The Five Pillars of RBI's Financial Sector Policies

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Britton Marshall
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1 The Five Pillars of RBI's Financial Sector Policies Speaking on the opportunities for growth in India, Mr. Raghuram Rajan said that the Indian population is young, India's infrastructure is inadequate, and too many Indians are poorly educated, poorly fed, and poorly connected. These are precisely the reasons for plentiful opportunities for betterment in the coming years. While some are of the opinion that India needs to focus on manufacturing, some others point out the need for industries such as electronics or computer chips. It is essential to focus on improving the overall conditions for growth instead of targeting specific industries for governmental attention, which risks bringing back of the Licence Permit Raj. The measure of success should be achieved by developing a facilitating, though competitive, environment that will result in the emergence of the best solutions. This requires a disciplined focus on four issues. First, the need to improve the quality of infrastructure, especially the logistical support and power that industry and services need. Second, the youth need education and training for the jobs that will be created. India can be at the forefront of providing mass technology-enabled education laced with appropriate human inputs to the world. Third, the need for better business regulation that is appropriate to the objective and that is enforced. We have strong labour laws in theory that are meant to protect employees, but in practice we have a very flexible system with no incentive for firms to invest in their workers or hold on to them, and no loyalty towards the firms from workers. This needs to change if we are to have more skilled manufacturing jobs. Fourth, the need for a better financial system, which will finance the needed infrastructure and the expansion of every producer ranging from the kirana shop owner to the industrialist even as it allows households to save safely with positive real returns, insure themselves against health emergencies or old age costs, and borrow at low cost to finance consumption. Importantly, the financial system should not require constant subsidies to bail it out. Focussing on what the Reserve Bank is doing to improve the financial system he said that they plan to build the RBI's developmental measures over the next few quarters on five pillars. First, we are among the large countries with the highest consumer price inflation in the world, even though growth is weaker than we would like it to be. Much of the inflation is concentrated in food and services. Inflation comes from demand exceeding supply, and it can be curtailed only by bringing both in balance. There is a need to reduce demand without having serious adverse effects on investment and supply. Thus there is a need for clarifying and strengthening the current monetary policy framework. Second is strengthening banking structure through new entry, branch expansion, encouraging new varieties of banks, and moving foreign banks into better regulated organisational forms. Third is broadening and deepening financial markets and increasing their liquidity and resilience so that they can help allocate and absorb the risks entailed in financing India's growth. Liquid markets will help banks offload risks they should not bear, such as interest rate or exchange risk, and it will also help promoters raise equity. Address by Raghuram G. Rajan at BANCON 2013, Mumbai on November 15,

2 Further, it will also allow banks to sell assets that they have no comparative advantage in holding, such as long term loans to completed infrastructure projects, which are better held by infrastructure funds, pension funds, and insurance companies. The Reserve Bank plans to roll out more recommendations of the Gandhi Committee report to improve the liquidity and depth of the G- Sec market, and then turn to money markets and corporate debt markets. It also plans to introduce new variants of interest rate futures and products like inflation indexed certificates, and work to improve liquidity in derivative markets. Fourth is the need for financial inclusion by expanding access of financial services to small and medium enterprises, the unorganised sector, the poor, and remote and underserved areas of the country through technology, new business practices, and new organisational structures. Many experiments are under way to use technology, mobile phones, new products such as mobile wallets, and new entities as business correspondents to link people up to the formal financial system. The Dr. Nachiket Mor Committee is helping with possible models, and at a more detailed level, committees like the Sambamurthy Committee have been set up to advise on how to expand mobile banking in India through encrypted SMS based funds transfer in any type of handset. Lastly, there is a need to ensure that the system recognises financial distress early, and improves the system's ability to deal with corporate distress and financial institution distress by strengthening real and financial restructuring as well as debt recovery. In conclusion he said that India is going through a period of great cynicism about what it can do. Moreover, every policy is greeted with suspicion and scrutinised for evidence of malfeasance, and decision making has slowed. Thus, the solution lies in action that is, and is seen to be, purposeful, unbiased, and effective, and the Reserve Bank of India aims to play its part in making this happen. Source: CCIL Monthly Newsletter December

