RBI usually doesn?t put clear communication of its policies and thinking at the top of its priority list. So, it was a very pleasant surprise to read the text of Governor Subbarao?s JRD Tata memorial lecture speech, delivered on July 31. Whether one agrees with the content or not?and there are elements that merit disagreement?one has to admit that it was a superbly crafted speech, which set out the governor?s (and hopefully RBI?s) thinking on the kind of role that RBI must perform as a central bank in the aftermath of the financial crisis.
Interestingly, RBI finds itself closer to the mainstream thinking on the role of central banks after the global crisis than it did before. Before the crisis, the mainstream consensus was in favour of independent central banks, which focused solely on targeting inflation using the one tool in their hands?interest rates. It was believed that regulation of banking and financial sectors, and managing the debt of the government were best left to agencies independent of the central bank. This was roughly the model followed in the UK, Europe and some other countries like New Zealand, which is now widely criticised for clearly failing to prevent the huge financial meltdown in the West. RBI, of course, performed and still performs all three functions?monetary policy (without inflation targeting), regulation and debt management.
So, when Subbarao says that RBI must not follow a singular goal of price stability?he outright rejected the feasibility of inflation targeting in India in the speech?but should also pursue output stability and financial stability, he is striking a chord with what is now the mainstream thinking on central banking. The only problem is that this model didn?t work in preventing the crisis either. The US Fed has a mandate to balance output and price stability, and always had considerable oversight over the US banking system. Yet, the roots of the crisis lay in the US. The argument for handing bank regulation back to central banks is more basic?only central banks have the money to bail out banks, so they ought to supervise them too.
It?s hard to disagree with Subbarao when he says RBI must have multiple objectives but it?s just that one had hoped that he would also lay out new thinking on how this should be done. To be fair, his speech was about asking the right questions after the financial crisis and he did an admirable job of getting the questions right. Moving forward, we need answers and one did not get the feeling that the Governor was as cogent and convincing about his answers as he was about his questions.
To the extent that he did give a specific answer about how he sees central banking at least in emerging economies, it was far from satisfactory. He basically said that RBI (like other emerging economy central banks) will have to do its best to manage the impossible trinity of macroeconomics?free capital flows, stable exchange rates and independent monetary policy?when he can only manage two of those at the same time. The ?impossible trinity? is one of those rare laws of economics that actually means exactly what it says. It is also the law that many central banks have unsuccessfully tried to subvert with limited success. Subbarao?s predecessor at RBI tried the same with unfortunate consequences for the economy.
Recall Governor Reddy?s actions in the summer of 2008. We had a massive inflow of capital from abroad, which forced an appreciation of the currency. RBI tried to manage the exchange rate (when it should have actually let it appreciate) through intervention, which squeezed liquidity in the domestic economy. The real economy (output stability) is arguably still paying the price for the fall in credit (and the hike in interest rates) that RBI?s intervention caused. But RBI had to abandon an autonomous monetary policy once it decided to keep the exchange rate stable. The only other option would have been to curb inflows but that is not an action we can afford to contemplate?it would send foreign investors out of India for a long while.
Now, Governor Subbarao doesn?t face the problem of massive inflows?the financial crisis has stalled that for the time being. So he may feel comfortable about managing the other two bits of the impossible trinity. But when inflows come back, and they already are doing, he will face a situation similar to what his predecessor did.
What your correspondent would have liked to hear from Governor Subbarao is as follows: his willingness to give up management of the exchange rate, and the abandonment of managing the impossible trinity. He also should have clearly said that there is no reason for RBI to micro manage the exchange rate, and that if RBI gave this up, it would be able to manage the more important goals of price stability and output stability, with greater competence.
?dhiraj.nayyar@expressindia.com
