Recent Financial Market Developments And Implications For Monetary Policy - ஆர்பிஐ - Reserve Bank of India
Recent Financial Market Developments And Implications For Monetary Policy
Dr. Rakesh Mohan, Deputy Governor, Reserve Bank of India
delivered-on செப். 20, 2007
Shri Bhatt, Mr Horiguchi, Ladies and Gentlemen, II. What is Going On? Perhaps the most defining feature of the global economy over the last three decades has been what has been termed as the ‘Great Moderation’ – the sustained decline in inflation and in inflation volatility. A comparison of the period since the Asian financial crisis i.e., 1998-2007 and the 30 years preceding the crisis (1970-97) shows that in the recent period, inflation (CPI) in advanced economies has averaged 1.9 per cent, down from 5.8 per cent in the earlier period. Over the same period, inflation in developing economies declined from 31.0 per cent to 7.0 per cent. Over the same time span, inflation volatility measured in terms of coefficient of variation has fallen from 0.55 to 0.20 in advanced economies and from 0.54 to 0.32 in developing economies. Consequently, average nominal interest rates (LIBOR rates on the US dollar) have also moderated from 8.3 per cent in the previous period to 3.8 per cent in the recent period. This feature has also been reflected in some decline in real interest rates as well, from 2.5 per cent to 1.9 per cent. The secular lowering of nominal and real interest rates across the world has enhanced the appetite for risk even as pricing of risk has become increasingly difficult. These considerations lead to the third set of issues that relate to the role of effective financial regulation and supervision. Has the recent crisis underscored the need for strengthening of oversight of advanced financial markets? Traditionally, financial surveillance has placed relatively more emphasis on banking regulation. Banks are highly leveraged financial entities who are also effective trustees of public money by virtue of holding deposits. Hence, they have to be effectively regulated and supervised in order to maintain public confidence in the banking system and depositors have to be protected from excessive risk-taking by banks. On the other hand, investors in hedge funds are high net worth individuals who do not need such protection. They are informed investors who are able to exploit the information efficiency of markets and, therefore, should be able to understand the risks implied by information asymmetry. The current crisis was, however, triggered by the difficulties encountered by these investors who had taken large exposures to sub-prime related investments without having accounted for the potential risks embedded in these instruments. There have been a host of ills underlying these transactions, which are now coming to light. We need, however, to abstract from the details of all the malpractices that have led to the current situation and reflect on the incentive structure that led to these malpractices. In the event, even bank depositors have got exposed and as soon as information asymmetries became evident and credit ratings came to be regarded as inadequate, markets got frozen resulting in illiquidity for banks and erosion in depositor confidence with its consequential impact on financial markets, and monetary policy. The links between banks and non bank financial intermediaries, and other off balance sheet exposures were not adequately recognised or recorded by banking supervisors. In the context of recent events, it is important to recognise that there is a need to understand better the process of transmission of risk information through various segments of the financial markets in order to address the crisis of collateral in the credit market. How much of the specialized information that rests with lenders can be systematized, packaged and transmitted to markets as credit ratings. The principle underlying securitisation is based on the lender having this specialized information which can be unbundled and sold in the market separately in tradable sizes. A large part of the market for structured finance products is over the counter. Can these products be further standardized so that they can be traded on an exchange which enables greater transparency from the point of view of the investor? Are there better ways of generating more objective information on the market value of collaterals, especially in situations where collaterals are not fully marked to market since such information may not be available on ongoing basis? Are there limits to marking to market certain kinds of assets whose values are not available on a high frequency basis? III. Response of the Monetary Authorities It is instructive to examine what central banks have done in the current context. The responses of the central banks to the recent events in financial markets have shown that concerns for financial stability can assume overriding importance, irrespective of the legislative mandate handed down to central banks as part of ongoing reforms. This is evident in the fact that central banks initially reacted by the injection of liquidity, including through special facilities and the expansion of eligible securities for collateral, rather than through interest rate cuts. Discussions involving central bankers in various fora indicate their willingness to consider other courses of action in favour of protecting growth. As we all know, the US Federal Reserve has gone further this week in cutting interest rates to promote both growth and in the interest of financial stability. And the U.K. authorities have had to provide liquidity to a specific institution, while giving a blanket guarantee to depositors on the safety of their deposits. Accordingly, it is becoming evident that central banks do have a role beyond inflation