The Hindu Business Line : Implications for monetary policy

Signalling that policy-makers should be forearmed to stave off any financial market fiasco that may arise because they didn’t intervene in time, the BIS report has some clues for the RBI in its effort to tame inflation while not stifling growth.

G. Srinivasan

Soaring crude prices, high inflation triggered by elevated prices of food and fuel and the attendant turbulence in global financial markets with equity values tumbling in many markets is hard to digest.

For many a country, this has followed closely on high growth, low inflation and pervasive feel-good factors, that may have seemed here to stay.

The present predicament is largely the making of inept policy-framing by almost all countries, developed and developing, over most of this decade, and this is well documented by the Bank for International Settlements.

In its 78th annual report, released on Monday, the world’s central bankers said pithily that “a powerful interaction between financial market innovation, lax internal and external governance and easy global monetary conditions over many years has led us to today’s predicament”.

Highlighting the stresses that have dominated the global financial landscape since mid-2007, it says the creation of complex structures that insert several layers of securitisation between the original asset base and the cash-flows to the ultimate risk bearers often obscured the risks borne by the structures’ managers.

The US sub-prime crisis was the origin of the current financial market turmoil, it says, adding that the shortcomings of the ‘originate-to-distribute’ model could be attributed mainly to the failure of individual players to develop a holistic view on the risks due to the excessive focus on their narrow, individual perspective.

System inadequacies

The BIS contends that inadequacies in implementation of the ‘originate-to-distribute’ model have had ‘calamitous side-effects’. Loans of increasingly poor quality have been made and then sold to the gullible and the greedy, the latter often relying on leverage and short-term funding to augment their profits. This alone was a serious source of vulnerability.

The opacity of the process implies that the ultimate location of the exposures was not always evident, it says, adding wryly that “how, then, to clear up the debris if it is not even clear where it lies?”

Financial innovations have heightened an inherent tendency to ‘pro-cyclicality’ in liberalised financial systems. That is, as credit expansion fuels cyclical economic growth, asset prices and optimism rise, while perceptions of risk recede.

This bolsters credit expansion, not least through the provision of more collateral, to allow more borrowing, leading to spending patterns that could ultimately prove unsustainable. “Initial rational exuberance might in this way become irrational, setting the stage for a possible subsequent collapse”, says the Report.

There were also deficiencies in both the internal governance and external oversight of financial institutions.

Individual firms have suffered enormous losses and forced recapitalisation would dilute future returns for current shareholders, who are unsurprisingly outraged at the behaviour of both management and supervisory boards.

“No one saw any pressing need to ask hard questions about the sources of profits when things were going so well”, the BIS says, adding that one consolation is that “those elements of Basel I that contributed to the excesses, in particular the effective absence of capital charges on off-balance sheet entities related to banks, will no longer play such a role under Basel II. The sooner the new framework is fully implemented, the better”.

Low interest rates

A still more traditional factor that contributed to credit excesses pertains to real interest rates — globally and not just in a few advanced countries — which have been at unusually low levels for much of this decade. With inflation initially low and stable, policy rates, long-term rates and risk spreads failed to increase in tandem as global growth rose to record levels. With low interest rates, the trend towards faster monetary and credit growth was seen in almost every major region.

The BIS says these low interest rates might inadvertently have encouraged imprudent borrowing, as well as eventual resurgence of inflation.

The BIS calls for steps both to mitigate the excesses in the expansionary phase of the credit cycle and to further reduce the costs in the downturn through better crisis management. It plumps for a new macro financial stability framework to resist vigorously the pro-cyclicality of the financial system.

The salient points of such a framework would be a primary focus on systemic issues. While such an approach would not imply paying less attention to the good health of individual institutions, it would certainly mean significantly enhanced oversight of firms that were very large or had complex relations with other parts of the system.

The second feature would be a much more ‘symmetrical’ or countercyclical use of policy instruments, which would be tightened in the expansionary phase of the credit cycle and eased in downturn.

Simply put, the new framework would reflect what the received wisdom for fiscal policy is now: That the good times should be used to prepare for the bad.

Sustaining growth

The BIS rightly points out that when currently in an upturn, neither monetary nor regulatory instruments tend to respond systematically to emerging imbalances.

Conversely, regulatory instruments are commonly tightened only when things turn bad, potentially rendering the downturn worse. In short, macro prudential instruments would be used either on a discretionary basis or following some rule-based criteria, to ensure that risk spreads, loan loss provisions and capital provisions all moved so as to reduce the amplitude of the credit cycle.

The BIS does recognise that a framework designed to reduce the amplitude of credit-driven cycles would not eliminate the risks therein.

Periods of turmoil and crisis would still have to be managed, and should also be prepared for through the introduction of a coherent set of ‘safety-net’ measures.

‘Off-the-shelf banks’ should be set up to allow crucial functions of bankrupt banks to be maintained. While not underplaying the element of moral hazard in all such efforts, the BIS argues that businesses and banks are expected to undertake business continuity planning in advance of trouble and surely “we should expect as much from policymakers”.

The BIS has thus signalled that policy-makers and policy-setters should be adequately forearmed to stave off any financial market fiasco that might happen in the absence of their failure to intervene on time or “to take away the punch bowl at the party, when the time is right”.

With the RBI set to unveil the review of monetary and credit policy of the first quarter in a few weeks, the country’s central bank might perhaps take a cue from the spot-on diagnosis and pragmatic prescriptions of the BIS for the credit-induced global financial market crisis.

As the Indian economy slows under the unrelenting onslaught of inflation, the forthcoming policy will be expected to keep alive the life-line for productive activity — in manufacturing and the real sectors of the economy, even as quelling inflation continues to be its primary focus.

This is all the more crucial because the RBI’s regulatory remit for the banking industry cannot be glossed over.

So the Mint Street mandarins have to prepare for the deft exercise ahead of taming inflation while not choking growth impulses. This is the wisdom the BIS advocates in this year’s annual report.

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