The following discussion illustrates possible changes in approach that can be considered by outlining the policies and approaches practiced by the Reserve Bank of India over the past decade or so. This approach not only has greater relevance for emerging markets, but it also contains important lessons for advanced countries.
Conditions Dictate Objectives and Institutional Structure
The conduct of monetary policy by the Reserve Bank of India has been guided by both price stability and financial stability objectives. These dual objectives are combined with a third important objective: to provide support to growth through adequate availability of credit. In other words, price stability and financial stability and economic growth are all considered inexorably linked in the policy mix.
The Reserve Bank, thus, is not only responsible for monetary policy; it is also responsible for development and regulation of the banking sector and key segments of financial markets, foreign exchange management and public debt management. Contrary to the predominant view that the combination of all these functions leads to serious conflicts of interest, my experience is that the coordination of these functions under one roof has been very helpful in preserving financial stability along with low inflation and sustained high economic growth, and, therefore, to the practice of independent monetary policy in India.
Globally, financial stability is emerging as an explicit objective for central banks only after the global financial crisis. In India, however, financial stability has been an explicit objective of the Reserve Bank since the early part of this past decade.
This unique and wide-ranging mandate grew out of, among other things, the growing degree of financial deregulation and liberalization in India combined with low income levels and limited capacity of the majority of population to bear downside risks. Thus, unlike the trend toward a single objective (price stability/inflation targeting), monetary policy framework in India is based on multiple objectives and instruments that recognize explicitly the risks of economic and financial instability while ensuring price and growth stability.
Why Inflation Targeting Is Not Enough
While price stability remains a key objective, an inflation targeting framework alone is inadequate because India is subject to a number of shocks and special regulatory and administrative structures not necessarily present in other countries. These shocks include recurrent supply shocks from vagaries of the monsoon; large weight of food prices (46-70 percent) in various consumer price indices; large differences in consumption habits across different regions and thus large differences in how these shocks affect spending power; large fiscal deficits and market borrowings by both the central and state governments; and impediments to monetary transmission due to administered interest rates in some government savings instruments. (Mohan, 2007)
Apart from the Indian specifics, the inflation targeting framework was— well before the current crisis hit us – considered to be too narrow and unsuitable given the complexities that a central bank faces in its objectives (Mohan, 2004). The global financial crisis has now justified such concerns.
Broader Objectives Require More Tools
The monetary policy framework switched from the extant monetary targeting framework to a “multiple indicators” approach in 1998. Under this framework, which continues to be in place today, monetary policy signals are largely transmitted through changes in policy rates (repo/reverse repo rates under the daily Liquidity Adjustment Facility (LAF)).
Unlike other major central banks, no single/central rate is targeted. Rather, the Reserve Bank has preferred an interest rate corridor (band) approach in view of large and recurrent exogenous shocks to liquidity emanating from volatility in capital flows and government cash flows.
In view of the large potential changes in monetary aggregates, principally caused by the volatility in capital flows, the Reserve Bank also uses changes in instruments such as the “Cash Reserve Ratio” (CRR) and the “Statutory Liquidity Ratio” (SLR), to modulate liquidity in the system and to keep the trends in monetary aggregates within the desired trajectories.
Sterilization operations through the use of multiple instruments are a particularly important component of monetary management in the face of volatile capital flows. Key elements of this framework have been: active management of the capital account, especially debt flows; tighter prudential restrictions on access of financial intermediaries to external borrowings; flexibility in exchange rate movements but with capacity to intervene in times of excessive volatility; and active management of foreign exchange reserves, accumulating them in times of excess flows and using them when reversals occur.
Furthermore, prudential regulations have been used in an integrated manner as supplements to overall monetary policy. Such measures are used to respond when large movements in credit growth to certain sectors are observed, particularly when such movement could lead to an excessive rise in asset prices with potentially adverse effects on financial stability.
Policies Operate in a Coordinated Manner to Smooth Market Effects
Financial markets have been developed continuously in terms of participants and instruments, but with a cautious approach to risky instruments. The financial sector has been strengthened through prudential regulation while also enhancing competition, and through pre-emptive tightening of prudential norms when necessary.
Policies operate symmetrically. During periods of heavy inflows, liquidity is absorbed through increases in the cash reserve ratio and issuances under the market stabilization scheme.
During periods of reversal, liquidity is injected through cuts in cash reserve ratio and unwinding of the market stabilization scheme. Overall, rather than relying on a single instrument, many instruments have been used in coordination.
This type of very sophisticated and effective coordination is possible because monetary policy, the regulation of banks and other financial institutions, and the regulation of key financial markets are under the jurisdiction of the Reserve Bank. Thus, the Reserve Bank had the tools and the mandate it needs to manage a disciplined execution of various policy instruments. This approach to monetary and market regulation minimizes adverse market effects because banks, investors and other financial intermediaries have time to adjust to the new environment.
Outcomes Are Satisfactory, If Not Perfect
The outcomes have, by and large, been satisfactory. Growth in monetary and credit aggregates is, by and large, contained within desired trajectories and consistent with the overall GDP growth objective. There has been significant financial deepening. Inflation has been reduced significantly from its levels prevailing during the 40-year period until the late 1990s.
Growth has accelerated on the back of productivity gains, based in part on the increased “predictability” (i.e., stability) in the economic and financial environment. The improvement in India’s fundamentals is reflected in the growth of exports of goods and services.
Domestic investment has increased substantially since the beginning of this decade, predominantly financed by domestic savings. The surge in investment and savings is made possible by efficient allocation of resources by the domestic banking system and financial markets, despite many constraints. Overall, financial stability has been maintained.
Lessons From the Indian Experience
The key lesson from the Indian experience is that monetary policy needs to move away from a narrow price stability/inflation targeting objective as may be warranted by circumstances. As guardians of financial stability and lenders of last resort, central banks need to be concerned not only with monetary policy but also with development and regulation of banks and key financial markets, like money, credit, bond and currency markets.
I have provided this sketch of the Indian approach to coordinated monetary policy, external account management and financial regulation as an illustration of the kind of complex response that is needed in the face of complex circumstances.
Such a multitude of instruments is probably not needed, nor feasible, in an advanced economy with well-functioning and efficient financial markets. But, as illustrated by the response of central banks when financial markets broke down in late 2008, even in advanced economies, when objective circumstances change, the toolkit does have to expand.
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