By Tamal Bandyopadhyay
Reddy sees no problem in the front-loading of the G-20 agenda, which is crisis management. But the back-loading of the agenda that relates to the fundamental changes are required to make the global financial system more stable may not be easy as it will change the existing balances and the US and the UK may not like that to happen. "You must remember that a large part of financial activities are concentrated in the US and the UK and it is in their national interest to ensure that their dominance in financial intermediation continues. To that extent, the model may be tilted in their favor if the agenda is dictated by them," Reddy said in an exclusive interview.
According to him, the debate on the future of the global financial system could be dictated by other institutions "which are more objective, more analytical" and take a "medium-term view". "Sometimes one gets the feeling whether the agenda of the whole reforms is being driven by the experience of those countries where there is a crisis than those countries where there has been less of a problem. This is somewhat intriguing."
Reddy blames "the short-term outlook of the political leadership, short-term horizon for financial markets and the clout of the financial sector" for the crisis. The biggest lesson from the crisis, according to him, is that the financial sector is special and the globalization of finance is not possible without avoiding regulatory and tax arbitrage.
Reddy spoke at length at his home in Hyderabad on a range of issues, including financial stability, inflation targeting, economic recovery, financial sector reforms, what led to the crisis and the path ahead.
Edited excerpts:
Q: When did you first sense that something was going terribly wrong with the global financial system?
By now we do recognize that the collapse of Lehman Brothers was just a symptom or a trigger. There were two types of underlying issues, which had been persisting for quite some time-global macroeconomic imbalances and the overall monetary management which was conducive to certain respect. Combined with that, we had the financial sector regulatory framework which believed in excessive deregulation. As articulated in monetary policy statements and speeches, there were significant risks to financial stability and there were significant macroeconomic imbalances. This was certainly clear from 2005. We articulated the fears and some sort of actions were taken, essentially counter cyclical.
Q: The general perception is that the trouble started in 2007 in the US mortgage market, but you are saying you sensed it in 2005.
To be very frank, it was not that people were very clear about how the problem will unfold. The discussions in those days-in 2005 and 2006-focused on imbalances and the point was whether there would be soft landing or hard landing.
As it turned out, in retrospect, many countries, especially systemically important countries in the world, did not take the type of action that was required in regard to macroeconomic imbalances both in terms of monetary policy and financial sector regulation. Because of not taking appropriate actions and persisting with deregulation for so-called financial sector development, there has been a hard landing. It was very clear from speeches from some of the central bankers that some sort of landing was required. Hard landing was feared.
Q: Did you ever anticipate the severity of the crisis that actually happened?
To be honest, I felt that there could be a serious problem of unwinding of imbalances and excesses. But nobody anticipated in what shape such unwinding would come. All the policymakers could clearly anticipate that there was something wrong with the model that was being adopted. How and in what form the crisis will unfold I don't think anybody could guess.
Q: There was an asset bubble, but instead of waiting for the bubble to burst they should have gone ahead and pricked it. Right?
That is what we did in India (and it) is pretty well known. But after the crisis, what is the current prescription? The current prescription is counter-cyclical monetary policy; counter-cyclical prudential regulations; the current prescription is "don't look only at prices, but look at assets also." So, today's wisdom is clearly very different.
Q: You left office exactly 10 days before Lehman collapsed. In retrospect, was it a great escape?
Maybe many people think that it was a great escape for the country and the economy that I got out (laughs). Frankly, it was a contract job and there was a date of departure at the end of the contract.
Q: If you were around, would you have tackled the crisis in a different way?
Broadly, directionally, I think the policy response in India has been most appropriate. You can always have differences on what should be the emphasis here and there, and that judgment has to be essentially based on in-depth, real-time information and I am sure the policymakers have that. So by and large I would say the package is appropriate.
Q: That's the post-crisis policy response. Before the Lehman collapse, how did you ring-fence the Indian financial system from the global meltdown?
Contrary to many other central banks, which had a focus on one objective-price stability-the Reserve Bank has always felt that it has responsibility for two most important things: overall stability of the financial and monetary system, and the integrity and strength of the banks. These two were very important for the Reserve Bank and that has stood our country in very good stead. People have still great faith in our banking system. Excess volatility in exchange rates and interest rates has been avoided, all through. What has added to the dimension is the financial stability. There, unlike other central banks, RBI, particularly under the leadership of Dr (Bimal) Jalan, clearly recognized the importance of financial stability. So, without any mandate, the Reserve Bank very clearly recognizes that ultimately central banking does not make sense if it cannot ensure financial stability. In terms of the structure of the policy framework as well as expectations of people, it is the responsibility of the central bank to take care of the financial stability whether there is a formal mandate or not. That was the realization which helped India to take appropriate policy-by doing independent thinking rather than following everybody.
Q: Globally, there has been a sort of obsession with price stability, inflation targeting. Now many financial sector observers feel that the Indian central bank too should have only one goal, that is price stability. Your take?
That was the wisdom before, but I think if you read the literature that has emanated out of the crisis, there has been a better recognition that policymaking has to go beyond price stability. I think the whole principle that one objective-one instrument is the most efficient, is very seriously questioned.
