Is the CD Deshmukh Memorial Lecture a political event?

August 13th, 2010

Going by Dr Subbarao’s contribution this year, it certainly seems to be. This speech, if one were to take it at face value, exhibited a complete lack of awareness regarding monetary matters which drew a sharp & detailed rebuttal from Ila Patnaik.

However, I believe that the speech was made with a very specific intention. While a large chunk of the speech was dedicated to it directly, with the RBI Governor detailing the reasons why he believes that the RBI should be the coordinating regulator, the rest of the speech dealt with the proposed environment in which this should happen, albeit indirectly.

Discussions concerning the RBI’s role in the economy came to a head recently with the government replacing the ULIP Ordinance with The Securities and Insurance Laws (Amendment and Validation) Bill, 2010 [PDF]. This Act provides for the establishment of a joint body to reconcile and rationalise jurisdiction disputes between the four regulators (RBI, Sebi, Irda and PFRDA) by a joint committee which apart from representation from these regulators, will have the Union Finance Minister, The Finance Secretary and The Secretary (Financial Services) in the Ministry of Finance as members with the Union Finance Minister chairing it. In a concession to the RBI, The RBI Governor will not just be an “ex-officio member”, as stated in the ordinance, but the “ex-officio Vice-Chairperson” of the Joint Committee. The Committee will then follow any procedure it considers suitable and inform the Central Government of its decision within three months. The decision will be binding on all regulators.

The RBI has always believed that it is far more important than any of the other financial regulators, and with good reason. After all, RBI decisions touch far more lives, and exert greater influence over the economy, than those of other regulators. However, in expressing the underlying reason for this “seniority” the RBI often, intentionally, mixes its up. This was evident in Dr. Subbarao’s speech as well.

He takes the RBI’s current responsibilities and builds a case for such seniority being formalized by law at a time when the scope of the RBI’s responsibilities is being intensely contested. To say that the monetary authority should also be the prudential regulator for banks as they are the primary channel for transmission of monetary policy is denying current reality. Financial system risk is no longer restricted to banks and non-banks, including Mutual Funds, play an important role as well. The monetary authority, therefore, needs to have authority over all forms of financial risk in the system. The RBI tries to achieve this by making a case for increased power. I think it is better achieved by reducing it. Let me explain.

RBI’s role as a monetary authority would be enhanced if it were to delegate all prudential regulation, including that of banks, to other regulators, specializing in various types of financial risk. As a monetary authority, its role can then be strengthened by giving it the power to supervise the functioning of all regulators without undue favoritism. Currently, with bank & NBFC prudential regulation entrusted to the RBI, it has a tendency to favor these over other financial intermediaries, which in reality, works against efficient transmission of monetary policy as was evident in the events of late 2008. In this case, the RBI was very willing to look at the problems faced by banks, but agreed to assist the mutual fund industry only after intense discussion and convincing. The result was financial mayhem. The suspicion RBI harbors about the intentions & regulatory framework surrounding other financial intermediaries is an outcome of its regulatory ownership of banks & NBFCs. It believes other regulators to be deficient not because it knows them to be so, but because it believes that it does a far better job than them. If we take this competitive ego out of the picture, the monetary authority will be far better placed to manage systemic financial risk.

But for such a monetary authority to be empowered to this extent would need it to be accountable for its actions. After all, we cannot have an unaccountable body overseeing all prudential financial regulations and this is where the rest of the speech fits in. Dr Subbarao, using archaic arguments, goes to great lengths to avoid any form of accountability for the RBI. He maligns the concept of inflation targeting as detrimental to the RBI’s other aims, namely development and financial stability, without defining a target for either. If the RBI wishes to support growth and control inflation in a financially stable environment, it can specify the target and relative priority for each and justify every action on this basis. If it believes that inflation in India comprises mostly of factors exogenous to monetary policy, as Dr Subbarao states in the speech, let it define the inflation it is willing to target. Many central banks do the same by ignoring food & energy prices (both exogenous factors) and focusing on managing core inflation But it needs to come forth and say what it wants to manage, define a target and justify all actions on that basis. This would also lend greater discipline to RBI’s decision making and reduce the scope of personality driven monetary policy which is common under the present system.

By avoiding any form of quantification, the RBI wants to gain control over all financial regulations without any form of accountability. Without the increased power it strives for as well, it is evident that the RBI needs to be more accountable in its role of monetary authority. With increased power, it would be critical. As mentioned earlier, its a two step process. We need to create a Monetary Policy & Financial Stability Board in which the current RBI Governor and two relevant Deputy Governors assume the role of Chairperson and Members of the Board respectively. Chairpersons of other regulatory bodies like Sebi, Irda and PFRDA should also be inducted on this board. The RBI, or what is left of it, should be headed by the senior-most remaining Dy. Governor. Similarly, other regulators can be led by the senior-most of their second line. However, this arrangement is only to ease transition, after which all members and the Chairperson of this board will be appointed by the Central Government. All regulatory bodies should then function under the supervision of the Board which takes ownership for monetary policy and financial stability with measurable targets and complete accountability.

