Why Stanford? What happened?Do you prefer academia to policymaking?
No. There is nothing specific that has happened. My term at Reserve Bank comes to an end in January 2010. You know there are a dozen great universities in the world and Stanford is one of them. So when I got such an offer, I thought it was worth taking it up. So there is nothing more or less to it.
The fact that my entire career, since I got my PhD, has not been in academia shows what my preference has been. The one commonality in all the different things that I have done is that I have done a certain degree of academic work wherever I have been. I have something like 100 published articles and five books. Despite the fact that I have not been an academic, I clearly had a great interest in the interface of the use of good academic work informing policymaking. I feel at home in either environment but I think one needs to keep crisscrossing to be alive intellectually.
What is the difference in the view of the economy from the finance ministry as compared to the Reserve Bank?
I don’t think there is necessarily a difference in the way the finance ministry at any given time views the economy and the RBI. However, the RBI, like any central bank, has a much larger staff working on the economy. The RBI top management has more time to look in detail at economic trends than the ministry because the ministry has a much larger ambit of responsibility its top management has very limited time to devote to looking closely at economic trends and the staff is much smaller. That is true of every central bank and treasury. There is more day-to-day monitoring because you have to manage liquidity and constantly look at financial stability. So there is a slight difference in approach in that sense. Obviously, the ministry’s interest is in looking at macro trends. The central bank too looks at macro trends but it also has to look at micro trends and has a greater focus on financial stability.Both in the Raghuram Rajan panel report and Percy Mistry panel report, there hardly was any involvement of RBI. Why?
There was no regulator [for these reports]. It was basically Raghuram Rajan and all private sector participants. There were public sector bank participants, yes.
But neither did they take any advice or comments from the RBI.
No, I think it was intended to be an independent report. Of course, all the RBI’s views are available as policy statements and the various reports like the report on currency and finance, the annual reports, the trends and progress in banking. And of course, the speeches of the governors and deputy governors which are always documented and published.The Raghuram Rajan panel and Percy Mistry panel reports draw a lot from the world bank-IMF model of financial architecture, a lot of western thought process. Do you think after the global crisis, a lot of it would have to be reviewed?
It’s a very interesting question. I would actually not characterise it as IMF-world bank model. I would characterise it as a certain mode of thinking that has been dominant over the last ten years in international markets in particular. But it is an interesting point because what has happened as a consequence of the international crisis is a great deal of rethinking going on internationally — on macroeconomic management, on monetary policymaking, on the role of central banks, on the connection between monetary policymaking and regulation, on the mode of financial regulation. Already there is a large body of work out there and in the next five years, certainly in the next couple of years, you will see [more work] both academic and otherwise on some adjustments and approaches that have been prevalent in the last ten years.
The change in view that is taking place is that at any given time, the practice of central banking and financial regulation is dependent on the prevailing thinking and understanding of the workings of the macro-economy and the workings of financial markets. What happened in the last ten to 15 years really taking on from the Reagan-Thatcher revolution in the 1980s and then lot of academic work is a view that financial markets are extremely efficient and regulation needs to be light-touch because the financial market participants themselves and their boards and so on will be self-regulating. On the monetary policy, the predominant view has been that central banks need to have a very clear single objective of inflation targetting and use a single instrument that is short-term interest rate setting. This has been the predominant view. Given the magnitude of the global financial crisis, both are now being questioned but the work is still in process but the questioning that is now taking place is that financial markets may not always be efficient and there are a number of problems that have to do with central structures that exist in financial markets which then lead them to behave differently to the detriment of the rest of the economy.
On the question of monetary policy, also particularly as a consequence of the financial crisis, the central banks had to use a multitude of instruments to deal with the crisis, as lenders of last resort, as market makers. They also had to act on the quantity of money as opposed to interest-rate setting. They had to co-operate with each other and give lines of credit to each other. So, there has been a whole series of different instruments used in the context of the crisis many of which will not be used if there was no crisis. But there is now questioning whether central banks should generally be looking at multiple instruments and multiple indicators and not be solely focused on one particular price index.
