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 funds.''
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
role.
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 systems:''
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 finance.
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