National policies alone cannot prevent a crisis : RBI’s International Research Conference concludes.

Give the known challenges, every central bank has to move in the direction of taking right steps that it may feel as appropriate despite lack of consensus on many critical issues, without waiting for the global system to move. It would be wrong, however, as noted by Mr. Stephen Roach, to presume that “best global policies are the sum of the best national policies”. In a globalised world, national policies alone, despite being the most appropriate, cannot prevent a crisis unless some of the global challenges are addressed collectively at the global level. This was one prominent message that came out of the two-day conference, the Reserve Bank of India had organised.

The Reserve Bank had organised the first international research conference on February 12 and 13, 2010 at Hotel Trident, Nariman Point, Mumbai. The theme of the conference was “Challenges to Central Banking in the Context of Financial Crisis”. The conference was the flagship event of the Reserve Bank’s Platinum Jubilee celebrations. In the context of the numerous challenges for central banks that have come to the forefront in the aftermath of the global crisis, this conference was viewed at the planning stage itself as an opportunity to seek suggestions and opinions from some most prominent policy makers and economists in the world on feasible options to deal with these challenges.

More than 50 international dignitaries, including seven Central Bank Governors, several Deputy Governors, academicians and eminent personalities from international financial organizations, such as, the IMF, the World Bank and the Bank for International Settlements participated in the conference. In addition around 50 domestic experts including chairmen of nationalised banks, private banks and other financial institutions as well as eminent personalities from academics, financial sector and media also participated.

There were several other key messages from the conference.

These were:

  • There was no consensus on the role of monetary policy for directly doing anything about asset prices and no one view was expressed on whether financial stability could be an explicit mandate of monetary policy.
  • LOLR and regulation were, however, generally seen as potential instruments to safeguard financial stability, though not enough.
  • There was no clear direction to resolve the impossible trinity, implying that countries have to adopt their own approach.
  • The need for macro-prudential regulation as an important, if not sufficient, next step was recognised. How financial innovations, with appropriate precautions, could contribute to high global growth, more particularly in emerging market and developing economies, was explained.
  • LOLR cannot solve insolvency problems was another key message.
  • The debate on what could be an appropriate Bagehot rule for the 21st century will continue.
  • It was also viewed that different dimensions of central bank independence may come under threat if high debt levels of the governments persist over protracted periods of time.

Summary of Sessionwise Deliberations

The conference started with the welcome remarks by Mr. Deepak Mohanty, Executive Director, Reserve Bank of India. In the inaugural address that followed,   Dr. Subbarao, Governor, Reserve Bank of India indicated why central banking could change in important ways after the crisis and how seeking solutions to the many challenges would be important for enhancing the contribution of central banks to the society at large in more effective ways and thereby regain greater credibility.

Setting the tone for the conference proceedings, reflecting in essence the expectations from the deliberations to follow, the Reserve Bank Governor outlined five key challenges of significance to all central banks in the current context:

*        managing national monetary policy decisions in a globalising environment, given the growing complexity in the interactions between external developments and domestic variables,

*        redefining the mandate of central banks, given the pre-crisis attraction of inflation targeting and the post-crisis debate on  the role of  central banks in relation  to asset prices,

*        the responsibility of central banks towards financial stability, particularly beyond the conventional Lender of the Last Resort (LOLR) function, and

*        managing the costs and benefits of regulation, in view of the difficulty in drawing a fine balance between  regulation and financial innovations, and

*        the autonomy and accountability of central banks, particularly in the context of  fiscal exit plans of countries as well as  possible  alteration to the  mandates of central banks.

The issues emphasised by the Governor in his opening remarks conveyed the message that in a globalising world, central banks need solutions to common challenges, even though the nature and magnitude of the challenge could vary across countries.