Connected with that issue is what central banks do, for instance, in the face of rising asset prices. There was a view well articulated by Greenspan that there is not much central banks can do or should do. Basically they just have to watch and act after something has happened. Basically, that you cannot spot a bubble. You don’t know when the bubble is reaching its height. There is another view that even if you can take the kind of actions that you will need to take will be so draconian that it will really harm the economy. Those were the kind of views that existed.
Now you are almost getting a consensus that central banks do need to act and watch asset prices and the action could be to do with financial regulation and other measures as opposed to monetary policy measures. That also brings into question a view that has been popular in the last number of years that central banks should not be financial regulators. And now, although there isn’t a consensus yet that they ought to be financial regulators as the Reserve Bank is and central banks used to be, but there is more of a debate now on what ought to be the connection between a monetary policy authority and a financial regulatory authority if it’s not in the same house. There is almost a consensus now that you need to do macro prudential regulations. What that means is that there are certain macro trends that take place say, if there is asset price rise, then you might have to do some macro-prudential regulations that are not institution specific whereas regulation is always institution specific. A lot of such very interesting discussion going on internationally that will lead to a good deal of change in thinking as well as practice, both in monetary policy as well as regulation which will give much more weight to financial stability than before.
So given the fact that both Raghuram Rajan report as well as Percy Mistry report did not have the advantage of hindsight with regard to the global recession and since all this rethinking happened after that, do you think a large part of those reports would require to be reviewed? I think your own report would have benefited from the hindsight.
Well, it’s not my report that you are referring to. I co-chaired it along with successive secretaries of economic affairs department (under the finance ministry). This is the important point that I wanted to mention in this context that the financial sector assessment programme, which is what this 6-volume report pertains to, is the culmination of work that was done over two and a half years and it had the involvement of the government, all the relevant departments, that is all the different department under the ministry of finance, department of company affairs and others. Plus, it had the participation of all the regulators like the SEBI, IRDA, RBI, also the accounting standards setters. So it’s actually a document which has been prepared with all the people concerned put in their contribution. The way the work was done was that there were four advisory panels each of which had only independent people but who were serviced by special invitees from each of the relevant regulatory authorities of the government. And it has done a huge amount of data work. And you are right that they also had the benefit of hindsight.
They took on board all the various existing reports to do with the financial sector, not just the Percy Mistry and Raghuram Rajan reports but also other reports. And, also of course, the events that took place until around December 2008. So this report has taken into account both the thinking before the actual performance of the economy, actual performance of the institutions…they have done very detailed stress testing. They have assessed the compliance of Indian standards, the international standards. So this is a much more comprehensive report. And I think one key view that has been taken is that you need to have a certain degree of humility in making recommendations of financial sector changes, for financial sector development as you go along, that you may be clear about certain directions of change but the actual policy changes that take place, really, are very contextual. And that the authorities at any given time will always have to take into account whatever is the context at any given time. And because the financial sector keeps changing, you have to keep that in your mind, I think, that is one difference in view as a philosophy as against giving very specific recommendations.Do you think of Mumbai as a financial centre is a viable possibility?
Well, that’s not a simple question. First of all, Mumbai is a financial centre. There is no definition of a financial centre. All the major financial centres in the world, that is, London, New York, Tokyo and secondary centres like Singapore Hong Kong, Frankfurt and others have not developed as financial centres because someone sat down and decided that I want to make it a financial centre. They have evolved. Of course, London perhaps has the longest history because it was the financial centre of the world. To my mind, financial centres evolve and emerge as either the economies in which they are based emerge as very important players in the world. So London was the financial capital when UK was the dominant economy of the world, New York when US was dominant and Tokyo as Japan developed in the 1970s, 80s and 90s. So except some offshore centres like Dubai, which are really niche centres and which to some extent are done artificially, financial centres evolve.
