Amol Agrawal
RBI governor Shaktikanta Das in his August 19 speech ‘Emerging Challenges to Financial Stability’ touched on the subject of financial stability — he has given eight speeches so far since he assumed office. Before getting to the nuances of the speech, it is important to understand how most modern central banks work — and talk.
This can be summarised under monetary stability and financial stability. More importantly, the central banks keep shifting attention from one stability to another.
The history of central banks has been around the word stability. The earlier central banks, such as those in England, France etc., were started to stabilise war finances, along with those in Sweden, Norway and the like, for stabilising currency issued by multiple players. In the 20th century, the US Federal Reserve was started for financial stability as the country faced panic in 1907.
This was a period where currencies were either backed by a commodity or gold, and inflation was not as much a problem. However, World War I and monetary mismanagement led to hyperinflation in Germany/Austria in the early 1920s, which brought central banks to focus on price stability as well. This was quickly followed by Great Depression where high financial instability and rectifying it became the major objective.
Post World War II, the wars stopped and central banks became the sole issuers of currency; the central banks’ objectives moved around two stabilities: price and financial. From 1945 to 1971, the currencies were pegged to the US Dollar under the Bretton Woods arrangement and there was not much concern around either financial or price stability.
In 1971, the US withdrew from the Bretton Woods agreement forcing countries to peg their currency to some other currency or allow them to float. This created uncertainty leading to financial instability. This was followed by twin oil shocks in late 1970s leading to high inflation in most economies, which in turn fuelled financial instability. The global policy drifted towards management of inflation and there was a feeling that as long as prices are stable, it will lead to stability in financial markets, too.
This thinking changed again during the 2008 crisis where despite years of price stability, financial markets across the world faced high instability. This saw herculean efforts to restore faith in financial markets. As unemployment and inequality suffered, central banks such as New Zealand have joined Federal Reserve and added unemployment to their objective.
Ten years after the crisis, prices remain stable, but financial markets are again posing a concern. The concerns this time are coming from the ongoing trade war between the US and China which has suddenly rocked the global economy boat. The central bankers keep assuring us that we are much better off compared to the 2008 crisis with higher capital and reserves. However, market participants doubt these beliefs as they were given similar assurances before 2008 as well.
Given this historical background, it is interesting how the RBI has dealt with both stabilities. It was established in 1935 with the objective of “securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage”. The Governor also said the “twin concerns of monetary and financial stability constitute the core objectives of the Reserve Bank”.
In recent times, the trajectory of Indian economy over these two stabilities has differed from the rest of the world during the 2008 crisis. Unlike other countries, Indian economy suffered from price instability where inflation averaged 8-10 per cent during 2008-13. Indian financial markets were volatile but hardly to the extent seen in other parts of the world.
The continued high price instability led to India adopting an inflation targeting regime in 2015, which has managed to bring inflation to around 3-4 per cent.
As prices were becoming stable, the financial conditions began to become instable. It started with banking sector where NPAs shot upwards to the shocking double digit figure of nearly 11 per cent of the overall advances.
Gradually, the problems of banking have moved to the NBFC sector where frauds and mismanagement have led to liquidity and solvency crisis which in turn resulted in troubles for mutual funds that had invested in these NBFCs.
This has been followed by problems with credit rating agencies, which are being blamed for not assigning proper ratings to these financial players. Eerily, India is going through similar sets of events as seen in western world during the 2008 crisis, albeit with a gap of 10 years.
Das highlights three more risks (headwinds) to India’s financial stability, apart from the banking sector: financial markets, external sector and payment system.
In the financial markets, the concern is increasing globalisation of finance where risks travel from one market to another in matter of few clicks of the mouse. In the external sector, the risks come from trade channels which in turn are dependent on global economic outlook. The global economic outlook has turned pessimistic recently with several agencies lowering global growth. The payment system has emerged as a new challenge where some new players have begun to dominate this landscape, posing concerns over consumer protection and thereby to financial stability.
Given the risks, the governor like all central bankers tries to assure that Indian financial markets are stable and measures have been taken and continue to be taken to make them even more stable. All these measures and policies will be tested as the developed world limps towards another slowdown and possibly a recession.
The saving grace for Indian economy is that we are still much more of a domestic economy and not really as dependent on foreign economies as some other countries. Even then, it is time to put on the seat belts to fight for mission financial stability one more time.
Amol Agrawal is faculty at Ahmedabad University. Views expressed are personal.
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