FSA) to a new Prudential Regulation Authority (PRA) under
the Bank of England; and (ii) to set up a Financial Policy Committee within the Bank of
England to "monitor macro issues that may threaten economic and financial stability". The
Committee will comprise a representative of the Treasury, other regulators and external
members appointed by the Treasury. The Treasury will, however, lead coordination of action
in a crisis.
27. The above trends recognise that while all financial sector regulators and indeed the
sovereign have a role in maintaining financial stability, from an effectiveness and
accountability perspective and for preventing as well as managing a crisis, it is imperative to
enjoin the executive responsibility for financial stability to a single entity and that the central
bank is best positioned to be that single entity. The participation of and indeed coordination
by the finance ministries underlines their role in crisis management and resolution.
28. Where do we in India stand on this issue of financial stability? Historically, the
Reserve Bank has played a central role in preserving financial stability. As central banks go,
the Reserve Bank is a full service central bank. In addition to being the monetary authority,
we are the regulator and supervisor of banks, non-bank finance companies and of important
segments of the financial markets. We also regulate the payment and settlement system.
29. This unique combination of responsibilities for macroprudential regulation and
microprudential supervision together with an implicit mandate for systemic oversight has
allowed the Reserve Bank to exploit the synergies across various dimensions. The
microlevel information coming from supervision of individual institutions has been a valuable input
for shaping the macro perspective. Vice versa, the broad understanding from
macroprudential regulation has been effective in instituting prudential safeguards at the micro
institution level. The micro and macro level oversight has helped address systemic risk by
providing an insight into: (i) firm level risk and the collective behaviour of financial institutions
as well as interconnectedness in the financial system through the direct links between
financial institutions and the indirect links created through the financial markets; and (ii) the
close links of the financial system with the real economy and the potential for strong
feedback effects.
30. This is a system that has served us well. Just to give one example, in the years
before the crisis, sensing an unusual build-up of credit in certain sectors such as commercial
real estate, consumer credit and capital market exposure, the Reserve Bank, to use a phrase
that is now commonplace, "leaned against the wind" and tightened the flow of credit to these
sectors by raising the provisioning norms and risk weights. This is one of the important
factors that shielded us from the worst impact of the crisis. Again, as the crisis set in, and
reflecting the need to revive the flow of credit, these norms were reversed to normal levels.
What we did in India is a classic case of deployment of macroprudential tools to preserve
financial stability, action made possible by the Reserve Bank's broad mandate and the host
of instruments at its command. It is interesting, although not surprising, therefore that
increasingly the reformed regulatory models around the world are moving towards
resembling our model.
31. After all this exposition, let me return to the original question: "should financial
stability be an explicit mandate of the central banks?". Pre-crisis, as I said, there was no
answer; post-crisis, the answer is mostly "yes".
Question 4: Are controls an appropriate mechanism for managing the capital account?
32. Pre-crisis, the question was usually posed in the context of the problems
encountered by emerging market economies in managing the adverse impact of large and
volatile capital flows. The answer, flowing from the free market paradigm, was largely "no".
33. Critics maintain that capital controls are distortionary, largely ineffective, difficult to
implement, easy to evade and that they entail negative externalities. Furthermore, the costs
of imposing capital controls far exceed the potential benefits because financial markets
always outsmart policy makers. On the other hand, supporters of capital controls have
argued that controls are desirable because they preserve monetary policy autonomy, save
sterilization costs and tilt the composition of foreign liabilities toward long-term maturities and
ensure macroeconomic and financial stability. Pro-controllers also contest the argument
about the ease of evading controls; they contend that the cost-benefit calculus is not all that
decisive since efforts to evade controls and move funds in and out of a country entail
additional costs which is precisely what controls aim to achieve.
34. The debate on capital controls resurfaced after the Asian crisis of the mid-1990s
especially as the root cause of the crisis was traced to the open capital accounts of the East
Asian economies. Even so, the intellectual orthodoxy continued to denounce controls on
capital flows as being inefficient and ineffective. The debate on capital controls was not
pursued to a logical closure as the Asian economies recovered in quick order, regained their
export competitiveness and started building up external reserves for self-insurance.
35. The recent crisis has, however, been a clear turning point in the worldview on capital
controls. Evidence coming in is that emerging economies which have been more open have
been affected more than those which were less open demonstrating that premature opening
hurts more than it helps. This has prompted a review of the earlier dominant view that capital
controls are inadvisable - always and everywhere. Notably, the IMF1 put out a policy note in
February 2010 that reversed its long held orthodoxy. The note has referred to certain
"circumstances in which capital controls can be a legitimate component of the policy
response to surges in capital flows". The World Bank2 has noted that "capital restrictions
might be unavoidable as a last resort to prevent a crisis or mitigate its effects, should one
arise". The Asian Development Bank Outlook - 2010 observed that "carefully designed
capital controls can help guard against disruptive short term capital flows and prevent
extreme volatility in exchange rates".
36. So, what does all this rethinking suggest? It suggests that wisdom lies in festina
lente, as the Romans used to say - make haste slowly. Open up your capital accounts but
calibrate the opening to your domestic and external circumstances. In the context of this
lecture, the answer to the question, "are capital controls an appropriate mechanism for
managing the capital account?" has shifted from a qualified "no" pre-crisis to a qualified "yes"
post-crisis.