3 Ebbing global liquidity and monetary policy interactions Drawing reference from his earlier speech in which Jaime Caruana had highlighted the interactions between accommodative monetary policies in major countries and emerging markets by five distinct overlapping channels, he said that the experience in 2013 has taught about each of the five channels, and how important policy spillovers were, are and will be. This evidence strengthens the case for policymakers to take into account these interactions when setting their own policy. Furthermore, policymakers in small open economies need to take advantage of the temporary lull to undertake prudent measures to make their economies more robust when the exit really happens. Proposing a new theme, he said that capital flows have become even less reliable as an indicator of overall positioning. The development of hedging markets means that investors can reduce their exposure with little outright selling. He then discussed about the five channels of international monetary interactions, which include: (i) follow-the-leader behaviour in setting low short-term policy rates; (ii) diffusion of low bond yields to local bond markets; (iii) exchange rate appreciation; (iv) booming dollar credit growth; and (v) capital inflows. Focusing on the follow-the-leader behavior, he suggested that central banks tend to set their domestic policy rates on the low side in the face of very accommodative monetary policy in the major currencies. It was also seen by plotting average policy interest rates against those indicated by a Taylor rule with fairly conventional parameters. Such rule of thumb suggested that policy rates have been low since well before the global financial crisis. The reason for variation in follow the leader were currency appreciation and its potential to damage the traded goods sector in some places and the threat of capital flows financing unsustainable and potentially damaging credit extension in others. However, between May - August 2013 the process reversed. The mere prospect of tapering in bond buying sent the exchange rates of many commodity exporters and emerging markets down, risked higher inflation. Thus, some emerging market central banks that had maintained interest rate differentials at prudent but often uncomfortable levels have been able to cut their policy rates since May, notwithstanding the pressure on their currencies. Second channel is through the integration of global bond markets. In 2013, authorities had succeeded in putting their thumb on the scale in the global bond market by making the investors pay away about 1% of the expected short term rates over the next 20 years for securing a yield. Investors in sovereign and corporate dollar or euro bonds were not surprised that these underperformed US Treasuries or German bunds, respectively. What came as a surprise to many, perhaps, was the Address by Jaime Caruana in Santiago Chile on 15 November

4 underperformance of many local government bonds. Domestic bonds did offer some diversification benefits in economies where previous prudence in policy rate setting allowed the central bank to stand pat, or even to lower rates. Without attempting a full analysis, there is no doubt some merit in the popular identification of the worst performers as countries that both ran current account deficits and depended on bond inflows. The third channel works through currency depreciation. Many studies had suggested that emerging market and other advanced economy currencies appreciated in response to announcements of large-scale bond purchases. Yet most of these studies, like those that analysed the global diffusion of lower bond yields from the same announcements, examined relatively short windows and left open the question of the persistence of any currency appreciation. It was observed that over a four-year period since mid- 2008, the US dollar had depreciated just a bit against emerging market currencies. The fourth channel was dollar credit growth outside the United States. Continued growth in dollar bank credit to borrowers outside the United States was all the more remarkable in view of the retreat of the largest providers of such credit, namely European banks. Their deleveraging has constrained the supply of dollar credit to borrowers outside the United States. The argument mentioned that if domestic currencies carried higher yields, if they were expected to appreciate and if volatility were priced cheaply, firms (and, in places, households) were tempted to redenominate their debt in major currencies. Such redenomination tends itself to put upward pressure on domestic currencies and creates the possibility of a scramble to hedge if the environment changes. From the borrowing country perspective, dollar credit in Asia was growing faster than credit denominated in domestic currency. In Latin America it was growing about as fast. At the same time, important changes have occurred that deserve some attention, in particular the rapid increase in emerging market corporate bond issuance in foreign currencies. Bond market borrowing by emerging market firms has advantages and disadvantages from a financial stability point of view. In contrast to firms borrowing from banks and banks in turn funding themselves with shortterm loans, bond market finance tends to bind investors and issuers over the medium term. This makes sudden reversals of dollar credit less likely. However, the longer-term funding available in dollars may tempt emerging market firms to run currency mismatches. The last channel includes capital outflows. Central banks said at different meetings about derivatives transactions that allow what might be called virtual selling by non-residents. Investors engaged in such virtual selling through sales of the domestic currency forward (and perhaps interest rate swaps) rather than cash selling. Instead of non-resident investors, including multinationals with local operations, liquidating positions, they hedged them through forward sales of the currency (often offshore). Such virtual selling amounts to crossborder risk flows rather than cross-border capital flows alone. This reinforces the point that capital December 2013 CCIL Monthly Newsletter 61

5 flows, like currency moves, cannot serve as a summary statistic of the manifold monetary policy interactions. Conclusion Policy rates may be set precisely to avoid capital flows; global bond markets can move in sympathy without flows; dollar credit can be funded domestically; and non-residents can trade in derivatives markets, leaving no trace in capital flows. All in all, the experience of May through August 2013 can be read as evidence of the previous effect of accommodative monetary policy in major countries in (i) lowering emerging market policy rates; (ii) lowering local currency bond yields; (iii) appreciating currencies; (iv) inducing the shifting of corporate liabilities to dollars and euros; and (v) propelling capital flows. He further stated that policymakers can use the current interval - however long it proves to be - to bolster their resiliency in the face of monetary policy normalization and the inevitable ebbing of global liquidity. Source: 62

Ebbing global liquidity and monetary policy interactions

Ebbing global liquidity and monetary policy interactions Speech by Jaime Caruana General Manager, Bank for International Settlements Central Bank of Chile Fifth Summit Meeting of Central Banks on Inflation