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RBI Governor Subbarao Speaks on Emerging Market Exit from Stimulus


RBI Governor Subbarao speak with a lot of unanswered questions, in Istanbul. (“Emerging Market Concerns: An Indian Perspective“)

From the perspective of Emerging Market Economies (EMEs) and particularly for that of India, I will highlight five concerns. These are: first, timing of exit from the accommodative monetary policy in the context of rising food price-led inflation but still weak growth; second, the possibility of another surge in capital flows, especially if we turn out to be an outlier in withdrawal of monetary stimulus; third, monetary transmission mechanism as it is evolving from the crisis period; fourth, return to fiscal consolidation and quality of fiscal adjustment; and finally, the implications of the efforts towards financial stability on financial inclusion and growth.

Although inflation pressures emanating from higher food prices may limit the scope for monetary policy action, there are implications for inflation expectations. Furthermore, unlike the major advanced economies, growth remains positive. Real GDP growth was 6.7 per cent in 2008-09 and is expected to be 6.0 per cent (with an upward bias) as per the Reserve Bank’s July 2009 projections. In view of the country specific features, we may need to exit from accommodative monetary policy earlier than advanced economies. This calls for careful management of trade-offs: growth concerns warrant a delayed exit, but inflation concerns call for an earlier exit. An early exit on inflation concerns runs the risk of derailing the fragile growth, while a delayed exit may engender inflation expectations.

He says Inflation is high on the CPI front, we have a current account deficit of 2.6%, and we’re a consumption based economy (private consumption is 55% of GDP).

Major central banks – such as the US Fed, the ECB, the BoE – have flushed their financial systems with unprecedented amount of liquidity. Till the first quarter of 2009, this liquidity was finding its way back to the central banks as excess reserves because of risk aversion.

Risk appetite is now returning. There are signs of recovery in portfolio investments to the EMEs. For instance, portfolio investments by FIIs in the Indian equity market amounted to US$ 13.6 billion in the period April 1-September 18, 2009 as against outflows of US$ 5.2 billion in the corresponding period of 2008 reflecting a turnaround of almost US$ 19 billion.

Moreover, as noted above, in view of incipient inflationary pressures, policy rates in our case may have to be tightened ahead of those in advanced economies. The resultant larger interest differential may attract larger capital inflows. Will capital inflows be modest or turn into a flood as in 2007? The latter concern is particularly relevant in view of abundant liquidity in the major advanced economies. What will the implications be for exchange rates? In India, the current account is in modest deficit; hence large and volatile capital flows can impose macroeconomic costs.

This is where I disagree. Increase in policy rates isn’t going to increase portfolio flows – that is so pre-financial-crisis thinking. First, look at the situation – banks haven’t cut their deposit rates much, and neither have public saving schemes. FII investments in government bonds have a stupidly silly cap. Still, the money went out, even with corporate bonds offering juicy 10-12% yields.

Second, the last time we had a capital inflow flood, we had low, not high rates. That was 2007; and the liquidity flow that happened then is literally being copied today as we speak – if we have to worry about the flood of capital inflow, that time is now, not after we increase rates. (The Rupee has appreciated to Rs. 46.4 to the dollar – a 5% rise – in the last week or so).

And finally, if we bump up rates, we will eventually stymie growth. We have a crappy non-transparent Corporate bond market. We have foreign investment limits in the only really transparent bond market – government bonds that is. When that is the case, you won’t get risk-averse inflows. But the risk capital, the biggest constituent of the “capital inflow” flood we have already received, Mr. RBI, will flow out because your rate increases will slow things down.

Emerging market central banks have three options in managing capital flows. The first option is for the central bank not to intervene in the forex market and let the exchange rate bear the burden of adjustment. Will undue exchange rate appreciation not further widen the current account and what will the implications be for future sustainability? Will exchange rate appreciation help to contain inflation? These are the questions to address if this option is adopted.

Second, the central bank can intervene in the forex market, but refrain from sterilisation. Such an approach runs the risk of excessive growth in monetary and credit aggregates which can lead to higher inflation as well as credit and investment booms and create financial fragility.

The third option is to sterilise the interventions. Irrespective of the method of sterilisation, the financial cost of sterilisation in terms of national balance sheet is obviously ultimately borne by the government even though direct costs may be borne by separate agencies. Sterilised intervention can exacerbate fiscal pressures, but this needs to be assessed against the benefits of macro-financial stability.

For those of you who find this difficult – option 1: let the rupee appreciate, that will reduce inflation (because commodities are linked to the dollar), but it hurts our exports and thus causes current account deficits to widen. Option 2: Hold the rupee down, but that will involve printing hajaar rupees to buy dollars. That will cause inflation and madness. Option 3: Hold rupee down and then use sterilization measures like selling bonds to keep the rupees from flooding the system. We did this once, and it doesn’t seem to help.

I would go with Option 1 – and not just because I want to spend lesser rupees on buying that Amazon Kindle. It’s fairer – we are a consumption economy, so let the rupee grow, we’ll eventually start using the dollars to import hajaar stuff and it’ll be more well balanced. But I think the RBI will go with 3 – a very short sighted measure.

The other thing Subbarao notes is that the RBI has limited means to make monetary policy flow in this direction (i.e. reducing rates). That I think doesn’t apply on the other side – one whiff of RBI increasing rates and all the PLRs, BPLRs and other lending rates will go up immediately.

It needs to be recognized that after a crisis, with the benefit of hindsight, all conservative policies appear justified. But excessive conservatism in order to be prepared to ride out a potential crisis could thwart growth and financial innovation. The question is what price are we willing to pay, in other words, what potential benefits are we willing to give up, in order to prevent a black swan event? Experience shows that managing this challenge, that is to determine how much to tighten and when, is more a question of good judgement rather than analytical skill. This judgement skill is the one that central banks, especially in developing countries such as India, need to hone as they simultaneously pursue the objectives of growth and financial stability.

Say what you will, this was an incredibly well written speech. And while Subbarao doesn’t yet answer his questions – maybe because it defeats the purpose to say it before he does it – he brings across the context beautifully.

There’s still zany asset price bubbles to deal with, though. Look at stocks and real estate. In that perspective, we are still a diseased economy on steroids. It feels great, but if we don’t slow down and rest a bit, we’ll be worse when the steroids stop. And it doesn’t matter that the world is on heavier steroids.


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