Noble Laureate Andrew Michael Spence in his enlightening keynote address questioned the Washington Consensus, the often highlighted formula for success, which presumed limited role for the Government. He highlighted the role of public investment in emerging market economies, both for human capital formation and addressing the infrastructure constraint to growth, besides promoting inclusive growth. The broad macroeconomic challenges for such economies, he stressed, include good governance, management of exchange rate, sequencing of capital account, real sector reforms – balancing job creation versus job destruction and the fiscal situation. He outlined four clear roles for central banks which are more or less established. These are managing inflation, managing shocks – both external and internal, managing volatility – with skill and judgement and achieving a level of autonomy while acquiring credibility.

He supported further extension of the role to cover financial stability, particularly given the challenges from asset prices, leverage and regulatory gaps. He suggested the extension of the role because, he felt that that: (a) Central banks have the comparative advantage on macro-prudential issues; (b) They have the information advantage; and (c) there is a general concentration of analytical talent in central banks.  He wondered that whether national governments will delegate that much of extra power to central banks remains a fundamental question.

The first technical session started with the paper by Wiliam Poole questioning the role of discretion in the conduct of policies. His aversion to policy discretion was evident from his concluding remarks that “…we should not be dependent on the expertise of policy makers and the timeliness of congressional action to stabilise the economy”.

The next paper by Benjamin Friedman highlighted that neither, self-regulation and vigilance by creditors, represent effective substitutes for regulation, which has to be the “responsibility of public policy to provide”. Regulatory systems, however, should differentiate inherently “risk taking trading” from “banking”, and differentiating “hedged positions” from “naked positions” should not be difficult for regulators.   He underscored the point that in a financial crisis, the distinction between illiquidity and insolvency generally disappears, creating testing conditions for real life use of the Lender of Last Resort (LOLR) function by a central bank. He recommended that central banks should distinguish between “losses that are reflections of genuine losses to the economy and losses that represent merely one side or the other of a zero-sum bet” and deny  access to the LOLR facility to such institutions that fail because of taking zero-sum bets.

The paper by Lars Svensson stressed the relevance of “flexible inflation targetting” even after the global crisis, which is particularly important in the context of the apprehensions expressed in some quarters about inflation focussed monetary policy involving  possible neglect of asset price bubbles and financial stability objective. Svensson elaborated as to why “asset prices” and “financial stability” should not be explicit objectives of monetary policy, but how both are important from the standpoint of the constraints they could pose for the monetary policy transmission process. He did not find merit in the argument that flawed monetary policy stance before the crisis contributed to the crisis, since use of interest rates for attaining financial stability objective would have made little or no difference to stop the credit and housing bubble, but in that process might have caused considerable collateral damage to the real economy. The best instruments to achieve financial stability, he felt, are supervision and regulation, including appropriate bank resolution mechanisms.

The second session that aimed at unraveling the challenges posed by increasing globalisation to central banks, started with the paper by Irma Rosenberg on a topic of immense direct policy relevance to most emerging market economies, i.e, the impossible trinity. Rosenberg explained the unpleasant trade-off associated with ‘impossible trinity’ and noted that “…the choice of monetary policy and exchange rate regime is neither simple nor clear cut”. She viewed that many emerging market economies in practice have intermediate solutions. She also highlighted that  more favourable growth prospects in emerging Asia, the possibility of interest rate in advanced countries remaining low for extended period and the associated carry trade possibilities could trigger   another wave of surge in capital flows to the Asian emerging economies, which has  to be managed. How these countries approach to resolve the trade-off, she stressed, could have consequences for the world economy. She concluded with the observation that “…since almost all advanced countries have chosen a monetary union or a float, there are good reasons for believing that other countries, when their capital flows are free and their financial infrastructure is complex and rich, will do the same.”

