Subbarao says inflation targeting neither desirable nor practical in India.
The Reserve Bank of India (RBI) on Thursday said central banks were best positioned to carry out the mandate of financial stability and could discharge their lender of last resort function more efficiently if they became the systemic regulator.
RBI Governor Duvvuri Subbarao, delivering the “C D Deshmukh lecture” at Hyderabad, made a strong case for giving the mandate of financial stability to central banks. The governor’s comment come at a time the government has proposed the creation of the Financial Stability and Development Council (FSDC) and prepared a discussion paper detailing the contours of the council. All four regulators, banking, market, insurance and pension, have been asked to give their comments.
Though Subbarao did not comment on FSDC, he said: “In addition to being the monetary authority, we are the regulator and supervisor of banks, non-bank financial companies and important segments of the financial markets. This unique combination of responsibilities for macroprudential regulation and microprudential supervision, together with an implicit mandate for systemic oversight, has allowed RBI to exploit the synergies across various dimensions.”
Subbarao, who started his speech by asking, among other things, that should financial stability be an explicit mandate of central banks, said at the end: “Pre-crisis, as I said, there was no answer; post-crisis, the answer is mostly ‘yes’.”
The RBI governor gave three reasons why the central bank should be at the centre of the financial stability function. First, he said, monetary policy and financial stability were mutually supportive and this inter-dependency between the two suggested that the central bank, with inherent responsibility for monetary policy, should also be the systemic regulator in charge of financial stability so that it could take a holistic view of policy options.
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“By far the strongest argument in favour of entrusting the financial stability responsibility to the central bank is that it is unquestionably the lender of last resort (LOLR) for the financial system,” Subbarao said.
He said since the responsibility of central banks for monetary policy was unquestioned and because banks were the conduits through which monetary policy decisions were transmitted, it was synergistic to entrust the responsibility for prudential regulation of banks to the central bank.
“And if the central bank is the prudential regulator, there is a strong case for it to be the systemic regulator,” he said.
On the issue of fiscal dominance over monetary policy, Subbarao said in the Indian context, the challenge for the government was to continue the fiscal consolidation that started with this year’s budget and for RBI to regain the space to conduct monetary policy free of fiscal compulsions.
He said there was a larger concern about structural fiscal deficits looming large in most advanced economies.
“Current estimates are that rich countries will see a rapid increase in their social security payment obligations because of ageing populations and shrinking workforces, and that they will need to raise significant amount of debt year-on-year to finance these commitments. If that be the case, monetary independence will remain circumscribed by fiscal compulsions into the medium term,” he said.
On inflation, RBI reiterated inflation targeting was neither desirable nor practical in India for several reasons.
“In an emerging economy like ours, it is not practical for the central bank to focus exclusively on inflation oblivious of the larger development context. RBI needs to balance between growth, price stability and financial stability,” Subbarao said.
Another hurdle for inflation targeting, as the governor mentioned, was lack of effective transmission of monetary policy in India.
“Our monetary transmission mechanism is improving but is yet to reach robust standards. It remains impeded because of administered interest rates, the asymmetric contractual relationship between banks and their depositors, illiquid bond markets and large government borrowings,” the governor said.