The RBI’s current stance is working against the emergence of a cohesive regulatory framework for the financial market as a whole. To designate a particular regulator as senior increases the risk of financial market development being skewed towards the industry it regulates. It’s not a risk India can afford to take.

But the speech was disappointing at another level as well. The CD Deshmukh Memorial Lecture is an event many look forward to, anticipating words of genuine wisdom. Well, this year, we got a political statement in the garb of wisdom. Extremely convenient wisdom.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at Views are personal the CD Deshmukh Memorial Lecture a political event? digg:Is the CD Deshmukh Memorial Lecture a political event? newsvine:Is the CD Deshmukh Memorial Lecture a political event? reddit:Is the CD Deshmukh Memorial Lecture a political event? Y!:Is the CD Deshmukh Memorial Lecture a political event?

Just what kind of money is this?

August 6th, 2010

Is this a strange question? Think about it…

Just what kind of money is this, when the only way to preserve its value is to lend it? If you hold it idle, it loses value. If you invest it in anything other than debt you may beat inflation, but then again, you may not. So the only way to preserve its purchasing power with any certainty is to lend it, and lend it to someone who you’re certain will pay you back. Which in most cases is the government, because regardless of how badly they mess up, they can always create more money to pay you back. But this means modern currency serves only as a “medium of exchange” outsourcing the “store of value” function to debt. And if one of money’s primary functions is assigned to debt, is it any surprise that debt has become the foundation for our economies?

But is that all our money is meant to be? Something that has “value in exchange” but no “value in use”? And if it doesn’t have value in use, how can it have value in exchange and/or be an effective store of value? On the hope that this mysterious “value in exchange” would persist tomorrow, next month and next year?

From the time Richard Nixon decided to default on the US Dollar’s obligatory link to gold, mankind has wondered what money had become. But Milton Freidman, with glib tongue and circular reasoning, convinced all who needed to be convinced that this was everything money was ever meant to be. I believe he exhausted people into accepting his theories, though the only proof I can offer for this belief is experiential. Argue with a modern monetary theorist, and I can guarantee you a headache, even if you are Arnold Kling. Politicians in the 1970s didn’t stand a chance. It was either accept or suffer. They, being politicians, chose to accept.

Circularity characterizes every chartalist currency argument, not just those connected with the importance of central banks, as Arnold mentions in his post. Imagine this conversation:
Me: Modern money has no value in use, so how can it have value in exchange?

Demented Chartalist (DC): As long as it can be exchanged for something valuable, it has value.

Me: But how can something without value be exchanged for something valuable?

DC: I never said it didn’t have value. In fact, I remember telling you that it did.

Me: So tell me once again, why does it have value?

DC (rolling his eyes): Because it can be exchanged for valuable things!

Me: But how can it be exchanged for valuable things when it doesn’t have value?

DC (smiling benignly): But it can be, so it does.

Me: So if it can’t be, then it won’t?

DC: Precisely! But that’s not going to happen. The government won’t allow it.

Me: Aah! So it has value because the government says so?

DC: Don’t be obtuse. It has value because it does, and the government likes it that way.

Me: But why does the government like it?

DC: Well, because the government can make all it needs without spending any of it to do so. And even if it did have to spend some of it, it could always make more.

Me (kneading my temples): But if the government can make all it wants without spending any of it, then how does it have value?

DC (smiling tolerantly): Didn’t we get past that?

Me (in pain): No, we did not! If the government can get it without exchanging anything valuable for it, then how can it have value?

DC (slowly): Because the government can exchange it for valuable things.

Me (with quivering lower lip): But how can the government not exchange anything valuable for money and then exchange money for something valuable? How?

DC (pityingly): You still don’t get it, do you? Because it can… That’s the beauty of the system. It can.

Me (weeping): No, I don’t get it… How can they.. Why can they… but…

DC (gently): I think you’re too overwrought to have understood. Do you want me to start over, a bit slower this time?

At which point I run out wailing like a little girl, damaged for life…

Living in a world with modern currency is like being imprisoned in a Joseph Heller book.

And I am Yossarian.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at Views are personal what kind of money is this? digg:Just what kind of money is this? newsvine:Just what kind of money is this? reddit:Just what kind of money is this? Y!:Just what kind of money is this?

Of Governors and “Senior Officials”…

August 4th, 2010

Over the last few days, apart from the regular newspaper columns and opinions, many readers have emailed saying the RBI is either confused about what its doing, or is acting under political influence. This feeling was compounded when an unnamed “senior official”, in comments soon after the recent policy announcement said that the current inflationary environment needed “aggressive policy action” and current policy wouldn’t tame inflation.
I agree with the official partly. Current monetary policy will not tame inflation, but that’s where my agreement with the unnamed official ends. It won’t do so, not because more needs to be done, but because current inflation has less to do with monetary policy and more with supply side shocks and international market movements. Inflation will reduce, but purely due to statistical reasons I have outlined earlier. Also, if any form of monetary policy can have a meaningful impact on current inflation, it will have to be the exchange rate policy and not the interest rate policy. Granted that there are signs of inflation getting broad-based, but isn’t that expected after a sharp increase in fuel costs. After all, transportation is an significant part of final cost in virtually every product today.

