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Central Banking in an Uncertain Age

There is no doubt that the financial sector in India was generally much less affected by the global financial crisis of the past year than in many other developed and developing countries.  This is not to say that Indian finance was unaffected: there were wild swings in external capital flows (particularly portfolio flows) as well as in the stock market.  And the credit crunch that was so evident in September 2008 may have abated for large corporates, but it continues to plague small producers in all major sectors.  If anything, the lack of financial inclusion that has been such a major failing of institutional finance in India has been further intensified during the crisis.

Even so, the overall resilience of Indian banking is now the object of international interest.  This outcome is seen to reflect the combination of a relatively cautious and calibrated approach to financial liberalisation (reflecting also the political equations that affected government policy in this regard); the continued presence and strengthening of public sector banks, which account for the majority of banking transactions in the country; and the recognition that in a developing country such as India banking and monetary policies need to serve a variety of social objectives.

Obviously, the central bank is absolutely crucial in all of this.  Therefore, much attention has also been focussed on how exactly the Reserve Bank of India (RBI) dealt with issues of monetary and capital account management and financial sector reform in the past five years, which was a relatively unusual period both globally and within the country.

Particularly, the role played by the then Governor of the RBI Dr. Y. V. Reddy, has been widely noted, because of his judicious approach to various financial liberalisation measures that were eagerly pushed by some sections of the Indian establishment.  During his five-year tenure, the RBI displayed what now turns out to have been extremely effective responses, in terms of strengthening public sector banks by recapitalisation; preventing some of the financial ”innovation” that allowed risk to be disguised rather than actually reduced; taming the overexposure of domestic banks to what are now seen as toxic assets globally; restraining the excessive bullishness of financial investors in real estate; regulating the activities of systemically important non-bank financial institutions; and speaking out against hasty and potentially risky attempts to liberalise the capital account of the balance of payments.  It also argued (albeit unsuccessfully) against some practices that continue to be dubious, such as the Participatory Notes route for portfolio capital inflows.  All these measures stood India in good stead not only by preventing over-enthusiastic responses during the global boom, but also reducing the negative impact of the global slump.

That may be why the Nobel Prize-winning economist Joseph Stiglitz, who was most recently head of the Commission set up by the UN General Assembly to examine the international financial architecture (of which Dr Reddy was also a member), famously said in an interview to an Indian television channel: ”If America had had a central bank chief like Y.V. Reddy, the US economy would not have been in such a mess.”

Naturally, in such a context, a book written by Dr Reddy that outlines the important elements of his approach and describes the challenges of central banking in these complicated times is of very great interest.  In general, books by central bankers are not known for their readability or their wider appeal.  But this particular book (India and the Global Financial Crisis: Managing Money and Finance, New Delhi: Orient Blackswan 2009) stands out as an exception.  It is very clearly written, in as accessible a style as possible given the inevitable complexity of much of his subject matter.  While describing the experience of the recent past, Reddy makes a number of points that remain even more relevant today.

The approach outlined in the book is essentially a pragmatic one, eschewing orthodoxies of either Right or Left and not falling easily into any definable camp in terms of policy orientation.  The Introduction as well as the various speeches and articles collected in the book make it clear that Reddy sees that central banker’s task in an economy like India is fundamentally about growth, stability and financial inclusion.  The latter is the most important addition, and it is significant that all three goals are seen to be equally important.  This makes the approach very different from mainstream ways of looking at central banking, especially the recently popular paradigm in which inflation targeting was typically seen as the only goal, with the interest rate as the sole instrument, while financial markets were largely left to fend for and regulate themselves.