The cost of delayed fiscal exit has been a general concern world over, and in this context, the paper by Stephen Cecchetti, M.S. Mohanty and Fabrizio Zampolli cautioned that the fiscal problems of industrial economies could be much larger than the official debt figures seem to suggest now. This could be on account of two factors, namely (a) pressure on revenues associated with possible permanent loss of potential output, and (b) rapidly aging population and the large and growing unfunded related liabilities.  They emphasised that fiscal problems of industrial countries need to be tackled relatively soon and resolutely, which could otherwise complicate the task of central banks in controlling inflation in future and might ultimately even threaten the credibility of monetary policy arrangements. They explained two channels through which unstable debt dynamics could lead to higher inflation: (1) direct monetisation of debt and (2) the temptation to reduce the real value of government debt through higher inflation. The current institutional setting of monetary policy in the advanced economies, however, may ensure that both risks remain contained, at least for now. The market assessment of sovereign risk, though, seems to be changing, unlike the pre-crisis perception that sovereign papers carry no risk.

Since the global crisis has generally been viewed as the result of weaknesses in the regulatory and supervisory systems, the focus of the next session was to deliberate on options and challenges to fix them. The paper by Stephen Roach highlighted the need for both a new approach to regulatory oversight that incorporates “macro-prudential regulations” and a major reworking of the mandate of monetary policy to include financial stability.  He rejected the idea that post crisis search for remedy should include only regulatory measures. The past approach of monetary policy to asset prices would not change, unless financial stability is mandated as an explicit objective. The pre-crisis mainstream view on the role of monetary policy with regard to asset prices has been so overwhelming that, as stressed by him, “..central banks cannot be relied upon to break bad habits on their own”. Temptation of ideological debates and discretionary policy response could be avoided by a more rule-based approach with financial stability mandate. One important message of this paper was that regulatory action is important, but that is no substitute for monetary policy. “…regulatory action can send an important message to market participants.  But the policy rate is a far more powerful enforcement mechanism,” Mr. Roach stated and added that a financial stability mandate could also help in adding clarity and direction to the “current ad hoc approach to evaluating hows and whens of the exit strategy”.

Financial innovations clearly contributed to the crisis and the excesses in an inter-connected financial system generally went unnoticed. The risk of excessive regulatory response to the crisis stifling innovations has been a general concern. The paper by John Lipsky provided valuable insights and direction on the current debate on the subject. He cautioned that “without a renewed effort to foster financial innovation in the global economy, all countries – including emerging market economies – will underperform their potential”. Innovations, according to Mr. Lipsky, could perform three important tasks: first, open up new markets, such as markets for long-term financing and efficient risk sharing; second, deepen liquidity in existing markets; and third, raise the quantity and quality of investment. Instead of recommending a one-size-fits all approach to financial innovations, he noted that each country should “find its own approach to fostering appropriate and useful financial innovations”. He concluded by emphasizing that “…financial innovations will continue to play an important role in raising growth globally, but especially in emerging markets and developing countries”.

One technical session was devoted to examining whether financial stability should be an explicit objective of monetary policy and whether the absence of such a mandate contributed to the crisis.  Central banks have an implicit role relating to financial stability because of the Lender of the Last Resort (LOLR) Function.  John Williams, in his paper titled two cheers for Bagehot, explained how the Bagehot of 21st century looked like in the US when the Fed responded to the sub-prime crisis with its liquidity injection methods. There are, however, limits to the Bagehot prescription, i.e., LOLR cannot address the insolvency problem. Williamson emphasised that  “…issues of insolvency cannot be solved by central bank liquidity policies. These are properly the domain of the fiscal authority”. He also viewed that “…institutions with inadequate liquidity and risk management emphasize from the actions of the Fed and the Government, undermining the effectiveness of market discipline”.Another dimension of central banking activities which gained prominence after the crisis is the size and composition of the balance sheets of central banks.  The paper by Krishna Srinivasan outlined the key policy actions central banks had to adopt “nimbly, decisively and creatively” to alleviate the financial crisis, and examined their effectiveness.  The scale and nature of unconventional measures differed across major central banks due to differences in institutional arrangements, the relative importance of banks in credit allocation, the degree of distress in the financial markets, and the depth and timing of recession or slowdown. In designing the exit strategy, he stressed that three aspects may have to be given particular attention; first, careful and consistent communication, second, unwinding should not  compromise central bank independence, and third, international spillovers of differentiated exit should not be ignored. Large and protracted increase in Government debt in many countries may tempt the governments to put pressure on central banks to maintain the accommodative stance. In this context he stressed that “to avoid return to damaging high inflation and preserve policy credibility, all the key dimensions of central bank independence – institutional, operational and financial – need to be respected and reinforced where necessary”.

