• Investment World
• eWorld
• Brand Line
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest
• The New Manager

Stocks

• Quotes
• SE Diary
• Scoreboard
• Open-End Mutual Fund

Cross Currency

• Rates
  
  

Shipping

• Ports
  
  

Archives

• Yesterday
• Datewise
• Resources
• In Focus
• In Depth

Group Sites

• The Hindu
• The Hindu ePaper
• Business Line
• Business Line ePaper
• Sportstar
• Frontline
• The Hindu eBooks
• The Hindu Images

S. Balakrishnan

Central bank independence, even if not enshrined in Constitutions, is an article of faith with practically all governments.

What should keep central banks awake at nights? Inflation? Money supply? Independence from governments in monetary policy and interest rates?

None of these, one would wager.

Why, one might ask? Isn't modern central banking supposed to be all about controlling inflation? And doesn't that need complete freedom?

Surprising it may seem, but these issues are, more or less, history. Central bank independence, even if not enshrined in Constitutions, is an article of faith with practically all governments.

Our RBI may not formally qualify as an independent central bank, but at least in the past year, the Government has given it sufficient leeway to decide, by itself, policy and rates. Indeed, most governments are willing, if not entirely happy, to be rid of monetary responsibility. If faced with rising inflation, central banks can, therefore, uninhibitedly wield all the weapons in their armour to bring it down to acceptable levels, without fear of their government's disapproval.

Actually, the problem now, more than anything else, is systemic risk. Money flows freely across borders, both within and across the developed and developing worlds. Earlier, there was nothing beyond stocks, bonds and currencies. And the institutions that invested in and traded in them were regulated either by the central bank or securities watchdog like SEBI.

Different situation

Today, the situation is vastly different. A bewildering variety of new instruments, predominantly of the derivative variety, are traded in over-the-counter (OTC) markets and futures exchanges. They encompass equities, currencies, interest rates, bonds, energy, commodities and precious metals. If something is not there, you can bet it will soon be invented. Such is the brainpower at work in financial engineering.

Complicating matters further is the latest avatar of financial institutions - the hedge fund.

Hedge fund

These are entirely unregulated entities privately managing the wealth of the wealthy. Their number is in thousands and the aggregate size of their corpus is a few trillions of dollars. They are significant players in just about every financial and commodity market — and derivatives.

The tricky part for central banks is that hedge funds are often highly leveraged, i.e., they borrow several times their capital to finance their positions in the cash, derivatives and futures markets. Wrong trades can wipe out their capital in no time and what is more put their lenders at risk (given the leverage).

The illiquidity of many hedge fund assets, i.e., they cannot be exited precisely when exit is a must (because the fund or the market -or both- is under stress) only heightens the risk of a simultaneous collapse of markets and institutions.

So there you have it - institutions outside regulation, holding unquantified positions in unknown assets mostly with borrowed money.

For central banks, managing inflation must be child's play in comparison!

More Stories on : Financial Policy | Financial Scan | RBI & Other Central Banks

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
How banks can lend long-term at fixed rates

Copyright © 2007, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line