Rules of the Monetary Game Prachi Mishra Reserve Bank of India Raghuram Rajan University of Chicago Presentation at the South African Reserve Bank October 27-28, 2016
Qualifier Views are personal. Not necessarily the official viewpoint of RBI. 2
Outline! Context! Concerns with the current international system! Principles for setting new rules! State of the literature! How to proceed? 3
Context! Great depression o Beggar-thy-neighbor policies! Bretton Woods regime! Fixed (but sometimes adjustable) exchange rates! Post Bretton Woods! No sustained unidirectional direct intervention in the exchange rate! Global environment has changed o Pressure to reach inflation target/ restore growth o Unconventional monetary policies o Adverse spillovers! Domestic mandates => Collectively sub-optimal path! Rules of the game for responsible policy 4
Concerns with the current system! MP spillovers! Normal circumstances o Demand creating > demand switching! Unusual circumstances o E.g. debt overhang o Demand switching > demand creating 5
Concerns with the current system (contd.)! Other effects o Risk taking and leveraging anticipating substantial future liquidity o Spillover to other countries through capital flows into credit and asset price booms -- inherit the accommodative policies of senders 6
Nonresident Portfolio Inflows to Emerging Market Economies 30 25 Billions of U.S. Dollars 20 15 10 5 0-5 -10-15 4/1/12 6/1/12 8/1/12 10/1/12 12/1/12 2/1/13 4/1/13 6/1/13 8/1/13 10/1/13 12/1/13 2/1/14 4/1/14 6/1/14 Date 8/1/14 10/1/14 12/1/14 2/1/15 4/1/15 6/1/15 8/1/15 10/1/15 12/1/15 2/1/16 4/1/16 6/1/16 8/1/16 Equity Bond Source: IMF Global Financial Stability Report 10/16
Corporate debt-to-gdp Ratio for Emerging economies 160 140 120 Debt-to-GDP ratio 100 80 60 40 20 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Year Source: IMF Global Financial Stability Report 10/16
Concerns with the current system (contd.)! Other countries can respond e.g. by letting the exchange rate adjust. Bernanke(2015) o Limits to capacity of countries to respond o Especially if they do not have institutions or credibility o Response cannot be targeted, and never fully offsets o As countries develop, can allow more response! Globally responsible assessment should take the world as is rather than a hypothetical ideal? 9
Concerns with the current system (contd.)! Simply because a policy is called monetary or unconventional, it may not be beneficial for rest of the world! What matters is the relative magnitude of demand switching vs creating effects and other net spillovers! Race to the bottom (musical crises) o Capital flows countered by reserve build-up 10
Race to the bottom (musical crises) Current Account Balance (as % of GDP) 5 Advanced Emerging Emerging Excl. China 2006 4 3 % of GDP 2 1 2015 0-1 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015-2 -3 Source. World Economic Outlook Database, April 2016. Emerging economies include emerging and developing countries. 11
Bottom-line! MP o Spillovers o Influence countries to undertake policies that shift costs o Inefficiencies when countries set policies unilaterally! Countries can agree to rules o Describe the limits of acceptable behavior o Reduce inefficiencies and increase welfare in all countries 12
Coordination vs Rules of the Game! Coordination hard to contemplate o Who will a central bank coordinate with? o How to reach consensus across countries?! Why not capital controls/ macro-prudential measures? o Blanchard (2016) o Bernanke (2015) 13
Coordination vs Rules of the Game (contd.)! Need constrained independence: Rules of the Game! We already have some rules of the game in place: No direct targeting of the exchange rate o What about indirect targeting or implicit targeting? o What about risk spillovers through capital flows?! Problem: Not sure how to measure effects of various policies on aggregate welfare. 14
Principles for setting new rules Policy Rating Green Red Criterion Meaning Example Positive effect on both home and foreign Net adverse spillovers over time Encourage by global community - Conventional MP in home - Booster shot to jumpstart a large home economy + temporary adverse spillovers for foreign Avoid at all times - UMP: small positive effect on home; but large negative effect on foreign Orange Large positive effects for home+ sustained small negative effects for foreign Use temporarily and with care (permissible but not on sustained basis) Conventional MP if financial cycle such that low interest rates lead to financial stability risks 15
Some general principles! Spillovers over time! Account for policies in receiving countries! Weigh spillovers to poor countries a little more at the margin! Measure spillovers in dollar terms 16
Bottom-line: number of factors would determine policy ratings! Time! Stage of business and financial cycle! Booster shot or a mild boost! Standard monetary transmission channels operative! Feasibility of response in foreign countries! Effect on poor countries 17
Five common reactions! Spillbacks! Problems already discussed at various forums! Complicated, hard to communicate! Rules will constrain only systemic CB! Domestic mandate 18
State of the literature! More art than science! Models may reflect policy biases and may be at an early stage! More empirical analysis on the lines of Kamin (2016) o 25 bps decline in US yields causes exchange rate to depreciate by 1% o Demand creating and switching effects exactly offset each other 19
How to proceed? 4-step process! I. Studies by independent groups of the effects of various policies o Group of eminent academics o Rate policies! II. International meetings o No policies to be off the table! III. International conference o New international agreement on the lines of Bretton Woods o Arbitration panel? o Enforced by multilateral organizations! IV. Change central bank mandates 20
How to proceed? (contd.)! Role of the Fund? o Articles of Agreement (IV.1): general obligation to collaborate with other members to assure orderly exchange arrangements. o What is general obligation o basis for the Fund to call on certain members to take specific actions or refrain from taking those o Set of policies to be widened? o Financial stability implications? o Countries are not obligated to take Fund advice o clear focus on downsides of particular policies can put political and economic pressure 21
Conclusions! Much needs to be pinned down on international spillovers of domestic policies! Economic analysis still at an early stage to get prescriptions, let alone international agreements! Period of focused discussion to understand what are reasonable rules of conduct! Next: 4-steps o Studies by independent groups o International meetings o Codify rules through international agreement or Articles of IMF o How countries can alter domestic mandate to incorporate international responsibility 22
Thank you! Questions? 23