In our own case, with the overall economic reforms taking place since early 1990s, very clearly Mumbai has become a more active financial sector from before. Also with all the developments taking place in the capital markets, the changes in the whole financial regime in terms of the deregulation of the interest rates, the establishment of SEBI, the national stock exchange, these are, to my mind, all evolutionary steps towards Mumbai becoming a larger financial centre. And I think as our economy develops further, Mumbai will become an even bigger financial centre.
And you really can’t have international financial centre without capital account convertibility. So I think that as the overall economy develops, as the financial sector in India gets deepened and as when and if we have CAC, I think it will evolve. But I don’t think you can artificially make Mumbai an international financial centre of the Dubai variety because I think they are niche activities and this is not part of an offshore place.
The second thing I would say is that, Mumbai as a city is not of a quality that international financial centres have as a city. And I think as our incomes increase there will be a need to give attention to the city as a whole, not just as a financial centre. The kind of poverty that exists in the city, the kind of transportation problems that exist in the city, the quality of life in the city. Again that will come with development but clearly much more can be done to improve the city of Mumbai.You have said in a paper that lack of CAC and restrained growth of foreign banks have helped keep India insulated from the global meltdown. Considering that the demand for CAC as well as unrestrained expansion of foreign banks in India is increasing, what is the way ahead?
First of all, I don’t know in the current context there is a demand for unrestrained growth of foreign banks in India given that the largest banks in the world have very severe capital adequacy problems. Over the past 12 months, the lowest growth in credit is of foreign banks in the country. And it’s because of their own capital problems in their own countries. That itself is a lesson to us that even when our country is growing at 6.7 percent that because of some problems that their parents have had, their credit growth has gone down. That itself tells you that if you had a large presence of foreign banks what would have happened to this country as it has happened in countries which have a very large foreign bank presence. And one of the things you observe is that the World Bank published the global financial report last year. They had a very good review of the foreign bank presence in different parts of the world. One thing they have observed there is that Asia as a whole has a lower proportion of foreign bank presence than any other region in the world and it has the highest financial stability except for the 1997 Asian crisis.
It is very good for any country to have a certain degree of foreign bank presence both from the point of view of that country’s position in the international economy because large financial conglomerates have a role in international financial intermediation. Also from the point of view that they transmit the new practices in the financial sector which is very good for any country. So the way we approach foreign bank presence has really to do with what we want the financial sector to do in the country. It is to have increased financial intermediation, more efficient financial intermediation, competition etc. It is really in that context that we should view their presence.
You recently said that inflation is not a concern. But while headline inflation has declined, the prices at which commodities are available to the common man have continued to rise, especially in the past two-three months.
What about CAC, because twice the lack of CAC has insulated us, in 1997 as well as now?
Well, as you may know, I had the privilege of chairing a working group for the committee of global financial systems of the BIS recently on capital flows to emerging market economies. The working group was appointed in mid-2007 consisting of 25 central banks including all the G7 central banks and BRIC central banks. So it was full participation of all the major countries. We reviewed the whole issue of capital flows to emerging markets economies.
It was very interesting because the group was appointed by the vice-chairman of the Federal Reserve Donald Kohn. The motivation at that time was the huge flows to the EMEs and reverse flow taking place from the reserves of the EMEs to the advanced countries. Of course, over the time that we worked everything reversed. So again, it was very interesting that the span of time that the preparation of the report took allowed us to give a balanced report to the BIS.
What we found was that, one, in the academic literature in the review of the evaluation of the benefits of the CAC, economists are not able to find specific benefits of total CAC. A number of academic reviews do find is that the foreign equity flows, in general, are beneficial, both foreign direct investment and foreign portfolio investment. And there is less of a benefit found from the CAC on the debt side. But this is a matter of degrees, not of zero-one issues. So from the literature, you will find that you need to be careful on CAC particularly dependent on development of the financial markets within the country.
