Archive for October 6th, 2009

A snapshot of European Systemic Risk Board

October 6, 2009

European Commission has recently set up proposals to establish two bodies:

  • a European Systemic Risk Board (ESRB) to monitor and assess risks to the stability of the financial system as a whole (“macro-prudential supervision”). The ESRB will provide early warning of systemic risks that may be building up and, where necessary, recommendations for action to deal with these risks.

  • a European System of Financial Supervisors (ESFS) for the supervision of individual financial institutions (“micro-prudential supervision”), consisting of a network of national financial supervisors working in tandem with new European Supervisory Authorities, created by the transformation of existing Committees for the banking securities and insurance and occupational pensions sectors. There will be a European Banking Authority (EBA), a European Insurance and Occupational Pensions Authority (EIOPA), and a European Securities and Markets Authority (ESMA).

    The ESRB will have the power to issue recommendations and warnings to Member States (including the national supervisors) and to the European Supervisory Authorities, which will have to comply or else explain why they have not done so. The heads of the ECB, national central banks, the European Supervisory Authorities, and national supervisors, will participate in the ESRB . The creation of the ESRB is in line with several initiatives at multilateral level or outside the EU, including the creation of a Financial Stability Board by the G20.

    Regarding micro-prudential supervision, currently there are three financial services committees for micro-financial supervision (supervision of individual financial institutions) at EU level, with advisory powers only: the Committee of European Banking Supervisors (CEBS), Committee of European Insurance and Occupational Pensions Committee (CEIOPS) and the Committee of European Securities Regulators (CESR).

    • The new Authorities will take over all of the functions of those committees, and in addition have certain extra competences, including the following:
      • Developing proposals for technical standards , respecting better regulation principles;
      • Resolving cases of disagreement between national supervisor s, where legislation requires them to co-operate or to agree ;
      • Contributing to ensuring consistent application of technical Community rules (including through peer reviews);
      • The European Securities and Markets Authority will e xercise direct supervisory powers for Credit Rating Agencies;
      • A c oordination role in emergency situations

    Here are FAQs on ESRB and ESFS.

    Lorenzo Bini Smaghi sums up the challenges and issues of having a European Systemic Risk Board. Anything to coordinate in Europe is so difficult. That is all the more why ECB is such a unique institution. To have a monetary policy for 16 countries is a mighty task. There are so many factors. That is also the reason why ECB should be evaluated differently. Plainly looking at efficiency of monetary policy will not work. It has too many constraints. One of the best constraint for ECB I read was this:

    Otmar Issing: “Translation was, of course, linguistically always very good, but the same words and phrases may seem different against the background of different historical experiences. For example, one colleague once said to me, Otmar, we have a paragraph containing three times a reference to price stability. I think this is too much for this argument. In my country, if you say three times why you seek price stability, it weakens your argument. And my argument was, if in Germany its only two times, they say, Oh, is the ECB less stability oriented than the Bundesbank? 


    Political economy of Bundesbank Monetary Targeting

    October 6, 2009

    I was reading this interesting paper by Jurgen Von Hagen. It was written in 1998.The paper reviews Bundesbank’s monetary targeting strategy from a political economy angle. Bundesbank and its successful monetary targeting strategy has always been a mystery for me. Bundesbank and Swiss National Bank were the only central banks that succeeded in adopting a monetary targeting strategy. Rest all failed. Mishkin in his paper points to this memorable quote:

     Gerald Bouey, the Governor of the Bank of Canada describing the situation by saying, “We didn’t abandon monetary aggregates, they abandoned us.”

     Coming back to the paper, it says:

    The recent debate over monetary strategies concludes that monetary and inflation targeting lead to very similar patterns of central bank behavior. Why, then, do central banks insist on the strategies they use. In this paper, we develop an answer from political economy, arguing that monetary strategies are helpful in solving internal and external coordination problems for the central bank. We illustrate the point by reviewing the Bundesbank’s experience with money growth targeting in the mid-1970s. Monetary targeting was a signal that the previous monetary regime had been overcome, and a means to define the role of monetary policy vis-a-vis other players in the macro economic policy game, and to structure the internal monetary policy debate.

    The main idea behind the paper is:

    Today’s discussion about monetary strategies raises an interesting puzzle. On one side of the debate, macro economists continue to follow the tradition of Poole (1970) and analyze the performance of alternative monetary strategies in the framework of stochastic macro models; see e.g. Svensson (1997, 1998). They regard the choice of a monetary strategy as part of an optimal control problem that depends on issues such as the stability of the demand for money and the relative variances of shocks to the real and the financial sector.

