Archive for March 29th, 2008

How right is criticizing India’s financial sector policies?

March 29, 2008

There are two flavors of the season people are writing on:

1) India’s financial sector policies and
2) Financial Innovation.

The majority of the articles says Indian policy framework is poor and financial innovation is useful.

I don’t know the reason why our financial sector policymakers are criticised. Experts say they have curbed our financial system, made it antediluvian, have limited variety of financial products.

Most criticism (perhaps entirely) is directed towards the Central Bank. The reasons are:

  • Managing the impossible trinity – Some even say if RBI has to manage the exchange rate it should give up monetary policy!. I have looked at the problem here and have shown it is not really RBI’s fault. It is sticking on the mandate given to it by the government. So, it is not right to criticise RBI but instead ask government to change RBI’s mandate. All Central Banks work as per the mandate given to them by their respective governments.
  • Inflation Management:  The analysts didn’t like RBI not cutting the rates in the January Monetary Policy meeting. RBI maintained its inflation stance and as current inflation numbers show, it former seemed to be right. The same analysts criticised RBI earlier in 2007 saying inflation is very high if we look at the CPI numbers and RBI is not tightening enough. RBI didn’t raise the rates as it expected inflation to come down (which it did) and didn’t cut rates as it expected inflation again to surge (which it did again).
  • Not allowing capital account convertibility- Well the experts hold empirical research close to their heart on first point which shows in an open economy central banks should only manage inflation and let exchange rates float. But on this topic they seem to ignore the research. The most comprehensive research from Rogoff et al shows benefits from capital inflows are at best limited.
  • For not allowing exchange traded derivatives in exchange rate products, interest rate etc: This is perhaps one of the most funny things I have heard. The experts have now started blaming the RBI for the recent exchange rate derivative mess. Just because the Banks and corporates got greedy and took bets on the currency doesn’t mean exchange rate derivatives would have helped. These derivatives essentially trade on an OTC market as they are designed on the basis of the client . Introducing exchange traded derivatives would have hardly helped.

    And then most experts criticising RBI have been on committees that looked at developing these derivative markets. The markets didn’t take off and then it took sometime to launch them again.

The idea behind this post is not to defend the Central Bank but to point it is not really its fault. No one disputes the benefits of the reforms in the financial sector but it has to move ahead with real sector.

The monetary transmission in India is still not as robust as developed economies and things work with a bigger lag. So we have to wait. The main issue is we need reforms in real sector to let things become better. The Doing Business report shows it is becoming more difficult to do business in India. Finance and its policies only work if we have things moving in real sector. Most analysts assume it to be an assumption which we all know is just that- an assumption.

However, one area where the Central Bank can surely do better is to communicate. The markets need more cues from the Central Bank especially in India where we have very little data coming and enormous focus on Indian markets.

I will write on the financial innovation debate later. I have actually expressed my initial views here

Assorted Links

March 29, 2008

1. WSJ Blog points to a Possner speech where he says don’t overestimate monetary policy. It also has a nice explanation of the Fed Soup.

2. WSJ Blog points to Jo Stigilitz’s prolific paper writing

3. Fin Prof on Bear Stearns after fallout effects. It also points to a paper on technical analysis


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