The five concerns
Governor Subba Rao continues:-
First Concern: Exit from Accommodative Monetary Policy: Growth vs. Inflation: While there is broad agreement that we need to exit from the present excessively accommodative monetary and fiscal policies, there is less agreement on when and how we should exit. There are incipient signs of recovery. Industrial production has picked up in the past couple of months, but export growth remains negative. Business confidence surveys suggest recovery from the troughs touched a year ago although the confidence levels remain below the earlier peaks.
Second Concern: Management of Large and Volatile Capital Flows: Major central banks – such as the US Fed, the ECB , the BoE – have flushed their financial systems with unprecedented amount of liquidity. Till the first quarter of 2009, this liquidity was finding its way back to the central banks as excess reserves because of risk aversion. . Risk appetite is now returning. There are signs of recovery in portfolio investments to the EMEs . For instance, portfolio investments by FIIs in the Indian equity market amounted to US$ 13.6 billion in the period April 1-September 18, 2009 as against outflows of US$ 5.2 billion in the corresponding period of 2008 reflecting a turnaround of almost US$ 19 billion.
Third Concern: De-clogging Monetary Transmission Mechanism: Following the collapse of Lehman Brothers, the global economic outlook deteriorated sharply, and the Indian economy got impacted by the contagion through all the channels – the financial channel, the real channel and the confidence channel. The Reserve Bank's crisis response included, like in the case of other central banks, both conventional and unconventional measures. These factors, which impeded monetary transmission, were in play even before the crisis. A definite task going forward will be to address the impediments to monetary transmission.
Fourth Concern: Fiscal Stimulus - Withdrawal and Quality of Adjustment: Like in other economies, fiscal stimulus measures and weakening of economic activity have led to substantial increase in our fiscal deficits. The Central Government's fiscal deficit is budgeted to jump from 2.7 per cent of GDP in 2007-08 to 6.8 per cent in 2009-10; the combined fiscal deficit of the Centre and the states is expected to increase from 4.2 per cent of GDP to 10.2 per cent over the same period. These deficits are large and need to be rolled back. What is the scope for adjustment? What lesson does our past experience offer?
We need to work seriously on expenditure compression. This is going to be politically challenging both at the Centre and in the States, but it needs to be done regardless.
Fifth Concern: Financial Stability, Financial Inclusion and Growth: Given the enormity of the crisis, financial sector regulation is being tightened under the aegis of international bodies such as the BCBS and FSB. There are proposals that would raise the reserve requirement of banks. New regulations for liquidity requirements are also going to be in place. There are also proposals to require banks to hold government securities. Many of these measures are necessary. But we need to recognise that all such proposals will have the impact of increasing the banks' funding costs which will translate into higher lending rates. How will banks react to such higher costs? Will this lead to an erosion of banks' social responsibility towards the poorer and other needy segments of the society? In economies such as India, a large part of population remains financially excluded. We will need to ensure that efforts at financial inclusion do not get negated by the ongoing tightening of the regulatory regime.
It needs to be recognized that after a crisis, with the benefit of hindsight, all conservative policies appear justified. But excessive conservatism in order to be prepared to ride out a potential crisis could thwart growth and financial innovation. The question is what price are we willing to pay, in other words, what potential benefits are we willing to give up, in order to prevent a black swan event? Experience shows that managing this challenge, that is to determine how much to tighten and when, is more a question of good judgement rather than analytical skill. This judgement skill is the one that central banks, especially in developing countries such as India, need to hone as they simultaneously pursue the objectives of growth and financial stability.