The past two years have been difficult for governments and central banks all over the world. Excessive credit expansion and asset price inflation, fuelled by so-called “financial innovations” of dubious value, and a lax regulatory environment led to an accumulation of risk that was not adequately understood and ultimately produced a severe crisis.
India was relatively insulated from these developments because our financial system was much less integrated with the global system. However, the Reserve bank of India (RBI) deserves credit for having been prescient of the dangers posed by property bubbles. The action taken by Governor (YV) Reddy, who is present here, well before the crisis, to tighten bank credit against real estate, limited bank exposure on this account.
When the crisis exploded in September 2008, RBI rapidly reversed its earlier tightening of credit to meet the new and changed circumstances. The cash reserve ratio, repo and reverse repo rates were rapidly lowered in a series of quick steps. Some initiatives were also taken to enhance access to bank credit by Non-Banking Finance Companies. Signs of panic withdrawals from some private sector banks in the initial weeks of the crisis were met with strong reassurances by both the government and RBI that our banks were sound and would be fully supported.
Ensuring that the Indian financial system remained stable in these very difficult times was a major achievement in financial and economic management. I would like to compliment Governor (D) Subbarao and his team at RBI for the role they played.
With the crisis now nearly over, we need to reflect on the challenges that confront us in the years ahead.
I believe we can get back to the 9 per cent growth path by the end of the 11th Plan and do even better thereafter. I have, therefore, asked the Planning Commission to explore the feasibility of achieving 10 per cent inclusive growth in the 12th Five-Year Plan.
Achieving this outcome will require many policy changes. Let me comment briefly on those that concern RBI.
As we pursue our objective of achieving rapid and inclusive growth, our monetary and financial policies must be guided by three important objectives. First, they must ensure that inflation is kept under control, since it hurts the common man the most and also distorts economic signals. Second, they must ensure stability of the banking and financial system, since, otherwise, we run the risk of experiencing financial crises that always impose high costs on the real economy as well. Third, they must meet the financial intermediation needs of rapid and inclusive growth.
It will be much easier for monetary policy to control inflation if the fiscal targets are met. This is not to say that monetary policy has no role to play in the face of fiscal imbalance. However, its role in that situation is essentially defensive — of avoiding monetary expansion to accommodate the deficit, since such accommodation will only stoke inflation. The problem is that monetary discipline in such a situation may help contain inflation, but it will not offset the negative impact of large fiscal deficits on the availability of resources for private investment, or on the long-term interest rate — both of which are critical for growth.
In fact, in an economy open to capital flows, monetary discipline in the face of fiscal imbalances can lead to a rise in interest rates, triggering excessive capital inflows, which put pressure on the exchange rate, making the task of macro-management much more difficult. This is the well-known problem of the impossible trinity or trilemma. In an economy with capital mobility, you cannot simultaneously have exchange rate stability and an independent monetary policy. The responsibility for handling this delicate balancing act falls on RBI. Its task is made easier by the fact that the capital account is not entirely open and there are restrictions on inflows of debt, especially short-term debt. Caution in the pace of opening the capital account has been a conscious feature of our policy, and there are good reasons to continue with this.
(Prime Minister Manmohan Singh at the Platinum Jubilee celebrations of the Reserve Bank of India, Mumbai, on April 1)
