In terms of policy, the quest for financial stability has a coupleof implications. First, central banks need to use macro-prudentialnorms (things like getting banks to build capital buffers during abusiness upswing) to ensure that the financial system is in goodfettle. Second, they need to have a set of tools at their disposalto smooth out the impact of a severe jolt to the financial system.Mere rate cuts, for instance, turned out to be far from adequate inrestoring some degree of order to the American and Europeaninter-bank markets. The Fed and the European Central Bank had toresort to the untested quantitative easing, which has now becomepart of central banks" standard toolkit. |
The use of some ofthese tools (massive liquidity infusion, for instance) could seemto work against the objective of price stability and confuse themarkets. It is the job of a central bank to make sure that itspolicy actions are interpreted correctly. Let me get to the point. It is about time the Reserve Bank of India(RBI) started giving financial stability top priority yet again andbuilding levees against the bore tide of another global financialcrisis.
While it certainly cannot be complacent about inflation atthis stage, it has to get concerns about the health of thefinancial system back on the table. The reason for this is somewhatobvious: Europe seems to be melting down and the risk of thingsgetting worse remains high. What"s the best bet on how things are likely to pan out inEurope? In the most benign scenario, that could mean someheavy-duty sparring between the emerging anti-austerity left andthe pro-austerity right, led by Germany. This might not immediatelylead to a break-up of the currency union but would be enough totrigger a major "risk-off" episode in the globalmarkets. The extreme scenario involves Greece exiting the currency union,perhaps in a bit of a huff, leaving European banks with largeholdings of a debt that is suddenly redenominated in a somewhatworthless currency.
European policy makers are likely to try to"manage" this exit as much as possible but a Lehmanmoment seems likely, in which the inter-bank markets freeze overand European and American banks wind up their external marketpositions to pull the money back into their home markets. The implications for India in both scenarios (with some differencein the degree of intensity) would be the following. There wouldcertainly be more pressure on the rupee. Equity investors who stillhaven"t left in droves could start going massively short. Asinternational banks cut their India positions to infuse liquidityback into their home markets, there could be a severe shortage offunding for domestic companies.
When these companies turn todomestic banks for succour, it could trigger a massive liquidityshortage in the domestic market. This shortage will not be confinedto the banking system, but it is likely to spill over — tonon-banking financial companies (NBFCs), for example. The RBI has to make a choice. It can wait for the crisis toactually unfold before getting into full-blown crisis-fighting modeor it can stay ahead of the curve.
I read its enhanced interventionin the foreign exchange market as a signal that it is beginning toworry increasingly about financial stability. Also, I don"t necessarily believe that the RBI is fighting alosing battle. The objective is not to successfully defend a levelof the exchange rate even if market forces are pitted against it.Instead, it is to signal to the market that the bank is notentirely indifferent to the fate of the currency and will, to theextent possible, make available a supply of dollars from itsreserves. This is a marked departure from its stance just a fewweeks back when it seemed somewhat squeamish about using itsreserves.
More administrative measures are also warranted —these could include a government-backed international bond issueand a separate dollar-sale window for oil companies. TheRBI"s willingness to hold the market"s hand could justprevent a phase of rapid depreciation from metamorphosing into afull-blown run on the currency. The other thing the RBI needs to address is the shortage ofliquidity that is likely to intensify going forward if the crisismoves along a similar path as it did in 2008. It has resumedopen-market operations but will have to do more if money marketsbegin to tighten further.
This is the trickier bit — if theRBI does infuse more liquidity, the markets could interpret this asa sign that the central bank is lowering its guard againstinflation. The way around this is to emphasise that, given thecurrent situation, the central bank"s agenda has to movebeyond the standard growth-inflation debate. If indeed moneymarkets freeze across the world, there will be a knock-on effect onIndia. Thus, a cut in the cash reserve ratio seems imperative.
Itis the central bank"s task to convince the perpetuallyhawkish sections of the market and the analyst community that,given the looming risks, easing liquidity is in the best interestof the system. The author is chief economist, HDFC Bank.
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