Back What kind of a central banker do we need?
V. Anantha Nageswaran
| Examining the issues involved in a central banker's attitude towards risk and experimentation and whether there is a case for more experimentation in a developing, than in a developed, country, V. Anantha Nageswaran concludes that there can be no final answers to these issues. Indeed, the conclusion is that the answer is context-specific. |
The Finance Minister flatly rejected there was any proposal to tax FII inflows and Dr Reddy had to hastily amend his remarks though he had only called for an examination of that option. The episode has stirred interest on the issue of appropriate policy framework for a central banker.
This article examines the issues involved in a central banker's attitude towards risk and experimentation and whether there is a case for more experimentation in a developing, than in a developed, country. To preview the conclusion, there are no final answers to these issues. Indeed, the conclusion is that the answer is context specific.
Impact of FII flows into India debatable
Dr Reddy may have been right fretting over the sustainability and quality of the non-debt flows . The last two years saw ample FII inflows into the Indian stock market but two years do not make a trend.
FII flows may remain positive in the coming years but if they drop to a trickle, as they did in 2001-02 in the event of a global crisis, then the impact on the stock market, IPO prospects and the general investment climate could be adverse. The recent resurgence in industrial production and investments could fade. Some argue that the impact of the FII activity on the real economy is limited given that there is only a weak and, perhaps, non-existent link between foreign money inflows and domestic credit creation. Interestingly, Dr Reddy hinted at the lack of any impact of FII flows on the quality of corporate governance.
In general, he was right to be worried about hot money given the lack of sensitivity of the political class to fiscal discipline. However, given that the FII flows are concentrated in equities, fiscal deficit might only have a relatively minor impact on their attitude towards Indian stocks. In fact, the deterioration in the quality of Indian public finances has hardly bothered them in the last several years.
Context of remarks is important
Further, three observations on his musings could be made:
(a) Whether his solutions (taxation and quantitative curbs) are the right ones given that they might even have a negative signal effect on the long-term Foreign Direct Investment (FDI) that he hopes to replace the FII with.
(b) Whether he should have thought aloud on as sensitive a matter, instead of putting them in a more pedantic working paper and circulating it to think-tanks for their feedback.
We live in a world dominated by sound-bytes and the RBI is not an insignificant entity in the global arena. Indeed, it is a tribute to India's recent macro-economic achievements that his remarks are being widely debated. Both of these call for extra caution on policymakers' loud thinking.
He should have been cognisant of the amplification effect that invariably accompanies public pronouncements on such sensitive subjects, unless it was deliberately intended. Based on the swift denial from the Finance Minister and Dr Reddy's subsequent retraction, it is clear that it was not intended to be a policy `trial balloon' done in co-ordination with the government.
(c) The last `criticism' is a larger question that goes beyond the immediate issue of Dr Reddy's pronouncement on the issue of FII flows. It is an issue of the attitude of a central banker in a developing country compared to a central banker in a developed economy.
Central banks must be pro-growth...
It is received wisdom that central bankers should be risk averse. The overused expression is that they should take away the `punch-bowl when the party gets going'. Perhaps, and I concede that I am just floating a hypothesis here, the emphasis in a developing economy ought to be more on fostering growth rather than preserving macro-economic stability. Lest I am misunderstood, I am not calling for a wholesale jettisoning of stability. It is a slight shift, nonetheless with important policy ramifications, in favour of growth over stability.
In developed countries, prosperity has been achieved and hence the accent is on its preservation more than on its creation. Hence, stability and low inflation are emphasised by economists over growth-supportive monetary policy. That is why there has been an active debate on the role of Mr Alan Greenspan, US Federal Reserve chief, in the last few years in fostering asset market bubbles in the 1990s and in the housing market in the first few years of this decade.
