Central bankers are a privileged elite even within the
now globally dominant financial community. Like all
elites they have their own codes of behaviour and modes
of communication, learnt on the job after entry into
the club. Language is crucial here. Phrases that would
be considered arcane and unwieldy, like ''prudential
regulation'' and ''risk-based supervision'', and acronyms
such as CAMELS and CALCS define a world that remains
exclusive and secretive despite all talk of transparency.
It is not surprising therefore that in a recent address
to the 8th Global Conference of Actuaries, the Governor
of the RBI, Y.V. Reddy, chose to use an oxymoron to
describe the current economic situation: ''stable disequilibrium''.
Realising that he may be leaving his audience behind,
he decided to reveal the meaning of the phrase. Put
simply, he said, developments every day add to the potential
for disequilibrium, even though the current situation
continues to be stable. That is, there is every possibility
that we are just experiencing a lull before the storm.
The grounds for perceived stability are high growth
with low inflation, which is ''indeed a central banker's
dream''. The causes for concern are global imbalances
and the outlook for oil prices. The obvious global imbalance
to fear is the huge $800-billion deficit on the current
account of the US balance of payments, financed with
surpluses from the rest of the world. If the world's
appetite for American assets reaches satiation, and
the US deficit cannot be fully financed, a sharp decline
of the dollar and a reduction in US growth would be
needed to reduce the deficit. In the event, a slow down
in global growth is inevitable. The point, however,
is that the US deficit has been around and rising for
so long that people are tiring of declaring it unsustainable.
In Reddy's words, the situation remains stable, even
though the potential for ‘disequilibrium' is immense
and still growing.
The experience with regard to oil prices is similar.
Despite the recent spike in prices and the persisting
geo-political uncertainties, inflation is under control
across much of the globe. But if the ability of the
system to neutralise the effects of higher oil prices
with lower wage and commodity price increases, state
subsidies and/or productivity improvements diminishes,
the threat of inflation is real.
Higher inflation and lower growth can convert the central
banker's dream into a nightmare. But this is not the
only source of the RBI's concern. What is particularly
worrisome is the effect that these possible developments
can have on financial sectors transformed by liberalization.
Such developments or even the suspicion that they may
occur can undermine the confidence of financial investors
entangled in risky transactions. If confidence weakens
and these investors seek to cut their losses by extricating
themselves from the web in which they are entangled,
the structure itself is under threat. Thus, financial
instability or crisis is the immediate danger.
The signs are that the RBI perceives that the process
of financial reform has gone so far that it has already
made India's financial sector a haven for foreign speculators,
including unregulated institutions like the Hedge Funds
that are known to be destabilizing. The difficulty is
that preempting crises in liberalized financial systems
is problematic. As Reddy noted in his speech referred
to earlier, for the regulator, ''monitoring where the
risk lies has become very difficult due to emergence
of large conglomerates, sophisticated market instruments
such as derivatives and presence of players like hedge
Confronted with a situation of this kind, prudent economic
managers could be expected to choose the obvious option:
halt and reverse those elements of financial reform
that have increased the potential for financial instability.
Unfortunately, in search of a global presence and its
pursuit of a strategic partnership with the US, the
Prime Minister's office and the Finance Ministry, are
taking the economy in precisely the opposite direction.
Policies of economic liberalization are being designed
not on the basis of an assessment of their net economic
benefits but as instruments to realise illusory strategic
gains in the global arena.
Decisions on financial liberlisation are, of course,
not outside the ambit of the RBI's policy space. The
Reserve Bank of India, therefore, is consulted and can
influence the extent of financial liberalization, or
the proliferation of institutions, instruments, markets
and new practices that fosters financial conglomerates,
encourages financial entanglement and increases the
potential for financial instability and crisis.
It must be said that the RBI, unlike other arms of government,
has called for caution when pursuing financial liberalization.
But the differences relate only to the pace and sequencing
of financial reform, rather than the ultimate goals
of the reform process itself. It is, however, difficult
to draw the line between promoting reform and holding
back. The RBI is resolving this dilemma by claiming
that what is important is to find new market-based systems
of monitoring and regulation. This obviously means that
the central bank is now choosing to redefine its regulatory
This shift has now been formally announced. In 2005,
the Reserve Bank of India completed 70 years of its
existence. In a belated event to mark the occasion,
on March 18 2006, the RBI released the third volume
of its institutional history and its annual Report on
Currency and Finance 2004-05, which has as its theme
the evolution of central banking in India. The Report
takes forward, even if in limited fashion, the story
that the first three volumes of the RBI history unravel.
The RBI's decision to take stock of its evolution is
clearly not a mere academic exercise. It is to justify
the new role it has chosen or been forced to adopt.
The Report on Currency and Finance recognises in its
opaque language that ''liberalized and integrated financial
systems and markets pose fresh challenges to central
banks as they tend to amplify existing distortions in
macroeconomic management'' and generate ''excessive optimism
and under-pricing of financial assets, which coupled
with capital account convertibility and high fiscal
deficits lead to crises.''
What then is the answer? Not less liberalization or
more regulation, the RBI says. In its reformed view:
''In a liberalised financial system, it is no longer
regulation, but market discipline, which maintains financial
stability. This necessitates greater transparency, fostering
strong institutions and developing better risk analysis
By why do we need tread this dangerous path of more
liberalization, when the RBI is finding it difficult
to manage even the capital currently flowing into the
country? The answer was amply clear in the speech by
the Prime Minister delivered while releasing the third
volume of the history of the RBI. ''Given the changes
that have taken place over the last two decades, there
is merit in moving towards capital account convertibility
within a transparent framework.'' In a related speech
the same day he justified such a move on the grounds
that it would facilitate the transformation of Mumbai
into a regional or even global financial centre, serving
as a bridge between Asia and the West in the world of
Since history was the flavour of the day, it may be
important to revisit it in full. It was a process of
financial liberalization spurred by the desire of countries
like South Korea and Thailand (at a much higher level
of per capita income) to become the financial hub of
the East, that created at least some of the conditions
for the Asian financial crisis. And it was that financial
crisis that taught India, to its benefit, to desist
from implementing the road map to full convertibility
that the Tarapore Committee had drawn up just then.
Clearly, some histories are recorded, only to be forgotten