    On the other side of the debate, central bankers have noted that the close similarity in the use of central bank instruments and the reaction of central banks to news and shocks under inflation forecast and monetary targeting, suggesting that strategy choice does not seem to matter much for the day-to-day conduct of monetary policy; see e.g. Freedman (1996), King (1996).

    In the same vein, Clarida and Gertler (1996), Bernanke and Mihov (1997), Clarida et al. (1998), and Mishkin (1998) all argue that the Bundesbank’s conduct of monetary policy looks much like what one would expect under an inflation target. But Groeneveld et al. (1996) point out that inflation targeting seems to have made little if any difference for empirical inflation and interest rate dynamics in the countries that adopted this strategy in the 1990s, and Almeida and Goodhart (1996) find no significant change in the conduct of interest rate policies of six inflation-targeting central banks. Are all monetary strategies the same, and do monetary policy strategies not matter after all?

    But why, then, do central banks make efforts to identify and defend their monetary strategies? The answer we develop in this paper focuses on political economy. Our analysis deviates from the conventional analysis of monetary strategies in two regards. One, we emphasize that central banks are no unified actors. Instead, monetary policy decisions involve many different individuals with different preferences and different views of the economy. Two, we emphasize that many of the shocks central banks face are not exogenous but rather the result of deliberate actions of other actors in the economic policy game. Central banks can use monetary strategies to structure internal decision making problems and to shape the form of the policy conflict with other actors.

    Read the paper for details. It is minus all the mon pol theories which we are so used to reading on central banks and price stability. Things like time inconsistency, anchoring inflation expectations,  targets, independence etc ect are given a complete miss here. What we instead get is an interesting insight into the choices Bundesbank has and makes given the political constraints.

    The monetary targeting may have economic reasons but one of the main reasons why it succeeded in Germany is because there was wide political acceptance to the framework. There was a lot of dissent as well but it was seen as a useful way by both political parties and Bundesbank officials to tell the people about the mon pol strategy. Again not that economics does not matter, but politics has a major role. A central bank no matter how independent it is basically created by govt machinery.

    This is something which most central bank/mon pol economists ignore. Well all would want to have a independent, transparent central bank only looking at price stability. But the political economy situation is different for all economies. Some economies go through hyperinflation and see the immediate need to have a central bank which is independent. Some never face it and don’t value it as much (like India for e.g. India has had inflationary episodes but none of the hyper variety). Then who would look at banks, financial system? There are many actors in an economic system and central banks are needed in all aspects of economic activity (whether they like it or not, RBI has to look at agriculture economics and developments).

    So, when I am evaluating monetary policy of a central bank, I would also want to look at these political factors. By doing it the Svensson way, the central bank may be seen as inefficient, but political economy wise, it may have little choice. Monetary Policy economists need to look at a central bank differently. It really is not as simple as it is made out to be.

    Five concerns for Indian economy

    October 6, 2009

    Dr Subbarao gives another useful speech on the concerns for Indian economy. He lists 5 concerns:

    • First Concern: Exit from Accommodative Monetary Policy: Growth vs. Inflation
    • Second Concern: Management of Large and Volatile Capital Flows
    • Third Concern: De-clogging Monetary Transmission Mechanism
    • Fourth Concern: Fiscal Stimulus – Withdrawal and Quality of Adjustment
    • Fifth Concern: Financial Stability, Financial Inclusion and Growth

    In Fourth concern he says:

    21. Like in other economies, fiscal stimulus measures and weakening of economic activity have led to substantial increase in our fiscal deficits. The Central Government’s fiscal deficit is budgeted to jump from 2.7 per cent of GDP in 2007-08 to 6.8 per cent in 2009-10; the combined fiscal deficit of the Centre and the states is expected to increase from 4.2 per cent of GDP to 10.2 per cent over the same period. These deficits are large and need to be rolled back. What is the scope for adjustment? What lesson does our past experience offer?

    22. As a result of the discipline imposed by the Fiscal Responsibility and Budget Management (FRBM) Act, the Centre’s fiscal deficit came down from 6.2 per cent of GDP in 2001-02 to 2.7 per cent in 2007-08. Over the same period, the deficit of the state governments declined from 4.1 per cent of GDP to 1.5 per cent. Thus, we saw a large adjustment over a relatively small period. This past experience with fiscal adjustment may raise hopes that we will be able to roll back the recent fiscal deficits.  Such a simplistic approach may be misleading. A large part of our fiscal deficit is structural and not cyclical. Also, at least a part of fiscal consolidation resulted from high growth, not the other way round. It is important to acknowledge this in order to define the problem and assess the enormity of the challenge.