This approach is elaborated in several chapters that provide a fascinating account of the dilemmas and policy choices that faced the RBI in particular episodes, in what must be seen as a turbulent and constantly changing domestic and international environment.  The difficulty of trying to ensure that prudential regulations operate in a counter-cyclical way, given that they have been designed to be pro-cyclical in effect, is neatly described — and it remains one of the central issues facing the Basel Committee today.  The problems of identifying which are the systemically important financial institutions (both banking and non-banking), and how exactly their activities need to be controlled, are also clarified through descriptions of actual decisions made at different times.  The need to curb excessive enthusiasm in introducing futures markets on an extensive scale within India is highlighted.  The risks inherent in opening up of financial markets, especially debt markets, to foreign investment, are identified in what now seems like a very prescient analysis.

During Dr. Reddy’s tenure at the RBI — when the articles collected in this volume were written — many if not most of these positions were seen as not just cautious but also heterodox and possibly even heretical.  But the validity of these arguments has been effectively underlined by subsequent experience, not only in India where many of these views prevailed in terms of actual policy, but in the counter examples of economies where excessive deregulation and lack of a coherent central bank strategy for controlling finance were closely associated with financial crisis.

Reddy does not subscribe to the view that foreign banks or foreign capital are critical to enabling improvements in the domestic banking sector, which continues to be dominated by public sector banks.  Rather, in the Indian case, domestic banks were effectively dealt with and strengthened through a variety of measures, by easing some constraints on the functioning of public sector banks and addressing the problems of vulnerable private sector banks through capitalisation, mergers and regulatory rigour.  This remains a critical issue since the advocates of further privatisation and foreign ownership of banks continue to press for such changes, despite recent international experience.

The book also provides a valuable insight into how the approach of the central bank has to change not only according to various goals that are seen as important, but also in response to the changing economic situation.  Reddy describes how the period after 2000 witnessed a move from what had been characterised by ”lazy banking”, in which banks simply invested in safe securities such as government bonds even in excess of the statutory requirement, to what he designates as ”crazy banking” with an explosion of credit after 2005.  This was dealt with by insisting on additional capital requirements, because of the uncertainties and risks that seemed to be emerging.  At the time there were those who cried foul, but there can be no denying that such protection eventually proved to be of great consequence.

The need for a more financially inclusive policy is clearly one of Reddy’s central concerns, as is only to be expected given the very poor degree of access to institutional finance to the bulk of the Indian population and large parts of the productive sectors in the economy.  Despite some efforts, this clearly remains a major area of underperfomance, at least partly because microfinance has been treated as an alternative.  Reddy provides a very interesting discussion on the qualities and possibilities of microfinance, and correctly notes that the long term objective should be the financial inclusion of all persons through the banking system, rather than to have two separate institutions, micro for the poor and banks for the rest.

This is an extremely useful book not only for those involved in finance, but even for laypersons who wish to understand how the Indian financial system works.  But it is also significant because of the importance of several of Reddy’s arguments for the ongoing debate on financial sector reform in India.  Now that the Indian government, in an apparently incomprehensible move, has chosen to take a World Bank loan to recapitalise public sector banks (even though the banks are generally perceived to be in good shape financially and in any case no foreign exchange is required for such a project) it is likely that many policies such as unnecessary opening up to foreign capital and allowing greater risk exposure and financial innovation will be pushed.  It is therefore essential to have cogent and sensible positions on the need for and the likely impact of such policies, as identifying alternative strategies for Indian banking and finance.

So Reddy’s book does much more than provide an illuminating account of central bank policy from the point of view of a recent practitioner.  It provides a reasoned critique of policies of unnecessary deregulation and highlights the need for balance and for recognising the requirements of the development project.  While it may not provide full details, it also sets out the possibility of an alternative framework that can be applied even in these more open and externally integrated times, to work towards the goal of social banking for all.

Jayati Ghosh is Professor of Economics and currently also Chairperson at the Centre for Economic Studies and Planning, School of Social Sciences, at the Jawaharlal Nehru University, in New Delhi, India.  With C.P. Chandrasekhar, she co-authored Crisis as Conquest: Learning from East Asia.  This article was first published by MacroScan on 7 October 2009; it is reproduced here for educational purposes.

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