The Hindu Business Line : `Special defences must for financial stability'

COUNTRIES such as India need to put in place special defences to ensure financial stability as they faced with the prospect of volatile capital flows, according to Dr Y.V. Reddy, Governor, Reserve Bank of India.

"Many emerging market economies do not seem to have adequate self-correcting market mechanisms in respect of such cross-border capital flows. In such cases, the capital flows at critical times reflect more the changes in the risk appetite of the international investor than a country's fundamentals. Hence, special defences need to be put in place for ensuring financial stability in the case of countries such as India that are faced with the prospect of volatile capital flows," he said while speaking on financial stability issues at the Zurich University, Switzerland.

The concept of financial stability too needs to be understood in its context, he added. In India, it means ensuring uninterrupted financial transactions, maintaining a level of confidence in the financial system amongst all the participants and stakeholders and the absence of excess volatility that unduly and adversely affects real economic activity.

India is still vulnerable to shocks in the real sector of the economy such as sharp rise in oil prices or extraordinary monsoon failure, while volatility in the financial system, such as fluctuating exchange rates or sharp movements in capital flows and interest rates, may be part of the market process in developed economies, for those where such volatility could affect the real economy.

Dr Reddy said such financial stability has to be particularly ensured when the financial system is undergoing structural changes to promote efficiency. The structural changes relate to ownership, regulation and competition, both domestic and external competition. Integration of financial markets is another dimension of the process; the integration of domestic financial markets is one aspect while global financial integration is another though related, he said.

Dr Reddy said, "Developing countries differ so much in size, nature and structure of the economy, level of development and socio-political conditions that my observations here are more of random thoughts to be mulled over rather than structured issues in respect of financial stability in developing countries."

Most of the currency crises in developing countries occurred around the times of political elections, particularly in countries with the presidential form of government. In India, political cycles have had a relatively muted impact on financial stability, he said.

In the context of ongoing reforms in the financial sector in India, the regulatory regime has also undergone certain fundamental changes. New regulators like those for the insurance sector and capital markets have been created.

The focus of regulation has also changed. The issues of regulatory co-ordination do arise often. However, the changes in the regulatory regime, meant for greater efficiency, may, on occasion, contain the risk of being a source of instability.

This leads us to the role of regulators in developing market-oriented financial systems while maintaining the independence and credibility of the regulator. In India, this process involved development of technological and institutional infrastructure by the Reserve Bank of India, changing the interface with the market participants through consultations and communication, which was critical for mutual benefit.

The relationship with the Government, as the majority owner of the financial entities, as the ultimate risk-bearer in the system and as the sovereign in law making, is also changing in the new environment. In this background, a single regulator, other than the central bank, i.e., separating banking supervision from the central bank, may not be workable, he pointed out.

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