Question 5: Has fiscal dominance of monetary policy ended?
37. The answer before the crisis was "hopefully". That judgement is being revisited
amidst apprehensions that the extraordinary fiscal expansion by the advanced economies to
combat the crisis is actually mutating into structural fiscal deficits and that monetary policy
will have no choice but to accommodate continued elevated government borrowing into the
medium term. Most recently, we have all seen how the European Central Bank has had to
show unusual accommodation in resolving the sovereign debt crisis in some European
countries. Many fear that this is just the beginning of a trend whereby fiscal policies will once
again start dictating monetary stances.
38. The history of fiscal dominance of monetary policy is quite interesting. The eighty
odd years since the Great Depression saw a famous rivalry between monetary and fiscal
policy for influence. For at least three decades after the Great Depression, Keynes'
intellectual heritage ruled; governments borrowed as much as they wanted and at the price
they wanted without worrying about the implications of debt build-up, and central banks had
willy-nilly acquiesced in this profligacy.
39. This trend began to reverse as a result of very influential work during the 1960s by
Milton Friedman and others arguing that inflation is always and everywhere a monetary
phenomenon and that output gains from debt financed public expenditure will not only be
temporary, but also eventually inflationary. Supportive evidence for this came from the
repeated episodes of stagflation during the 1970, which saw a baffling combination of
unemployment and inflation. The belief that continued fiscal deficits are clearly not
sustainable gained ground during the 1980s especially as countries integrated into the global
system, and fiscally irresponsible economies realized that the world capital markets
penalized them by demanding higher premia.
40. The trend since the mid-1990s has been for a growing number of countries to adopt
fiscal rules placing limits on deficits and/or debt and also prohibiting primary financing of debt
by the central banks. One of the broad outcomes of this effort has been that central banks
found themselves relatively free to conduct independent monetary policy, not only free of
fiscal compulsions but also in a predictable fiscal framework. The environment of price
stability coupled with steady growth that characterized the Great Moderation came to be
seen as a vindication of the merits of freeing monetary policy from fiscal dominance.
41. That happy state of affairs ended in the aftermath of the crisis, and fears about fiscal
dominance of monetary policy have resurfaced. There are widely shared concerns about the
extraordinary fiscal expansion necessitated by the crisis, and when and how long it will take
to reverse that. But, by far the larger concern is not about the crisis related cyclical deficits
but about the structural fiscal deficits looming large in most advanced economies. Current
estimates are that rich countries will see a rapid increase in their social security payment
obligations because of ageing populations and shrinking workforces, and that they will need
to raise significant amount of debt year-on-year to finance these commitments. If that be the
case, monetary independence will remain circumscribed by fiscal compulsions into the
medium term.
42. The sovereign debt crisis in Europe over the past few months has turned out to be
yet another arena where the tensions between fiscal and monetary policies played out. What
characterizes monetary unions like the euro system is that member countries pursue
independent fiscal policies but do not have recourse to exchange rate or monetary policy
levers to make the adjustment needed. This underscores the importance of sound and
credible fiscal policies by member countries to ensure the independence and credibility of
their collective monetary policy. Absent that, monetary policy will become hostage to fiscal
excesses of individual members.
43. Where do we in India stand on this? It will be fair to say that we followed the global
trends, indeed more so. During the 1970s, and much of the 1980s, monetary policy was
almost totally hostage to fiscal policies. However, again following trends around the world,
there has been a gradual abatement of fiscal dominance of monetary policy starting the
1990s.
44. The easing of fiscal pressures on monetary policy has been a continuous process
but two discrete events marked significant milestones. The first was the agreement between
the Reserve Bank and the Government to completely phase out ad-hoc treasury bills from
April 1997, a move that saw the termination of the egregious practice of automatic
monetization by the central bank of the government's fiscal deficit. The second was the
enactment of the Fiscal Responsibility and Budget Management (FRBM) Act which, among
other things, prohibited the Reserve Bank from financing government debt in the primary
market with effect from April 2006.
45. Like in most countries, in India too, fiscal stimulus was part of the crisis response
and monetary policy had to acquiesce in elevated government borrowing. Going forward, the
challenge for the Government is to continue the fiscal consolidation that started with this
year's budget and for the Reserve Bank to regain the space to conduct monetary policy free
of fiscal compulsions.
46. What this broad review of the global and the Indian scenarios shows is that the jury
is still out on the issue of fiscal dominance of monetary policy. But it will be less than honest
not to acknowledge that the autonomy of monetary policy from fiscal compulsions is once
again under threat, and resolving that threat requires credible efforts by both governments
and central banks.
47. So, in the format of this lecture, the new answer to the question, has fiscal
dominance of monetary policy ended, is the same as the old one. "Hopefully".
Conclusion
48. That brings me to the conclusion of old questions and new answers. As I sign off, I
want to say that this crisis has been a reminder, if one was required, of the need to question
conventional wisdom and approaches. Like Sir Chintaman, who presided over a time when
the world, as well as the national, political, economic and financial order was undergoing
radical transformation, we too stand on the cusp of what may be a significant turning point in
the international financial architecture. The best tribute we can pay to Sir Chintaman Deshmukh
is to remember that we can make progress only if we are willing to accept new answers to
old questions when circumstances change.