'The IMF can't deal with a financial crisis'

Q&A/ Bimal Jalan

Bimal Jalan took over as RBI Governor just a few months into the Asian crisis. A decade later, he reflects on the lessons the world has learnt and argues that he would probably have taken similar actions even today, given that, as he says, a financial crisis can bring a country down to its knees within a very short period.

Importantly, Jalan says institutions like the IMF are not built to deal with such crises. Excerpts from a conversation with Sunil Jain and Siddharth Zarabi:

How is a financial crisis different from other crises?

There are two or three very interesting things about a crisis in the financial system as compared to the old notion of balance of payments crisis or other kinds of economic crises.

In a financial system the real crisis occurs within a very short period "" before you know it, you are gone. You don't realise it and do not get enough time to prepare. All other crises take time to pan out. The key thing that I want to emphasise about a financial system crisis as was witnessed in east Asia is the short time duration in which it happens.

It started with the Thai baht being devalued on July 2, 1997...

And within a very short period it was over. The second point, which is also important, is the contagion effect. This is not just related to east Asia but elsewhere also "" Mexico and Argentina, for instance. Unlike the real economy, where you have separate segments, the financial system is highly interconnected.

What happens to the dollar vis-à-vis the euro affects us not because of anything that India has done. Exchange rates affect interest rates, bond market, banking sector... The east Asian crisis may have occurred in Thailand or Indonesia or Hong Kong, but when it happens, when people are pulling out of countries, it affects all financial systems.

The third thing, unfortunately for policymakers, is that the crisis may already be there before they know it!

What is the big lesson that should have been learnt?

That eternal vigilance is the price that you have to pay for prosperity and stability. Central banks have to be eternally vigilant, but that should not mean intervention or control. The second lesson is that central banks have to hold large amounts of reserves "" all of us concentrate on a 25 basis point change in interest rates, but forex market changes are much larger.

But when everyone bets against a currency, no amount of reserves help.

That is correct, but high reserves increase the central bank's credibility as far as intervention is concerned. The world has learnt that intervention by central banks may be necessary under certain conditions even if you believe in fully flexible exchange rates. The IMF has changed its position on capital account convertibility after the east Asian crisis "" it is now closer to the Indian view.

You came in four months after the crisis. How did you deal with it?

It was our first experience of this kind of a problem in the wake of the Asian crisis. There was a decision to relax the informal band on the rupee and this gave us the flexibility to take a view on exchange rate intervention in light of the market conditions. It also helped that our reserves were not too low.

And that the economy was quite closed, the FII position was relatively smaller...

Certainly it helped, but that did not make the job easier. Remember there was tremendous pressure on the rupee during that period and our tolerance for that kind of pressure was limited.

What was the mood like during those days at the RBI?

During those days, there was a lot of speculation in the learned dailies about where the rupee was going. One thing that we made very explicit over a period of one or two months was that the RBI would intervene in the forex market at any stage, mainly through public sector banks, but not exclusively.

The idea then was to do away with the "herd" mentality in this market and expectations of continuous depreciation. Our main target was not the level of the exchange rate but to reduce this pressure for self-feeding frenzy on the part of market operators that the rupee will depreciate at a fast rate.

People had the view that the RBI would intervene on a round number ... that we would come in when the rupee crossed 38 or 39 to the dollar. We decided we would never intervene at a round figure "" just to keep the market guessing!

We decided that we had to take big steps in order for them to have an impact. So, when we hiked the interest rate, we did this by 200 basis points and then we hiked the CRR. The idea was to restrict the supply of liquidity. Once the crisis eased, we lowered interest rates substantially in successive steps.

Looking back, the other important thing that was done was to come out with bonds like the Resurgent India Bond and Millennium Bond "" at a time when we were not too weak. Even during the time of the crisis, we did not pay more than 140-150 bps over the Libor.

Did you have an internal target for the rupee?

Honestly, no. The idea was not to keep it around any particular level or any round number! The longer term objective was to minimise the volatility but there was no fixed level.

Were there hourly consultations with New Delhi on what to do?

There were policy consultations, and there was complete unanimity on the objective of trying to not lose reserves at a fast pace; there was no day-to-day consultation.

Did you over-react given that the chances falling into an east Asian type crisis were rather low? The rupee wasn't convertible...

I don't think so. I would do the same today. Giving up growth by, say, one percentage point for a few months is better than exposing yourself to the possibility of this kind of crisis. It is like paying an insurance premium.

Is the other big lesson that you cannot depend on international institutions for help during a crisis?

Yes, that is the obvious conclusion. The IMF was not founded for this kind of fast-paced financial crises. You can't negotiate an IMF loan so fast.

In 1991, various banks refused to extend credit to India. Was there, is there, a political angle to such crises?

I don't think that's true any more.

Are flexible currencies the solution?

Not in a crisis. If you allow your currency to collapse, your banks close, your factories close ... It took south-east Asia a very short time to collapse and seven-eight years to recover.

Are you in favour of capital account convertibility?

Yes, for all practical purposes; but not for speculation. It's okay to sell your house here to buy one in the US. But I'm not in favour of freeing up financial outflows completely because domestic bank deposits and financial assets are far greater than forex reserves. Most crises take place because locals take their money out, not because only foreigners do.