India seems to have forgotten the lessons of the process of financial liberalisation that had led to crises in Asia not long ago.
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 Eighth Global Conference of Actuaries, Reserve Bank of India Governor Y.V. Reddy chose to use an oxymoron to describe the current economic situation: "stable disequilibrium". Realising that he may have left 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 the 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 U.S. balance of payments, financed with surpluses from the rest of the world. If the world's appetite for American assets reaches satiation, and the U.S. deficit cannot be fully financed, a sharp decline of the dollar and a reduction in U.S. growth would be needed to reduce the deficit. In that case, a slowdown in global growth is inevitable. The point, however, is that the U.S. deficit has been around and rising for so long that people are tired of declaring it unsustainable. In Y.V. 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. However, if the ability of the system to neutralise the effects of higher oil prices with lower wages 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 could have on financial sectors transformed by liberalisation. 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 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 hedge funds that are known to be destabilising. The difficulty is that pre-empting crises in liberalised financial systems is problematic. As Y.V. Reddy noted in his speech referred to earlier, for the regulator, "monitoring where the risk lies has become very difficult due to the emergence of large conglomerates, sophisticated market instruments such as derivatives and the 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 U.S., the Prime Minister's Office and the Finance Ministry are taking the economy in precisely the opposite direction. Policies of economic liberalisation 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 liberalisation are, of course, not outside the ambit of the RBI's policy space. The RBI is consulted and can influence the extent of financial liberalisation, 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 liberalisation. 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 the priority should be 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 RBI completed 70 years of its existence. In a belated event to mark the occasion, on March 18, 2006, it released the third volume of its 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 recognises in its opaque language that "liberalised 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 liberalisation 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 to tread this dangerous path of more liberalisation, 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 the Prime Minister delivered while releasing the third volume of the RBI's history. "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 liberalisation 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.
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