RBI and central banking

If you read Ajay Shah's blog, you will notice that he is an ardent supporter of inflation targeting, rule based central banking and by and large critical of RBI's policy actions. Specifically, he believes that in an emerging country likely to have weak institutions, like India, the central bank has no business using discretion, that currency depreciation should not be fought using fx reserves, that modern academic macroeconomic insights (of the Monetarist-New Keynesian variety) like inflation targeting are widely used and widely effective and that RBI's heavy handed approach to regulation has drastically stunted financial markets and innovation and thus stunted entrepreneurship and growth. Ila Patnaik, with whom he has collaborated on several papers and other research initiatives, has more or less similar positions. I refer to the two of them because of two recent pieces - this op-ed by Dr Shah in FE and this one by Dr. Patnaik in the Indian Express.

Before we turn to the op-eds in question, it is interesting to explore each of the broader positions in some detail. Rule based central banking is thought to stabilize market expectations and prevent the central bank from committing policy mistakes which it might otherwise do on account of insufficient data, incompetence or vested interests. However, it also takes away some important tools that central banks have to fight pro-cylicality. Dr. Shah is however ok with de facto if not de jure central bank positions, but seems to insist that India cannot afford de facto positions because our institutions are weak. This characterization of Indian institutions, while broadly correct if we were only talking in generalities, fails as a logical argument when one specific institution is being discussed, whether the RBI or any other. Rule based central banking could be a great idea if there was sustained evidence of RBI policy failure, otherwise there is no specific need for us to be pessimistic about RBI simply because on the average, Indian institutions are weak. And how has the RBI done? We'll turn to that in some time.

The specific measures of inflation targeting and using fx reserves to fight currency depreciation are trickier issues. Basically, as this article by Raghuram Rajan points out, the two objectives cannot be managed well together with a single instrument - interest rate - at your disposal and currency defences are widely thought to be ineffective at best (as in the case of England, 1992) and ruinous (Indonesia & Malayasia, 1997) at worst. Combine that with the hypothesized effectiveness of the Taylor Rule in combating stagflation, and we seem to have a no-brainer: open capital account completely, let the currency fluctuate and manage the price level through inflation targeting. Broadly, this makes complete sense. However, there are important nuances that are probably being missed out in such a simplified narrative.

For one, emerging market currencies tend to be strongly correlated with all other asset markets in the country. Most capital inflow into emerging markets is on the basis of perceptions of macroeconomic and political risks and stability. In India, the situation is further complicated by the fact that foreign institutional investors are not allowed to buy and sell rupees in the spot (cash) market, unless it is for the explicit purpose of buying equities or some other assets. Now anyone who has any knowldge of trading desks will tell you that such correlations are often speculated on, or other speculations are often based upon assumptions of such correlations. In a crisis, when there is sudden asset deleveraging, such speculations can form a strong postive feedback looop, further aggravating the deleveraging. It is futile to try to establish the cause and effect chain in such feedback cycles - to counter them, one or both the legs of the cycle may be attacked, and this could be the fx market or the correlated asset market (equity, for example). It is interesting to note that the darling of the free market, Hong Kong, had managed to avert the 1997 crisis to a great extent through such operations. The nature of the operations may be different for an economy like India, for the degree and even the direction of the correlations may run different, but point is - it is possible and perhaps desirable to defend a currency provided one does so judiciously. And without discretionary monetary policy, such actions are impossible.

What of inflation targeting? Though the evidence has been mixed, IT gives a robust way to achieve price stability, which is key in an economy with fiat currency, fractional resevrve banking and credit. The question is not whether IT is a worthy goal - it surely is. The question is - should IT be the only focus of the central bank, or are there other objectives just as worthy? Specifically, should the central bank pro-actively intervene in asset price bubbles? This paper by Janet Yellen (governor of Federal Reserve of SSan Francisco and one of the economists touted as Bernanke's successor) discusses the issue in great detail. Yellen notes that not all asset price fluctuations are created equal and broadly says that while equity market booms and busts may be left alone, credit markets deserve a deeper look as credit is the main mechanism of transmission between the financial and the real economy. In either case, praising and echoing Minsky, she emphasizes the need to bring the financial sector and financial stability as explicit constructs in macroeconomics and monetary policy.

Next, what about capital account liberalization? Let's treat the restrictions on corporate debt investments later. First, let's recall what exactly is forbidden in the Indian currency market - FIIs are not allowed to speculate on the spot value of the rupee. They can buy and sell NDFs (non-deliverable forwards) though, and these are short-dated enough to be considered close proxies for the spot market by most trading desks. What this ensures, however, is that the very short term rupee liquidity in the market is insulated from manpulation, allowing RBI greater room to act as a manipulator itself. Raghuram Rajan, whose committee has recommended full capital account convertibility, himself finds in this paper that

Cross-country regressions suggest little connection from foreign capital inflows to more rapid economic growth for developing countries and emerging markets. This suggests that the lack of domestic savings is not the primary constraint on growth in these economies, as implicitly assumed in the benchmark neoclassical framework.

and goes on to suggest a 'pragmatic' way for the process of capital account liberalization. In another paper, he and his co-authors conclude that

even successful developing countries have limited absorptive capacity for foreign resources, either because their financial markets are underdeveloped, or because their economies are prone to overvaluation caused by rapid capital inflows.

seemingly confirming some of the common sensical arguments around the 'hot money' of capital inflows.

