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One significant lesson from the recent global financial turmoil has been the limitations of monetary policy in achieving the financial stability objective, if it follows a purist approach of single objective--price stability--and single instrument--short term interest rate. The experience in handling the crisis has shown that the central banks on their own, or in coordination with other regulators of institutions and markets, should have an extended arm of macro prudential policies in its armour to tackle new vulnerabilities of a global market place, and prevent recurrence of the crisis of the magnitude seen since 2008-09.
With the reappearance of the crisis situation in Euro area, triggered by the unsustainable sovereign debt of some major countries, sustainable public debt has become an added concern of major countries on top of macro prudential concerns. Public debt has touched unsustainable levels also because of huge bail out operations of markets and institutions in unconventional ways by governments in coordination with central banks in advanced countries.
Keeping these post-crisis developments in view, the Reserve Bank of India (RBI) has aptly chosen the theme of Monetary Policy, Sovereign Debt and Financial Stability: The New Trilemma for its second two-day international research conference opened on February 1. The RBI Governor Mr Duvvuri Subbarao has eloquently brought out in his keynote address at the conference the rationale for the choice of the subject and several issues associated in dealing with this new trilemma.
According to him, unlike the old trilemma arising out of the well known impossible trinity, namely independent monetary policy versus free capital account and fixed exchange rates, the new trilemma represents a holy trinity inasmuch as the three objectives of price stability, financial stability and debt sustainability do not inherently conflict with each other, but on the other hand reinforce each other in achieving the overall macroeconomic objective of sustained economic growth or employment. So far so good. But, the concern is how to institutionalise the new arrangement. We try to address this issue in the Indian context.
Monetary Policy
In India, monetary policy is ingrained in the legislation governing the central bank and the twin objectives of price stability and support to growth by ensuring flow of credit have evolved by well established conventions and practices over time with emphasis shifting depending upon the emerging macroeconomic environment. For instance, since December 2011, the emphasis has tilted in favour of growth after a period of nearly two years of stress laid on containing inflationary pressures and expectations.
The new framework of using different quantitative instruments such as cash reserve ratio and open market operations in combination with single policy repo rate can be said to be serving the goal of non-inflationary growth well. The RBI has been enjoying a reasonable degree of operational independence, though legally it is not so and the extent of freedom depends upon the willingness of the government to allow it. Whether a legislative change will help in improving the autonomy of the RBI in this matter is debated, but as of now, this does not appear to be such a substantive issue. Hopefully, the legislative reforms commission will surely have a look at this. In any case, there does not seem to be any urgency in disturbing the status quo on matters relating to monetary policy.
Financial Stability
Financial stability became an added objective of financial policies of the RBI in the post-financial sector reform period since early 1990s, particularly after the East Asian crisis, and the context was maintaining orderly conditions in financial markets -- money, foreign exchange and government securities markets. Over time, institutional regulation and supervision, especially of banks and non-banking financial companies, have been strengthened both legally and in practice. Both, macro and micro prudential measures were used in conjunction with monetary policy instruments to sustain financial stability. The capital requirements of banks were extended to cover market risks and liquidity concerns of banks were addressed by the RBI well ahead of advanced countries. Several counter-cyclical measures in terms of time varying risk weights applicable to sensitive sectors were also followed.
All these were guided by a precautionary motive and the RBI was not waiting for a crisis to evolve such practices. These initiatives were proactive and preventive and not reactive, as has been the case with Western countries now. This helped the country to withstand the adverse consequences of global contagions, with minimal pain on several occasions including during the recent crisis period. There could be valuable lessons from this experience when the global standards are finalised in multilateral discussions.
As we go along, there are two issues which need to be addressed. First, there is a need to arrive at a workable definition of financial stability, since conventionally this term acquires meaning in the negative sense of the absence of financial instability. May be 'orderly functioning of financial markets and institutions' is a candidate for serious consideration in a broad sense. Second, the adequacy of legal provisions and institutional arrangements needs to be examined de novo. This is especially so because of the complexity of evolving financial system and products and overlapping or missing regulatory powers with the multiple regulators, that leaves large room for regulatory arbitrage or gaps. One thing is clear. The RBI alone may not be able to handle financial stability issues and other regulators have to be involved, but lead role may perhaps to lie with RBI since it is the only institution with the lender of the last resort function.
Public Debt Sustainability
Public debt sustainability in India has not reached such an alarming proportion as in advanced countries now, though addressing the issue of restoring fiscal consolidation is a priority. Both, RBI and the government seem to understand this and the forthcoming Budget of the central government should lay down a clear road map for fiscal consolidation. The existing fiscal responsibility legislation is robust enough, if implemented in good spirit and no attempt should be made to tamper with it. Though debt sustainability is a concern for the central bank, the responsibility for that squarely lies with the government. This can hardly become an extended arm of monetary policy.
(The author is Director, EPW Research Foundation. The views are personal.)
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