Hollowness in banking

News coverage of Dr. Y.V. Reddy’s (former Governor of the Reserve Bank of India – India’s central bank) second book launch was extensive. He has friends in the media. MINT and Business Standard did their interviews with him. You can find them here and here. His comments on the hollowness in our banking in his interview to MINT caught many eyes predictably since they put it up in the header. This is what he said:

The major area of concern is the hollowness in banking. And, especially when there are huge uncertainties and volatilities in global markets, the importance of stimulating productive activity within the economy is important.

I think it is time for some countries—and I am not restricting to India, it may even be United States—to consider selective credit controls and the credit allocation to sectors. It may appear to be too retrograde, but these are extraordinary times when you have to stimulate (productive sectors).

Alarm bells would go off in many heads and for good reason. Government allocation of credit is not what he is after, though. Think of how private equity, venture capital funds and even hedge funds try to limit their exposure to any one stock or sector or company, etc. Ultra-lowshort-term interest rates together with free international capital flows mean that many investments go for investments with short horizons. Invariably, they are to be found in the financial markets with liquidity. Real estate comes next because it is much more profitable than patient investing into businesses and new ventures. So, how to ensure that the so-called and alleged positive impact of low interest rates is felt in real investments and not in speculative and/or financial investments? (for the most part, both mean the same thing).

That is the question that Yours Truly tried to grapple with (or, ended up merely posing) in one of his recent MINT columns:

…central banks in the region must think of internal capital controls before they think of holding back hot money inflows from abroad.

Naturally, this might bring howls of protests of capital rationing, etc. Central banks and governments have been intervening in financial markets for dubious ends in the last several years. For a change, they could do so for a good cause. It is invariably the case that loose monetary policy and low interest rates encourage speculative investments rather than good investment that officials seek. That they are determined to inflict low interest rates on the economy with the fond hope of boosting the right investment spending in the economy in disregard of empirical evidence raises doubts about their intent or intellect or both.

Hence, for a change, they and their governments must consider either signalling or directing capital to inflation-unfriendly investments (those that lift potential GDP growth rate) than to inflation-friendly investments (stock markets and property). [More here]

It is hard to quarrel with Dr. Reddy when Sanjaya Baru writes, after his interview with Dr. Reddy for Business Standard,

He is not too enthused by the global response to the crisis. Neither the International monetary Fund (IMF) nor the G20 has yet grasped the fundamentals. Globalisation of finance without global governance is a recipe for disaster. Recent events in Europe are a reminder that all is still not well, so India’s policy makers have to be on constant alert.

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