    23. Three issues are important in this context. First, this concept of ‘fiscal adjustment over a cycle’ is inadvisable for us. Adjustment over a cycle is for mature and advanced economies. Even there it does not work – the UK, for instance, was running its highest fiscal deficit at the peak of the economic cycle. We will be safest sticking to a single formula and tying ourselves down to annual, inflexible targets. This is a blunt but safe way of de-linking fiscal adjustment from democratic pressures. Second, we must focus on the quality of fiscal adjustment, not just chase a numerical target. The ratio of capital outlay to GDP for the Central Government has stagnated between 1 and 2 per cent of GDP since the early 1990s from around 2-3 per cent in the preceding decade. Third, we cannot sit back and hope that tax increase will deliver fiscal consolidation on a platter. Revenue expenditure has increased from around 12 per cent of GDP during the period 2000-08 to over 15 per cent now. We need to work seriously on expenditure compression. This is going to be politically challenging both at the Centre and in the States, but it needs to be done regardless.

    Taking the fiscal concerns heads on.

    In fifth concern he says we need to ensure more stringent financial regulation does not lead to financial exclusion:

    Given the enormity of the crisis, financial sector regulation is being tightened under the aegis of international bodies such as the BCBS and FSB. There are proposals that would raise the reserve requirement of banks. New regulations for liquidity requirements are also going to be in place. There are also proposals to require banks to hold government securities. Many of these measures are necessary. But we need to recognise that all such proposals will have the impact of increasing the banks’ funding costs which will translate into higher lending rates. How will banks react to such higher costs? Will this lead to an erosion of banks’ social responsibility towards the poorer and other needy segments of the society? In economies such as India, a large part of population remains financially excluded. We will need to ensure that efforts at financial inclusion do not get negated by the ongoing tightening of the regulatory regime.

    26. In order to safeguard financial stability, we have traditionally used a variety of prudential measures such as specifying exposure norms and pre-emptive tightening of risk weights and provisioning requirements. But these measures are not always costless. For instance, tightening of risk weights arguably tempers the flow of credit to certain sectors, but excessive, premature or unnecessary tightening could blunt growth. Similarly, exposure norms offer protection against concentration risks; however, such limits could restrict the availability of credit for important growth sectors. This is a live issue in our country in the context of the immense needs of infrastructure financing. Thus, as in the case of price stability, central banks face the challenge of managing the trade-off between financial stability and growth.

    27. It needs to be recognized that after a crisis, with the benefit of hindsight, all conservative policies appear justified. But excessive conservatism in order to be prepared to ride out a potential crisis could thwart growth and financial innovation. The question is what price are we willing to pay, in other words, what potential benefits are we willing to give up, in order to prevent a black swan event? Experience shows that managing this challenge, that is to determine how much to tighten and when, is more a question of good judgement rather than analytical skill. This judgement skill is the one that central banks, especially in developing countries such as India, need to hone as they simultaneously pursue the objectives of growth and financial stability.

    Another food for thought speech from Dr Subbarao.

    Reserve Bank of Australia first to press exit policy

    October 6, 2009

    Reserve Bank of Australia is perhaps the first central bank to start its exit policiy from the monetary stimulus. It increased its benchmark Cash Rate from 3.00% to 3.25% in mon pol meeting held today morning (6 Oct 2009).

    Australia was not as badly impacted by the crisis and was quite robust and higher than expectations. Governor’s statement in the end says:

    In late 2008 and early 2009, the cash rate was lowered quickly, to a very low level, in expectation of very weak economic conditions and a recognition that considerable downside risks existed. That basis for such a low interest rate setting has now passed, however. With growth likely to be close to trend over the year ahead, inflation close to target and the risk of serious economic contraction in Australia now having passed, the Board’s view is that it is now prudent to begin gradually lessening the stimulus provided by monetary policy. This will work to increase the sustainability of growth in economic activity and keep inflation consistent with the target over the years ahead.

    Hmm….this is quite interesting. All other developed central banks are still saying we will continue to stimulate. There was even talk of coordinating exit policies. So, which one is next? New Zealand?? India??

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