targeting. Evidently, both growth and financial stability matter for central banks. When it comes to the crunch, in their roles as lenders of last resort (LOLR), and in discharging their responsibilities as the guardians of financial stability, they do need to perform functions that are more complex. Should central banks be lenders of last resort to the system as a whole by injecting systemic liquidity through open market operations only, or should they also provide liquidity to individual financial institutions that are judged to be solvent but illiquid? How do they arrive at such judgments if they do not have adequate information on individual institutions? Can they have such detailed information without ongoing responsibilities for regulation and supervision? This issue is not dissimilar, in terms of the existence of asymmetric information to that of the problem of adequate transparency of information related to the value of collateral underlying asset backed securities. Banks and financial institutions are typically highly leveraged institutions: thus judgements related to their solvency depend on the valuation of their assets at the time when difficulties arise. In the current case, banks have invested through a chain of vehicles in securities whose values are in doubt. When providing LOLR liquidity support, how is the central bank to make a judgement on the solvency of institutions to whom it is providing liquidity? As a greater recognition and appreciation of the appropriate role of central banks gains ground, it is possible that this will result in further rethinking on the functioning of central banks. A case in point is the separation of financial regulation and supervision from monetary policy which could have resulted in ineffective and inadequate surveillance in the context of the current crisis. There is a view that problems of information asymmetry might have got further aggravated with banks reporting both to the monetary authority and the regulatory body in charge of banking supervision. In reviewing the evolution of central banks, one is struck by the constant evolutionary change that they have undergone over time, and the differences in their functions across different countries. Their functions have changed almost continuously in response to evolving circumstances. In fact, it is the occurrence of financial instability that led to the formation of some central banks, most notably, the founding of the US Federal Reserve after the 1907 financial crisis in the United States. Thus, it will be interesting to see how thinking evolves as a result of the current crisis. Reams are already being written in the thoughtful financial press and much more is to come. We had begun to forget the danger of contagion and the speed with which it takes place when it does occur. The current developments which began in a relatively minor segment of the financial market, viz., the sub-prime mortgage segment, have spread far and wide across continents. Similarly, problems arising in one financial institution have led to the suspicion of similar problems in other institutions leading to conditions similar to bank runs. The smooth running of banks, financial institutions and financial markets depends crucially on trust and credibility along with the availability of transparent information. Hence the legitimate role of central banks in maintaining financial stability can inevitably lead to unconventional actions that do indeed restore financial stability when there is a probability of the opposite taking place. What is most instructive in the current crisis is that small problems or problems in small institutions can cause financial instability through contagion. In this context, things do not appear to have changed much for a century. The 1907 financial panic that also travelled across continents started with difficulties in a relatively small New York financial institution, the Knickerbocker Trust Company! Systemic risks do not necessarily originate in institutions judged to be too big to fail. IV. Assessment of the Future First, according to the IMF’s assessment, the systemic consequences of the turmoil are likely to be manageable with the fundamentals supporting strong global growth. The repricing of credit risks that is underway is a healthy correction and should not lead to a more serious market crash. The IMF expects that the reestablishment of credit discipline due to the recent prompt action by a number of central banks should help to ensure that the adjustment process occurs in an orderly manner. Long term investors tend to support this view. The ongoing flight to quality (US Treasuries) and into global equity funds suggests a continuing faith in strong fundamentals of the global economy. Second, recent developments carry implications in the form of heightened market discipline and a stricter regulation of financial markets. Investors who relied on credit ratings of Collateralised Debt Obligations (CDOs) and Collateralised Loan Obligations (CLOs) are likely to question the value of ratings in other markets. Moreover, leveraged buy-out activity is likely to wind down. While this could cause worries about equity valuations, it is expected that such concerns would eventually recede so long as corporate profitability remains strong. Furthermore, it is argued that carry trade, which has been a source of financial flows, may moderate and may even go through an abrupt unwinding and this would help in maintaining global financial stability. In this vein, it is also argued that the recent developments will have a positive impact on the outlook for EMEs as a consequence of the diversification of portfolios of international investors and would further incentivise the maintenance of good macroeconomic policies in these countries. At the current juncture, it is expected