Q: So, it's not relevant.
Well, it is not accepted as the only truth or important truth. In fact, it is viewed with some suspicion.
Q: Your successor D. Subbarao has said financial stability is like pornography and cannot be defined. Can you define it?
In a broader sense, almost all the discussions at the global level today centre around a) acceptance of the importance of financial stability and b) if necessary, even introduce it as a formal institutional responsibility. Globally, the wisdom is that financial stability is important and it should be pursued. How should it be defined and measured? Well, there are measurement problems even in inflation, but that does not mean that you stop inflation targeting. You have the measurement problem of price. There is measurement problem in stability, too. In fact, stability is defined as a state of mind rather than a number. But in the context of global debate, I believe it is very clear that stability is recognized as an important objective. The only question is whether financial stability is already subsumed in the mandate of the central bank or it should be specified. That's the only debate. I don't think there is any other way that the world is looking at the issue of financial stability. As far as the Reserve Bank is concerned, particularly in the last 10 years, that financial stability is an important objective to pursue has been articulated and I think it has been pursued. Some countries make a formal report (on financial stability). For example, the Bank of England writes a report on financial stability. But I remember the governor saying, "Yes, all we do is give a report in England, but we do not have the instruments to achieve that."
Q: Whose responsibility is this? Should it be RBI's responsibility or should all regulators collectively take care of financial stability?
Globally, some people say that financial stability has to be formally mandated to one particular institution. The other view is it should be subsumed in any central bank's mandate and there is no need to specify it. Whether it is specified or not, it is essential because you cannot not have overall stability, price stability, growth stability, macroeconomic stability without financial stability. That's one simple lesson that the financial crisis has taught. So, I think anybody who ignores financial stability with or without a mandate is doing it at the country's risk.
Q: Would you recommend a formal institutional structure where representatives of all regulators are present?
There is a debate that is going on globally, but I think there is recognition that there is need for coordination amidst different regulators. But the fact remains that the global financial crisis occurred in different institutional structures. It happened under the multiple regulators in the US, it happened where there is a single regulator in the UK. It's not a question of institutional structure alone, it is a question of what policies they pursue. And very clearly there is evidence that policies by all concerned, irrespective of the institutional structure in the financial sector, are partly because of the short-term outlook of the political leadership, the short-term horizon for financial markets and the clout of the financial sector. It's not a question of simple institutional structure. Empirical evidence shows that where there have been different types of experiments, there have been collapses in most of the cases which were in fact considered to be models. Where did the crisis come from? The crisis came exactly in those countries, which were considered models in institutional structures, models of regulatory excellence and models of best risk management. So, I think there has to be a fundamental rethinking and in what we believed in. That's exactly what happened after the Great Depression.
Q: Various Fora, including the G-20, have been discussing the problems to find a solution. Some people see in it the politicization of financial issues. The perpetrators of the problems are now offering solutions.
There are two levels. The fundamental issue is that G-20 represents the political will to handle the global financial crisis and bring about stability. This is a good thing. Second, all important countries are coming together, which again is good. Third, G-20 has done excellent work in terms of coordinating measures to combat the crisis and try to bring some normalcy in the function of the financial markets. These are the plus points. But there are also minus parts. The minus part is, generally, the G-20 agenda is dictated essentially by the US and the UK and there is some discomfort even for Europe. So the front-loading of the G-20 agenda is crisis management. On that, there is concerted action. The back-loading of the G-20 agenda relates to the fundamental changes that are required to make the system more stable. Now, that fundamental change, if it occurs, there will be problems because the existing balances will be changed. You must remember that a large part of the financial activities are concentrated in the US and the UK and it is in their national interest to ensure that their dominance in the financial intermediation continues. To that extent, the model may be tilted in their favor, if the agenda is dictated by them. The whole issue that the analysts are looking at even today at intellectual and policy debate is dictated by G-20, but not by other institutions, which are more objective, more analytical, and take a medium-term view. Somehow, there is a feeling of discomfort, particularly in non-G-20 countries, that the whole debate is determined by part of the group.
Q: The entire world is applauding you for your conservatism, which saved the Indian financial system. Tell us which is true-were you conservative or were the regulators of the developed world reckless?
We need to look at the facts objectively. There was some deregulation in many countries and there was too much of deregulation in some countries. Those countries that adopted a risky attitude got into problems. Two years back what was considered to be conservative now seems to be appropriate and what was considered to be progressive has been proved to be reckless, if not greedy.
Q: RBI was conservative and other central bankers were liberal. Now other central bankers have started talking about conservatism, while within India there is an increasing demand that RBI should be more progressive.