Now finally, we turn to the recent critiques that Dr. Shah and Dr. Patnaik have dished out to the RBI. Dr. Patnaik asserts that India is not the only country that has remained relatively unscathed in the crisis and hence there is no evidence that RBI has done a spectacular job and that the world has nothing to learn from RBI. She criticizes the self-praise that some recent RBI establishment people have heaped upon themselves (perhaps Dr. Y V Reddy) and points to the micro and macro-prudential frameworks of east Asia as being worthy of emulation. She concludes memorably

A villager with no roads may foolishly boast of having no accidents, but he cannot teach people how to regulate traffic on busy intersections. It is important for policy makers to remember that India has no lessons to offer to regulators operating in the sophisticated world of finance, and proposals suggesting that they should learn our style of regulation only makes us look foolish.

Let's take a look at what RBI and Dr. Reddy have praised themselves for. This NY Times article provides a clue.

One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved — and then only to make construction loans.

...

Then, as securitizations and derivatives gained increasing prominence in the world’s financial system, the Reserve Bank of India sharply curtailed their use in the country. When Mr. Reddy saw American banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India. As a result, banks in India wound up holding onto the loans they made to customers. On the one hand, this meant they made fewer loans than their American counterparts because they couldn’t sell off the loans to Wall Street in securitizations. On the other hand, it meant they still had the incentive — as American banks did not — to see those loans paid back.

Seeing inflation on the horizon, Mr. Reddy pushed interest rates up to more than 20 percent, which of course dampened the housing frenzy. He increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of capital banks were required to hold in reserve in case things went awry. He made banks put aside extra capital for every loan they made. In effect, Mr. Reddy was creating liquidity even before there was a global liquidity crisis.

Now, if these aren't micro and macro-prudential measures, I don't know what are. I fail to see why Dr. Patnaik feels that these measures are something that no one can learn from. Interestingly, Yellen also notes that a way for central banks to induce financial stability is to manage liquidity requirements

Capital requirements could serve as a key tool of macro-prudential supervision. Most proposals for regulatory reform would impose higher capital requirements on systemically important institutions and also design them to vary in a procyclical manner. In other words, capital requirements would rise in economic upswings, so that institutions would build strength in good times, and they would fall in recessions. This pattern would counteract the natural tendency of leverage to amplify business cycle swings—serving as a kind of “automatic stabilizer” for the financial system."

Now compare this with D V Subba Rao's speech, the one that has come under fire from Dr. Shah. Subba Rao, outlining the measures that the RBI recommends to stave the crisis, says

24. It may be relevant to highlight some of the specific features of our system that have contributed to financial stability:

• Banks are required to hold a minimum percentage of their liabilities in risk free government securities under the statutory liquidity ratio (SLR) system. This stipulation ensures that banks are buffered by liquidity in times of stress.

• We managed the capital account actively. In the face of large capital inflows during 2006-08, we sterilised the resultant excess liquidity through calibrated hikes in the cash reserve ratio (CRR) and issue of market stabilisation scheme (MSS) securities. When the flows reversed during the last quarter of 2008, we reversed the measures too. We cut the CRR and bought back the MSS securities to inject liquidity into the banking system.

Seems like Subba Rao and teh RBI, through design or default, have integrated Minsky and Yellen's insight into the system already. He also outlines the fundamental philosophy of RBI's monetray policy and management

20. In contrast to the minimalist formula of ‘single objective, single instrument’, the conduct of monetary policy by the Reserve Bank has been guided by multiple objectives and multiple instruments. In general, our three main objectives have been price stability, growth and financial stability, with the inter se priority among the objectives shifting from time to time depending on the macroeconomic circumstances.

The RBI's philosophy then, is nothing more than what Minsky suggests in his financial instability hypothesis. It is ahead of its time in explicitly recognizing the importance of financial stability as a goal beyond price stability, though I consider Yellen's skepticism about central bank intervention in asset price bubbles healthier than Subba Rao's conviction.

By stark contrast, Dr. Shah's and Dr. Patnaik's op-eds seem like rants that assert what they want to argue. They smirk at RBI's gloating, but this is what Subba Rao says

Sure, we have been hurt by the crisis, but much less than most others. It will be a folly though to let that lull us into complacency and to believe that there is something inevitable about India’s financial stability.

Now let's be charitable and remove all the smirking and rhetoric in the op-eds and look at RBI's philosophy on the main issues - capital account liberalization, financial sector regulation, inflation targeting and currency defence. The RBI has a medium term inflation target of 5% and intervenes in the fx market only when there is "excess volatility'. RBI let the rupee fall from 40 to 52 against the dollar in the crisis, intervening only in most difficult phases. Fx reserves have not been depleted by any significant amount, and as Prof. J R Varma points out, the sterilizing of capital inflows that RBI did during the boom years meant that it was long US treasuries and short Indian equity, an immensely profitable trade in 2008. And this is what DVS says about the capital account liberalization process

We view capital account liberalisation as a process and not an event.

Indeed, this resonates with Rajan's paper. Where the RBI has really been messing up is the regulation of the corporate debt market, which irrespective of its relation to economic growth, is a trade that loses India lots of money, pointed out by Prof. Varma in the same post. This is also the ground on which Subba Rao's integration of financial stability into monetary policy objectives seems the weakest

The policy framework encourages equity flows, especially direct investment flows but debt flows are subject to restrictions which are reviewed and fine-tuned periodically.

If Dr. Shah and Dr. Patnaik were to restrict their critiques of the RBI on this account, and in a juicier more content-filled manner, one would feel bound to agree with them. However, they dilute their strong arguments with a plethora of weak ones, and rather than show some effects of the stunting of the corporate debt market (as Prof. Varma does), take potshots at the RBI's 'gloating'.

This is a classic policy debate situation. The central argument that Dr. Shah espouses is made to look weaker than it is by his undercooked takedown of his intellectual opponent.