that the fall out from the US sub prime crisis is likely to be limited for Asian banks and can easily be accommodated within their current rating positions. According to Moody’s, exposures of Asian banks have book values that do not exceed 10-35 per cent of annual pre-tax pre-provision profits. The mortgage backed securities and CDO tranches held by these banks are usually senior and therefore losses, if at all, would be substantially below 100 per cent. The bulk of foreign currency investments by Asian banks (barring those in Japan, China, Korea and Singapore) continue to be in highly rated government and corporate bonds. Policy makers need to work with rather than against the grain of markets by continuing to enable financial innovations. They should, however, be vigilant for any signs of disorderly global rebalancing. Looking ahead, entrenching financial stability into the future would depend upon bolstering market confidence. In the overall assessment, the adverse consequences of the US sub prime turmoil could weigh heavily on the future stability of financial markets and have the potential to have a wider impact on global growth with particular concerns centred on the prospects for EMEs. If credit conditions tighten, EMEs could become particularly vulnerable to reversals of capital flows with serious implications for their future prospects. A slowing down of the US economy, in combination with capital reversals, could also have adverse consequences for growth on a prolonged basis by affecting exports of manufactures and services, depending on the extent of linkage with the US economy. On the other hand, the flight of capital to safety through diversification could even enhance capital flows to these countries. This could further complicate the conduct of monetary policy. We will have to wait and watch. In general, recent financial markets developments are indicative of evolving uncertainties for EMEs with significant challenges for the conduct of monetary policy and for ensuring financial stability in their economies. As central bankers, we will have to enhance our vigilance. While taking a view on the debate, it is important to recognise the changes in the landscape of financial markets - transformation in structure, process and products of financial markets, consolidation in banking, increased electronic data flow and dramatic rise in volumes and volatility. The key issue for central banks is to differentiate between providing short term liquidity and operating medium term monetary policy and communicate the difference credibly. The conduct of monetary policy is also complicated by a host of factors which seem to be simultaneously at work: risk of sustained contagion; global capacity constraints; rising food prices; record high international crude oil prices; tensions in inflation expectations; evolution of sovereign pools of foreign exchange reserves; extent of effectiveness of monetary policy; surveillance and risk monitoring systems; and downgrade risks. In this evolving scenario, central banks may find it necessary to blend the traditional setting of monetary policy with some rethinking and non-traditional policy options which could include coordinated interventions, assurances of liquidity, backed by timely and credible action; emergency liquidity plans, business continuity plans and disaster management strategies. Admittedly, heightened uncertainties continue, even after taking into account the recent central bank activities in key jurisdictions. It is not even clear whether all the related issues have come to the surface for us to make meaningful assessment. I expect that I can't conclude this address without saying a few words on the domestic situation in India. The best way of doing this is to quote the Governor from his recent speech in Mexico City. “Available information indicates continuation of the growth momentum during 2007-08 so far at a strong pace with the impulses of growth getting more broad-based. Steady increases in the rate of gross domestic saving and investment, consumption demand, addition of new capacity as well as more intensive and efficient utilisation/capitalisation of existing capacity are expected to provide support to growth during 2007-08. The recent gains in bringing down inflation and in stabilizing inflation expectations should support the current expansionary phase of growth cycle. It is, however, necessary to continuously assess the risks to the inflation outlook emanating from high and volatile international crude prices, the continuing firmness in key food prices and uncertainties surrounding the evolution of demand-supply gaps globally, as well as in India. Risks from global developments continue to persist, especially in the form of inflationary pressures, re-pricing of risks by financial markets and danger of downturn in some asset classes. Excessive leveraging has enhanced the vulnerability of the global financial system. Large changes in liquidity conditions are obscuring assessment of risks, with attendant uncertainty. Given the flux associated with both financial markets and monetary policy settings globally, India cannot be immune to these developments. The policy challenge for Reserve Bank, now, is to manage the current transition to a higher growth path while containing inflationary pressures and focusing on financial stability. Contextually, we in the Reserve Bank are, therefore, maintaining enhanced vigilance to be able to respond appropriately to the prevailing heightened uncertainties in global financial, as well as, monetary conditions”. Valedictory Address by Dr. Rakesh Mohan, Deputy Governor, Reserve Bank of India at IIF's inaugural Asia Regional Economic Forum on September 20, 2007.Assistance of M.D. Patra and Indranil Bhattacharya in preparing the speech is gratefully acknowledged. |