The technical discussions deliberated extensively on the key challenges for central banks and options to deal with them. After these sessions, views of the central bank governors, who face the real challenge on a day-to-day basis and deliver without the benefit of hindsight, were elicited. In the two panel discussions with Mr. Martin Wolf as the moderator, Governors of eight central banks offered their candid views on ten important issues, with the flavour of country-specific positions interspersed with their own global perspectives. The theme for the first panel – domestic monetary policy – covered five important issues, namely (a) the implications of the crisis for inflation emphasize; (b) the role of asset prices in monetary policy formulation; (c) the role of central banks in managing crises; (d) the role of central banks in regulation; and (v) exit from the crisis measures.

Governor Christian Noyer of Bank of France advocated that financial stability should be the second pillar of strategy. Financial imbalances are better addressed by macro-prudential policy and there is a need to better understand the interactions between monetary and macro-prudential policy.

Governor Glenn Robert Stevens of Reserve Bank of Australia put forward the argument that notwithstanding the questions raised about the utility of inflation targeting in the current crisis, it would be wrong to abandon it completely. Instead, it would be useful to develop a more realistic model explaining the interactions between the financial sector and monetary policy.

Governor Tarisa Watanagase of Bank of Thailand outlined the need for emphasiz more on supervision rather than regulation. Financial stability should be part of central bank’s mandate so as to maintain sustainable growth and prevent boom-bust cycles. He said that more corrective efforts are required in areas such as risk awareness, risk management, moral hazards associated with policy response to crisis and the right kind of policies for creating right incentives.

Dr. Subbarao, Governor, Reserve Bank of India, was emphatic that a lesson from this crisis is that pure inflation targeting does not work, because price stability, though necessary, is no guarantee against financial stability.  He also explained why India has not adopted explicit inflation emphasize, even though price stability is clearly one of the overriding objectives of the Reserve Bank.

The theme for the second panel discussion – International Monetary System – covered five key issues, namely (a) Exchange rate policies and reserves accumulation; (b)  Management of capital flows; (c)  Future of the global reserve system; (d)  Reform of the International Monetary Fund; and (e) The potential for developing regional monetary arrangements.

Governor Mark J Carney of Bank of Canada emphasized that the important issue right now is that of adjustment mechanism between surplus and deficit countries rather than a single currency dominance or the issue of reserve currency.

Governor Miguel Fernandez Ordonez of Banco de Espana stated that “We must emphasize the significance of unprecedented coordinated action led by G20 in avoiding another great depression and in view of the expected difficult years ahead, we must sustain the global approach despite domestic differences in  policies.”

Governor Atiur Rahman of Bangladesh Bank underscored the point that the international system should reorient itself to take into account the concerns of low income countries. In this regard, he emphasized the role of discussions of India with other Asian countries in forums like ACU, SAARC FINANCE etc.

Managing Director Daw Tenzin of Royal Monetary Authority of Bhutan emphasized the importance of reserves in case of small economies like Bhutan. He viewed that crisis gives an opportunity to redefine market discipline and consumption patterns. He noted that IMF should focus on the issues relevant to emerging market economies.

Dr. Subbarao, Governor, Reserve Bank of India was categorical in his remarks that the International Monetary System was inadequate to prevent a major structural problem, that is, global imbalances, which had to manifest in the form of some crisis or the other at some stage. He noted that even though India did not contribute to global imbalances, it has to face the consequences.

Alpana Killawala
Chief General Manager

Press Release: 2009-2010/1125

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