Fixing the unsustainble global imbalances is the main lesson of this crisis

Dr Subbarao’s speeches (and mon pol statements) just get better and better. His recent speech(JRD Tata Memorial Lecture -2009) is a must read for number of purposes:

  • He provides some good anecdotes abt JRD and RBI meetings (he was a board member)
  • Reviews the global crisis and its impact on India
  • Poliy responses in India
  • He points most policy responses and discussions have missed talking about how to fix unsustainable global imbalances. We can’t eliminate imbalances as some countries deficit would be matched by surpluses in others. What is imp is to limit the growing deficits and surpluses.
  • The fiscal and mon policy have intervened but the conflicts between them have once again come to limelight (high fiscal deficits lead to more borrowing and bonds, central banks buying govt bonds to provide monetary stimulus etc)
  • Fiscal and Mon Pol coordination in India
  • Why India cannot go for Inflation targeting (see this as well)
  • Finance Sector should follow real sector and not the other way round

What was very interesting was his mention of fiscal and mon pol in India:

The countercyclical spending by the government and the accommodative monetary policy of the Reserve Bank were both necessary in order to cushion the economy from the onslaught of the crisis. Nevertheless, the sudden and rapid expansion of government borrowing programme has impeded monetary transmission.  Last year, the final net government borrowing was two and a half times the original budget estimate. This year’s budgeted borrowing is going to be at least a third higher than that. The intent behind Reserve Bank’s monetary easing was to encourage banks to reduce lending rates and maintain the flow of credit to the productive sectors.  But government borrowing had resulted in firming up of yields, notwithstanding the substantial excess liquidity, militating against the low interest rate regime that we want.

This is exactly the interest rate dilemma I talked about. However, he is not happy as it puts a lot of pressure on RBI.

The huge government borrowing programme demanded active liquidity management by the Reserve Bank, and we responded by way of open market operations (OMO). For the first time we put out the programme for the OMO along with the programme for borrowing so as to reduce uncertainty and infuse confidence in the market. This year again, the Reserve Bank will have to manage the delicate balance between government borrowing and maintaining ample liquidity to meet the demand for private credit as it picks up in the months ahead. We will follow the same open, transparent and consultative process as we did last year.

And the challenges are expected to continue.

Going forward, we need to tread the balance between short term compulsions and medium term sustainability with care and good judgement. In the short term, the countercyclical public spending was necessary; the important point here is to spend that money quickly, effectively and to create durable assets. On the monetary side, the increased fiscal deficit is going to pose more than a proportionate challenge. Creation of high power money in the face of large fiscal deficits, even if there is no direct primary financing, is not costless; it can sow the seeds of the next inflationary cycle. The challenge for the Reserve Bank is to maintain a comfortable liquidity situation while at the same time anchoring inflation expectations.

Wow! This is some plain, frank and great talking on the concern of fiscal deficit for RBI. 

His comment on why RBI cannot adopt Inflation targeting as suggested by Percy Mistry report and Raghu Rajan report are also worth reading.

Where do we in India stand on inflation targetting? Over the last few years, there has been an animated debate in India on inflation targeting fuelled by two influential studies, one by Percy Mistry and the other by Raghuram Rajan. While Mistry strongly urged that the gold standard for stabilizing monetary policy is a transparent, independent, inflation-targetting central bank, Rajan held that reorienting RBI towards inflation targetting will have to dovetail with the government’s commitment to maintain fiscal discipline and not hold the central bank accountable for either the level or the volatility of the nominal exchange rate.

The debate on inflation targetting in India has to some extent been overtaken by the learnings from the crisis. Nevertheless, it is worthwhile noting that inflation targetting is neither desirable nor practical in India for a variety of reasons. I will defer a detailed exposition on this issue to another forum; I will allude here only to the important reasons.

  • First, it is inconceivable that in an emerging economy like India, the central bank can drive a single goal oblivious of the larger development context. The Reserve Bank must be guided simultaneously by the objectives of price stability, financial stability and growth.
  • Second, food items which have a large weight (46 – 70 per cent) in the various consumer prices indices are vulnerable to large supply shocks, especially because of the vagaries of the monsoon, and are therefore beyond the pale of monetary policy. An inflation targeting RBI cannot do much to tame a supply driven inflation except as a line of defence in an extreme situation.
  • Third, which inflation index do we target? In India, we have one wholesale price index and four consumer price indices. There are ongoing efforts at a technical level to reduce the number of consumer price indices, and I believe the technical issues are not insurmountable. But that still will not give us a single representative inflation rate for an emerging market economy with market imperfections, diverse geography and 1.1 billion people.
  • Fourth, the monetary transmission mechanism in India is impeded because of the large fiscal deficits, persistence of administered interest rates and illiquid private bond markets. Inflation targetting can be efficient and effective only after monetary transmission becomes streamlined.
  • Finally, we need to manage the monetary fall-out of volatile capital flows that queer the pitch for a single focus monetary policy. A boom-bust pattern of capital flows can lead to large disorderly movements in exchange rates rendering both inflation targeting and financial stability vulnerable. Like other emerging economies, India too will have to navigate the impossible trinity as best as it can.

Fantastic stuff. It can’t get better. Managing impossible trinity is not an ideal  choice but emerging eco central banks have little choice (see my papers on this here and here)

Niranjan Rajadhyaksha of Mint says Subbarao is his own man. After some initial criticism that he is a finmin man but has clearly made his mark as an independent central banker as he nears one year of completing his tenure at RBI. I think most would agree on this.


5 Responses to “Fixing the unsustainble global imbalances is the main lesson of this crisis”

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