Today, I will be a lot more humble than what I was two or three years ago. This is because the world has become more complicated. At that point in time, I knew that there there was something wrong in the model adopted by the Western world but I was not sure what the right model was. Today, I am sure that I do not know what the right model is. Every country wants financial sector reforms. But what is the right model? There is no agreement among the countries, there is no agreement among the various agencies within these countries. The global system wants financial sector reforms, but as of today people do not know what is the destination and the path. My understanding is everybody is groping to find out what is the appropriate model, but definitely in discussions at various global fora the Indian experience comes out as one of those that's managed well contrary to others. And so lessons have to be drawn from both. Sometimes, one gets the feeling whether the agenda of the whole reforms is being driven by the experience of those countries where there is a crisis (rather) than those countries where there has been less of a problem. This is somewhat intriguing.
Q: Do you get a sense that the financial intermediaries have hijacked the reform agenda and it is not driven by macroeconomic compulsions?
Absolutely, that's the sense one gets. A couple of days ago, somebody was asking what happens to the profitability of banks if they are over-regulated. It's very interesting that profitability of banks has become a social concern and not profitability of other enterprises. How is it? If profitability has to be a concern, then all other aspects should be a concern. Two lessons which come out of the crisis are-the financial sector is special and the globalization of finance is not possible without avoiding regulatory arbitrages and tax arbitrage. And both regulations and tax are in the interests of the nation. These fundamental issues are now coming to the forefront.
Q: In your book, you mentioned "light-touch" regulation in financial centers such as London and New York and how they were responsible for the crisis.
Not me, it is the global consensus. Basically, how do you create an international financial centre? For financial activities, all you require is a computer and an address. Everything operates electronically, right? Where does the financial activity go? Where there is least regulation. So, there is competition for deregulation between some so-called international financial centers. As the Stiglitz Commission says in its report very clearly, there was a race for the bottoming regulation. We should not allow people to have regulations below a particular level.
Q: Former US Federal Reserve chairman Alan Green span recently said the Indian financial system is too regulated and it costs long-term growth. Do you agree?
My approach to this problem is simple. First, to say a particular regulatory regime is over-regulated or under-regulated, I must know what is appropriate regulation. So, we must make the assumption very clear that this is what I believe is appropriate. To say something is more regulated or under-regulated, I am not very clear what is appropriate regulation and what is currently acceptable. Second, we have been told that you have to pay a price (if you are over-regulated). Both India and China have been told that for the last 25 years because the financial sector is not adequately developed, a huge price is being paid. You have to look at empirical evidence. There is no empirical evidence to show that financial sector development of the type that has been undertaken by many countries has risked growth or the other way (round). At one stage, it was felt that capital controls are very bad, but now the whole issue is being revisited somewhat reluctantly by G-20, but enthusiastically by Unctad (the United Nations Conference on Trade and Development) and the United Nations. Finally, who is making the judgment? The judgment has to be reasonably objective-sometimes the links between some of the macro analysts in the financial sector are so close that it may not necessarily be objective, is one of the lessons of the financial crisis. In any case, I would like to see some idea of what is appropriate regulation and, most importantly, in the context of the country. Only after I study it will I be able to say whether US regulations are appropriate or not because it requires some knowledge as regulation is specific to institutions and society.
Q: Were you shocked that such a comment came from Greenspan who, many believe, is responsible for the crisis?
We can always say that having experiences, he knows better (laughs). My own approach will be that the days you people believe more deregulation is good are simply over. Now we have to recognize the subject in view of appropriate regulation. Appropriate regulations could be more regulation in some area and less regulation in some areas.
Q: Is the worst over?
I can't predict at all, even though Andhra Pradesh is well known for its astrological prowess. As far as the global situation is concerned, from a public policy point of view, the central banks, governments, financial markets, all want the crisis to be put off. It is like a house on fire. When a house is on fire, the neighbors and all will rush to put out the fire. When you want to rebuild the house that was on fire with the same material, the neighbors will say don't do it as it will catch fire again. There are two issues that have come up. One is the exit from the crisis. Here, the interest of different stakeholders may diverge, particularly in terms of timing and sequencing. When you exit from the crisis, where are you exiting to? Are you exiting to status quo ante? The same building material? Or new material? A lot will depend on these factors as we move along.
Q: Both the finance ministry and RBI have started talking about withdrawing monetary accommodation.
I would trust the public policy authority in India to do it well.
Q: At this point in time, the biggest concern seems to be rising inflation. How serious is the situation?
I don't want to comment because it requires full information. At the global level, there are two positions. There are some countries where there are a lot of unutilized capacities. Because of low employment, the aggregate demand is low. So, you should push the aggregate demand, and the unutilized capacities will simply take care of the inflation problem. There are some other countries where there are supply bottlenecks. Now, if there are supply bottlenecks and there is not too much of unutilized capacity and the aggregate demand is pushed, then the whole situation is very different.
Q:How do you see the next year?
It's a matter of prediction and I don't want to indulge in it at all. But there is a paper by the BIS (Bank for International Settlements) where the indication given with regard to some of the countries affected by banking crisis (was that) the pre-crisis level of GDP (gross domestic product) growth may be possible only in the second half of 2010. I explained the exit complexities of reconciling the existing imbalances, apart from the whole issue of getting an agreement on the appropriate regulatory policy, regulatory structures, regulatory institutions. I think these are very interesting times for young active people like you.