One of the things that we perhaps ought to have learnt from the financial crisis of 2007-2008 is that price stability does not necessarily guarantee financial stability. The latter has to be an independent mandate for central banks. The sub-prime crisis incidentally came at a time when inflation in western economies was well within central bank targets and the macroeconomic environment seemed somewhat calm.
In terms of policy, the quest for financial stability has a couple of implications. First, central banks need to use macro-prudential norms (things like getting banks to build capital buffers during a business upswing) to ensure that the financial system is in good fettle. Second, they need to have a set of tools at their disposal to smooth out the impact of a severe jolt to the financial system. Mere rate cuts, for instance, turned out to be far from adequate in restoring some degree of order to the American and European inter-bank markets. The Fed and the European Central Bank had to resort to the untested quantitative easing, which has now become part of central banks’ standard toolkit. The use of some of these tools (massive liquidity infusion, for instance) could seem to work against the objective of price stability and confuse the markets. It is the job of a central bank to make sure that its policy actions are interpreted correctly.
Let me get to the point. It is about time the Reserve Bank of India (RBI) started giving financial stability top priority yet again and building levees against the bore tide of another global financial crisis. While it certainly cannot be complacent about inflation at this stage, it has to get concerns about the health of the financial system back on the table. The reason for this is somewhat obvious: Europe seems to be melting down and the risk of things getting worse remains high.
What’s the best bet on how things are likely to pan out in Europe? In the most benign scenario, that could mean some heavy-duty sparring between the emerging anti-austerity left and the pro-austerity right, led by Germany. This might not immediately lead to a break-up of the currency union but would be enough to trigger a major “risk-off” episode in the global markets.
The extreme scenario involves Greece exiting the currency union, perhaps in a bit of a huff, leaving European banks with large holdings of a debt that is suddenly redenominated in a somewhat worthless currency. European policy makers are likely to try to “manage” this exit as much as possible but a Lehman moment seems likely, in which the inter-bank markets freeze over and European and American banks wind up their external market positions to pull the money back into their home markets.
The implications for India in both scenarios (with some difference in the degree of intensity) would be the following. There would certainly be more pressure on the rupee. Equity investors who still haven’t left in droves could start going massively short. As international banks cut their India positions to infuse liquidity back into their home markets, there could be a severe shortage of funding for domestic companies. When these companies turn to domestic banks for succour, it could trigger a massive liquidity shortage in the domestic market. This shortage will not be confined to the banking system, but it is likely to spill over — to non-banking financial companies (NBFCs), for example.
The RBI has to make a choice. It can wait for the crisis to actually unfold before getting into full-blown crisis-fighting mode or it can stay ahead of the curve. I read its enhanced intervention in the foreign exchange market as a signal that it is beginning to worry increasingly about financial stability.
Also, I don’t necessarily believe that the RBI is fighting a losing battle. The objective is not to successfully defend a level of the exchange rate even if market forces are pitted against it. Instead, it is to signal to the market that the bank is not entirely indifferent to the fate of the currency and will, to the extent possible, make available a supply of dollars from its reserves. This is a marked departure from its stance just a few weeks back when it seemed somewhat squeamish about using its reserves. More administrative measures are also warranted — these could include a government-backed international bond issue and a separate dollar-sale window for oil companies. The RBI’s willingness to hold the market’s hand could just prevent a phase of rapid depreciation from metamorphosing into a full-blown run on the currency.
The other thing the RBI needs to address is the shortage of liquidity that is likely to intensify going forward if the crisis moves along a similar path as it did in 2008. It has resumed open-market operations but will have to do more if money markets begin to tighten further. This is the trickier bit — if the RBI does infuse more liquidity, the markets could interpret this as a sign that the central bank is lowering its guard against inflation. The way around this is to emphasise that, given the current situation, the central bank’s agenda has to move beyond the standard growth-inflation debate. If indeed money markets freeze across the world, there will be a knock-on effect on India. Thus, a cut in the cash reserve ratio seems imperative. It is the central bank’s task to convince the perpetually hawkish sections of the market and the analyst community that, given the looming risks, easing liquidity is in the best interest of the system.
The author is chief economist, HDFC Bank