... favour stability in developed world
A snapshot of the American economy actually vindicates Mr Greenspan's approach. America has an unemployment rate at 5.4 per cent, GDP growth at around 3 per cent even if one eliminates statistical manipulation, a stock market that sports a multiple of 20, a bond market with a yield of tad above 4 per cent and a fiscal deficit of about 2.7 per cent of GDP, based on projected 2004-05 deficit.
Hence, on the face of it, Mr Greenspan's aggressive, risk-seeking monetary policy stimulus has worked. This strengthens the case for fiat money (issued under the authority of a sovereign government and hence, largely discretionary) compared to the Gold Standard (which is rule-based and thus effectively determines the money in circulation).
That is, America's relatively (or, seemingly) easy recovery from an almost statistically non-existent slowdown seems to argue the case for policy discretion over policy rules.
Arguments in favour of rule-based policy
A monetary policy based on a nominal anchor such as the Gold Standard would not have allowed the liquidity binge of 2001-03 nor, consequently, home prices to rise which actually allowed consumer balance-sheets to recoup stock market losses. Which means the American consumption boom may not have continued as it did between 2001 and 2004 and which means global growth would have been a lot lower. So, a moral case seems to exist for policy discretion over policy rules.
However, there are two counter-arguments in favour of policy rules:
(1) No one knows the long-run costs of the rise in household debt, current account deficit in the US that accompanied this seemingly robust recovery. That is, despite the short-term pain that one might associate with rule-based policies, their long-term consequences could arguably be a lot less harmful. Conversely, the long-term costs of policy discretion are uncertain and could be significant.
(2) A more compelling counter-argument is that policy rules might dampen the boom-bust cycles if not totally eliminate them. If policy by rules was in force, a speculative and unsustainable boom such as the Internet and technology stock boom of the late 1990s would not have occurred at all.
So, there would not have been a bust and hence, there would not have been the need for policy stimulus (large and unwise distribution of fiscal stimulus and a large monetary policy stimulus in the US) that has created potentially another bubble — this time in the housing market. Money supply, credit and interest rates would be largely dictated by the nominal anchor and hence, there would have been little discretion of the sort that allowed America to experiment with the Non-Accelerating Inflation Rate of Unemployment (NAIRU) in the 1990s.
Such experimentation, which recognised low inflation in goods and services but ignored the acceleration in asset price inflation, led to ultra-low interest rates and hence, an unsustainable boom in stock prices, not to mention all sorts of ethical and moral transgressions that had to be resorted to, to justify the `bubblesque' prices of stocks.
Further, monetary policy discretion and fiat money sit rather uncomfortably with the concept of laissez-faire economics. The fiat money system which is an integral part of discretionary monetary policy thus distorts market signals.
Hence, if a collapse in the dollar and the global monetary system that might yet follow America's galloping trade and current account deficit and Asia's complacent financing of the same restores the role for some nominal anchor to monetary policy, genuine laissez-faire economics would have taken an important step forward.
India's past stability was at cost of growth
Therefore, it appears that the booms and busts of the 1990s seem to call for less discretion, less risk-taking and experimentation and more stability in the monetary policy regime in the industrialised world. In contrast, developing countries need change over stability. Most would agree that India enjoyed macro-economic stability up to the 1980s. But, to what avail? The world would have hardly bothered about the remarks of the RBI Governor then. Indian economic growth was lacklustre.
Again, not to be misunderstood, financial system stability maintained through proactive and continuous regulation and supervision of the financial institutions in the country is a necessary condition for growth and I do not wish to de-emphasise it. In fact, the record of the Reserve Bank of India on that has been spotty, at best.
It is in strategic policy-making that one prefers experimentation, a certain boldness and innovation in the context of our overall macro-economic goals than an obsession with risks. Indian central bankers, indeed even reform-minded Ministers, have yet to show the courage of their convictions on reforms as opposed to reacting to the compulsions of circumstances.
(The author is founder-director of Libran Asset Management (Pte) Ltd., Singapore. The views are personal. Address feedback to van@libranfund.com)
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