Independence and interdependence

What follows are verbatim extracts from a speech delivered by Dr. Y.V. Reddy at a conference held in Patna nearly a month ago on public finance:

In brief, the three policies like all other policies have an over-arching objective of welfare with each policy having its own defined set of objectives and appropriate operating instruments to achieve the specified objectives.  It is believed that one of the contributing factors to Global Financial Crisis (GFC) is underestimating the inter-dependence of these policies, and over-emphasising their independence. 

[The three policies he is referring to are fiscal, monetary and regulatory]

Exclusive focus of monetary policy on price stability had its pitfalls.  It has become clear that financial stability considerations, in particular, the asset prices, cannot be ignored.  The possibility of excess liquidity provided by the monetary authorities for a prolonged period impacting the excesses in finance is noted. 

The assumption that financial markets correct themselves and have a benign influence on growth is questioned.  The incentive mechanisms in the financial institutions and the possibility of excessive financialisation in the financial markets are recognised. 

[In the paragraphs above, he is pointing to the lessons learnt from the crisis of 2008. I guess, they are lessons that ought to have been learnt but not quite learnt]

As regards monetary policy, RBI rejected inflation targetting and single objective, unequivocally.  It did not share the enthusiasm for capital account convertibility and decided to manage impossible trinity.

[That is a nice summary of the policy framework of RBI under his leadership]

While concerted action was possible for strengthening the private sector banking system, the regulatory actions of a prudential and counter-cyclical nature by the RBI were undertaken despite some resistance from government and financial markets. 

[He is rather understated here, on the tensions that existed between RBI and the Government of India in 2006-08 on the regulation of the financial sector]

The objectives of monetary policy in India continued to be price stability or credit for productive activities, depending on the context.  Inflation targeting was not adopted in India. Dominance of banking, in particular, public sector continued though presence of private sector increased.  There was a cautious deregulation of the banking sector.  Counter-cyclical prudential policies were followed, and capital account was managed.

[That is an excellent summary of the differences in the global ‘best practice’ (?) and Indian policy framework between 1993 and 2008. After 2008, the world has copied some of the above practices.]

A common thread in all these arrangements is that they were intra public sector transactions that were transparent and strengthened effectiveness of public policy.  All of them strengthened the balance sheet of RBI to enable it to serve the economy and government. 

[He is referring to the various arrangements put in place between the GoI and RBI on management of foreign exchange reserves, sterilisation costs, on the guarantees that RBI had extended on foreign exchange losses, etc. Indirectly, he is hinting that the current differences could have been handled if there was recognition that these were ‘intra public sector transactions’]

Government continues to be a privileged owner of enterprises in the financial sector – thus constraining the regulator’s effectiveness. 

He is right to reiterate his reservations on the Government ownership of the banking system inasmuch as it adversely affects RBI’s regulation of these banks. He endorses Urjit Patel’s comments in this regard.

The overall thinking in Government about reforms changed from the moment Raghuram Rajan Committee gave its recommendations in 2008; and Justice Sri Krishna Committee gave its report in 2010.  The influence of RBI on the general thinking on reforms changed and a new framework took its place.

[In the above comments, he leaves more unstated than state them. Justice Sri Krishna Committee’s recommendations were made in 2013, I think. I think Dr. Reddy is referring to the recommendations of the Financial Sector Legislative Reforms Commission. Or, it could be another Committee.]

The government by virtue of its role as a coordinator and at the same time as the owner of the regulated entities puts / makes the central bank and the regulators somewhat ineffective unless they are on the same wave length as the government. The financial intermediaries in banking, insurance and even non banking mutual funds, etc. continue to be dominated by the presence of public sector.  Hence, the regulators’ standard tools are ineffective. 

[A rather forthright comment by the former Governor. The votaries of public sector banking in the present ruling dispensation must take note of these observations.]

Under the new regime, the financial stability considerations are not explicitly taken into account. In regard to external sector also, the stability considerations are not explicitly built into the monetary policy objectives. Is there a danger that the advantages of in-built coordination available in full service central bank been foregone?  Is there an identity crisis because of the juxtaposition of the MPC in a full service central bank? 

[Dr. Y.V. Reddy has raised some very important questions here on the monetary policy framework, on the government-RBI relations, etc.]

The effectiveness of “independent” monetary policy is blunted by the criticality of government owned banks for transmission of monetary policy.

[In a sense, he is highlighting the incompatibility of independent monetary policy and government-ownership of the banking system]

The regulatory framework of banks is not neutral to ownership in the sense that governance of public sector banks continues to be determined by the government.  The fiscal authorities use the banking system to implement some of the government developmental programs and RBI as a regulator does facilitate the use of public deposits with the banks for pursuing governmental programs. 

[Dr. Reddy again reminds us of the complexity that the RBI has to deal with, given government’s ownership of the banking system and its fiscal and development imperatives.]

This speech is not yet uploaded on his website. Once uploaded, you will find it here.

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