Second, on the actual empirical side, there have been increasing cycles of international capital flows since the early 1980s at least. Lot of this actually went to Latin America as debt flows. And it was coincident with relatively loose monetary policy in the advanced countries, the monetary aggregates were rising internationally and so excess liquidity in that sense went off as debt to EMEs, particularly Latin America. Then when the advanced countries tightened the monetary policies, the capital reversal took place. And you had the Latin American debt crisis.
Same sort of cycle took place in the early 1990s when there was relatively loose monetary policy in advanced economies. This time a lot of this went to East Asia. Again, when there was a reversal of the monetary policies, there was a reversal of capital flows and you had the Asian crisis. And what is also interesting is that the recent IMF paper documents this and says that gross capital flows among advanced economies increased from around 8 percent of GDP to around 16 percent of GDP between a period of 5 years from 2002 to 2007.Again as the reversal took place they had problems.
Third, the report also documents about the issue of presence of foreign banks and what happened in eastern European countries and Baltics with a very large presence of foreign banks.
To summarise, the issue really is that, whether it is the presence of foreign banks or CAC, you need to look at these things as intermediate objectives or instruments to achieve some final objectives. They are not ends in themselves. So what you are interested in is that the financial sector and the international economy in the case of CAC helping the economic growth of a country. And we should take measures and decisions which help the economic growth of the country not as objectives in themselves.
This is why we have been saying at RBI that we need to look at all the information that is available. So we were looking at WPI, CPI. I have said very consistently that in our country it is important for us to get information about what is the CPI for the rural areas or agricultural labour, what is CPI for industrial workers etc. So that I have much more information on the texture of inflation. That’s why I have maintained that inflation targeting is not a good idea for India because of the variance between how different sectors of the population are affected. My inflation is larger than the advanced countries and so if you suppose you had a unified consumer price index, which of course you can have because you can make any index, then it’s not very useful information for me because there are large differences in what different people face.
For example, the point that you are making: if it is the case that 70 percent of the people have a consumption basket which sees higher inflation than others then it has an impact on inflation expectations even if the overall price index may not be showing inflation. So this is why you need to have a much more complex monitoring from the RBI.
But now coming to the specific point. We have been documenting, in our policy statements, the different inflation indices and it is very clear that along with the rest of the world the WPI has come down to less than 1 percent and is expected to remain there or become negative but the CPI has now started coming down but nowhere as fast as the WPI. So we have been monitoring these different trends but it is also clear that for the rest of the financial year inflation is not going to be an issue. Also, keep in mind that given the expectation of a continued recession in this calendar year, in the world as a whole and advanced countries in particular, and the recovery may come in 2010, inflation is really not a concern.Do you think the crisis has increased the burden on public sector banks due to restructurings and borrowers shifting loans, including their foreign currency obligations?
Restructuring with respect to the banks’ own loans does not have any impact. Of course, it is correct that with the drying up of international capital markets a greater burden has fallen on the domestic financial system. What kind of stress does it place on the financial system?
Well, the stress that is placed is that if you could have excess credit demand, which does not seem to be the case at present because the banks clearly have excess liquidity. So, excess demand doesn’t exist, but in principle that could happen. If some other sources of finance dry up you could have excess demand for credit on the local financial system. What about the health of the banking system’s assets?
Obviously when there is a slowdown you would expect some impact on the health of assets but so far from what the banks have been telling us we are not expecting a very significant impact on the health of assets of the banking system but we have to watch carefully as we go along. And from the stress test that we did for the financial sector assessment programme, we did conclude that even if there is a significant increase, our banking system is going to be resilient because of the capital adequacy that it currently has.
(This story appears in the 19 June, 2009 issue of Forbes India. You can buy our tablet version from Magzter.com. To visit our Archives, click here.)