Though comments of this nature confuse the market and observers about RBI’s real thoughts, this isn’t a new phenomenon. Dr Y V Reddy, when he was Dy Governor, frequently & publicly disagreed with his Governor, Dr Bimal Jalan. And it was always caused by his angst of Dr Jalan’s refusal to combat everything through interest rate hikes.

In reality, the formative years for most of the RBI’s middle & top brass were simpler times. Times when the exchange rate was decided by the RBI and obeyed by the market. Times when the possibility of attracting capital flows in excess of our requirements was unimaginable. Times when inflation was largely a domestic phenomenon (remember oil prices remained stable for a long long time before going through the roof only in the 21st century, and when they did spike we had ourselves a crisis) and India was still a nation where individuals could only save, and not borrow. Times when the government did not have to borrow from the market to fund its deficit and wasn’t affected by interest rate changes significantly.

In these times when inflation rose, interest rates were hiked regardless of what constituted inflation. And it wasn’t because  that was the right thing to do. It was the only thing they could do. As an added benefit, the purchasing power of savings was protected, at least partly, due to such higher rates which imparted moral underpinning to actions devoid of any other kind. To a section of these people, every step of the liberalization process has been accompanied by a growing feeling of inadequacy, driven by their inability to deal with the consequences. Consequences like excessive capital flows and their impact on the exchange rate, like domestic prices which are increasingly connected to global prices and the fact that inflation can now exist without any domestic reason whatsoever.

Some of them (a minority) faced by their own inadequacy and the lack of an incentive to change with the times, turned increasingly dogmatic and defended their beliefs with quasi-religious zeal. They oppose and object to anything that reduces the power they had over markets, like capital flows and flexible exchange rates. But more than anything else, they object when the only policy instrument they are familiar with is not used to impose sacrifice and austerity on an increasingly indulgent population.

Another minority, however, chose to adapt. Excited by liberalization and the opportunities it offered, they updated their knowledge and enhanced their skills. It is this minority that stood by Dr Jalan in his efforts to forge a new path for Indian monetary policy. One that was characterized by transparency and an open minded analysis of the suitability of traditional policies, parameters and goal posts. It was at this time when the foundation for India’s best economic years was cast. Monetary policy then was an eclectic mix of the traditional and the unconventional. But it wasn’t always so. In his initial years as governor, Dr Jalan was fairly tentative in his attempts to break the mold. He spent the first couple of years identifying and manning  key positions with the right people. It was in his third year as governor, in 2000 when he eventually succeeded, aided by the team he had painstakingly built.

But this divide doesn’t exist just within the RBI. Outside as well, we see a clear divide between those who look at headline inflation and demand hikes and those who analyze the components and request patience, realizing that there is nothing, absolutely nothing to be gained by hiking rates in the current environment. This divide existed during Dr Jalan’s time and exists now.

Dr Subbarao is charting a course similar to Dr Jalan’s. In his latest monetary policy statement are signs of a new found independence in thought and a self assurance which was missing in earlier policy statements. And while current inflation still doesn’t demand the sharp interest rate increases he has imposed, neither rates nor liquidity are, at the moment, serious threats to growth. The 10 year GOI benchmark yield has remained stable moving from 7.89 per cent on March 19, 2010 just before the rate hikes began to, well, 7.89 per cent on August 3, 2010. Hardly a sign of bond market distress. While there are those who will see this as a worrying sign of inefficient monetary policy transmission and still others who would claim this to be a sure sign that RBI is behind-the-curve, I would contend that it reflects an increased certainty regarding the conduct of monetary policy which has compensated, at least in part, for higher overnight rates. The hands off approach to exchange rate volatility is another example of change. In refusing to control the exchange rate market on a day to day basis and increasing the range of tolerable movement, both positive & negative, Dr Subbarao has relieved the RBI and the Indian debt market of a great burden. This preference towards domestic stability at the cost of exchange rate volatility is welcome, more so when compared to Dr Reddy’s time when fixation with exchange rate stability caused unprecedented volatility in domestic overnight rates. The worst episode, in March 2007 saw interbank call rates move between 2.50 per cent and 75 per cent within the month (Source: RBI)

While I have, and continue to, oppose rate hikes, I sense light at the end of the tunnel. This isn’t a governor who is confused or tentative. This is a governor finding his feet and preparing to make a difference, allowing his detractors small victories that don’t cause much harm; gaining strength with each passing month.

I take the comments of the anonymous senior official as a sign that interest rate hawks are playing a smaller role in policy making. So now, all they can do is speak.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at Views are personal Governors and “Senior Officials”… digg:Of Governors and “Senior Officials”… newsvine:Of Governors and “Senior Officials”… reddit:Of Governors and “Senior Officials”… Y!:Of Governors and “Senior Officials”…