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Tackling the bubbles threat
| What the RBI is trying to do is to erect fences to safeguard the real economy from shocks |
Much of the debate on bubbles (asset price inflation) is in the context of the relationship between asset prices and inflation and strategies for inflation targeting.
BALANCING ACT: Y. V. Reddy (right), Governor of RBI with Deputy Governor V. Leeladhar addressing the press after the announcement of credit policy in Mumbai last month.
IN THE past, announcement of its annual credit policy by the Reserve Bank of India used to be a ritual of interest only to bankers and chambers of commerce. Now it involves all of us.
In its Report on Currency and Finance 2004-05 released in March this year, the RBI narrates how, since the early 1990s, it has been adopting a broad-based multiple indicator approach whereby interest rates or rates of return in different markets (money, capital and government securities) along with data on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, exchange rate and forex transactions are juxtaposed with output data for drawing policy perspectives.
Such an approach provides the RBI flexibility to respond effectively to changes in domestic and international markets. In a press briefing, after releasing the credit policy, the Governor of the RBI, responded, "I don't want the markets to think that a change will come only when the quarterly review comes." He went on to add that the bank was neither attempting to show its autonomy nor going by the wishes of North Block.
Interest rate untouched
What is intriguing is that while the financial press and the trade were anticipating a rise in interest rates in keeping with the stance of other central banks such as the U.S. Fed, the RBI has held on to levers such as repo rates and cash reserve ratio. This has led to the criticism that the RBI is, perhaps, swayed by the political winds.
Apparently, these critics had not studied the credit policy in full or related the implications of measures such as increasing the provisioning requirements in respect of loans to the capital market, real estate and retail borrowers. Some critics felt that these would translate into higher interest rates for the real estate sector and slow down development. In fact, what the RBI is trying to do is to erect fences to safeguard the real economy from shocks that could emanate from hazardous zones. Or, the RBI is readying to prick incipient bubbles.
A close study of bank credit discloses a disturbing picture. There is concentration on retail lending, which has expanded since 2001-02 at 22 to 41 per cent accounting for 26.7 per cent of incremental non-food credit in 2005-06. While non-food bank credit increased by 45 per cent during April-September 2005-06, real estate, housing and trade segments absorbed it. The housing boom has fuelled an increase in credit to the sector with an increase from Rs.75,173 crore in March 2005 to 1,53,267 crore in October 2005. Dispensing housing loans seems the easiest option for many banks.
Alerted to the risks arising out of the skewed nature of bank credit, the RBI had two options: one was to increase interest rates across the board and the other was to take other regulatory measures as a supervisor of the banking system to ensure financial stability.
The first option would be a bludgeon and hurt many other sectors in the economy needing credit at current rates. It would upset the balance in the interest rate structure built diligently in recent years. It could upset the fiscal strategies of the Central and State governments. The monetary and fiscal interface has been elegantly developed in the Currency and Finance Report referred to earlier. (Pages 194-95.) It notes, "Successful stabilisation policy requires that fiscal and monetary policies are perfectly coordinated, both for expansion and contraction of economic activity.'' As it proceeds to observe, the need for coordination is less in advanced countries and greater in developing countries "since the market mechanism is not perfect.''
The RBI chose the second option. It takes recourse to powers as a regulator cum supervisor of banks and raises the bar (increase in capital provisioning) selectively for sectors identified as risk prone.
RBI's selective approach
The advantage is that it allows other sectors to grow. Furthermore, the limits or percentages may be fine tuned in due course. In fact, the RBI had initiated action on these lines even earlier. In Article IV Consultations for 2004, the International Monetary Fund (IMF) agreed that the trends in retail credit required a watch and welcomed the RBI's move to increase the risk weight of these loans. (PIN 05/12, February 3, 2005.) In other words, unlike the U.S. Fed, the RBI has no hesitation in intervening in the market to prick financial bubbles before they emerge.
Much of the debate on bubbles (asset price inflation) is in the context of the relationship between asset prices and inflation and strategies for inflation targeting.
Contentious issue
The area is highly contentious and there is no unanimity among scholars and bankers. Alan Greenspan, former Fed chief, spends a lot of time explaining why central banks could not foresee rising bubbles or decide when to prick them. Adam Posen of the Institute for International Economics (Working Paper 06-1, January 2006) could argue that the connection between monetary conditions and the rise of bubbles is tenuous and anything short of inducing a recession by tightening credit conditions is unlikely to stem their rise. Stephen Cecchetti of Brandeis University could elaborate, "Monetary policymakers have no choice but to face the risks posed by asset price bubbles head on.'' (Asset Price Bubbles and Inflation Targeting, November 2005.) There are many others labouring these themes.
Though Bernanke, Fed Chairman, was the earliest votary of inflation targeting as a monetary economist, his prescriptions given way back in October 2002 in a lecture on Asset Price Bubbles and Monetary Policy would surprise many. Referring to the range of powers the Fed has with respect to financial institutions, including rule making powers, supervisory oversight and a lender of last resort function, he advocated that the Fed could use them to protect and defend the financial system. The RBI's new policy could well be seen in this light as well.
K. SUBRAMANIAN
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