Interview with Duvvuri Subbarao

Duvvuri Subbarao, former Governor, Reserve Bank of India.

Has the experience of the crisis changed your view of the central bank policy toolkit?

Governor Subbarao: Most certainly. Post crisis, I believe, the central bank toolkit has expanded in three important dimensions: (i) deployment of unconventional monetary policy by way of quantitative easing (QE); (ii) extensive use of forward guidance; and (iii) use of macroprudential policies to maintain financial stability. Each of these policy tools has spawned a vigorous debate on its appropriateness and effectiveness. Let me briefly refer to the contours of those debates.

Quantitative Easing (QE). The purported rationale for QE and the mechanism by which it is expected to work are now standard fare. However, the extensive use of QE, first by the US and the UK, then Japan and most recently the ECB, has raised some important questions:

1. Is QE really unconventional monetary policy (UMP)? Indeed, can it be seen as an addition to the central bank policy toolkit?
2. What has been the impact of QE in achieving the intended objectives in the source countries?
3. What has been the impact of QE by way of cross-border spillovers and how are these spilllovers to be managed from the perspective of a global optimum?
4. Will advanced economy (AE) central banks be able to make a smooth exit from QE? What will be the cross-border impact of the exit policies?

The first question, is QE indeed UMP? Some scholars, analysts, and even some advanced economy central bank governors, have argued that QE is, in fact, not UMP. Monetary policy, they contend, has two principal tools both of which are conventional - the interest rate tool and the balance sheet tool. QE, according to them, is a standard balance sheet tool and cannot be called unconventional.

This argument is specious. Admittedly, liquidity management is an integral part of monetary policy. But QE has gone beyond the barriers of conventional liquidity management in four respects: (i) It has been resorted to after the policy interest rate hit the zero lower bound; (ii) The quantum of purchases has been exceedingly large, oftentimes testing the limits of the balance sheet of the central bank; (iii) The nature of assets bought has been very diverse; and (iv) Asset purchase has been followed up with repeated assurances that the extreme accommodation will be maintained over an 'extended period'.

In my view, therefore, QE is undoubtedly UMP and a clear addition to the central bank policy toolkit.

The second question on my list is the impact of QE in terms of the stated objectives. QE has two stated objectives: (i) restore financial market stability; and (ii) stimulate the economy. There is evidence to suggest that QE has been successful in restoring financial market stability in the short term by lowering the long-term real interest rate. As regards the second objective of stimulating demand, evidence of success is scanty as the transmission from the financial markets to the real economy has been weak. In fact, in Japan and the Euro Area, the only working transmission channel has been the exchange rate, which raises its own concerns.

Moving on to the third question, that QE has led to massive capital inflows into emerging markets (EM) is beyond question. These capital flows, far in excess of their current account needs, have destabilized EM currencies, eroded their competiveness, threatened their financial stability and complicated their macroeconomic management.

The responsibility of the advanced economy central banks, which have resorted to QE, for this cross border spillover impact has been a contentious issue in global forums such as the G20 and the IMFC [International Monetary and Finance Committee of the IMF]. EMs have contended that AEs should be mindful of the adverse cross border impact of their QE policies and should take that into account in their policy calibration. If they do not show the requisite sensitivity, EMs will be forced to resort to capital controls which would result in a globally suboptimal situation. Advanced economies have not been persuaded by these arguments. They maintain that their policies are driven entirely by domestic concerns, their financial stability and recovery is a global public good with positive spillover impact across the world, it will be impractical for them to take external factors into the policy calculus and that EMs should learn to manage the spillover impact by making their domestic economies more resilient. This is an issue that continues to elude a consensus.   

Regarding the final question on the exit scenario, if the exit from QE is smooth, it could be less of a problem. However, if it is bumpy, as is more likely, it could create huge volatility in the global financial markets, especially EMs, with attendant implications for the real economies.

Forward Guidance. The second dimension of the expanded central bank policy toolkit is forward guidance. Given the nature and depth of uncertainty, and in the face of several known unknowns, central banks found it expedient to follow up their policy action with guidance on the forward path of the policy.

While forward guidance has been effective in giving confidence to financial markets, it has also entailed costs for central banks by way of loss of credibility when actual outcomes deviated from those envisaged under the guidance. The use of forward guidance has thrown up some other complex challenges: how to communicate the nature and extent of uncertainty, how to make the markets treat the guidance as 'guidance' subject to conditions and not an irrevocable commitment, and how to 'guide' the markets in correctly interpreting the guidance. 

Even as forward guidance is now an integral part of central bank policy toolkit, central banks have a lot to learn yet on when and how to use it effectively.

Macroprudential Policies. The last dimension of the expanded toolkit of central banks post crisis is macroprudential policies to maintain financial stability. Among the most powerful lessons of the crisis has been that the costs of central banks ignoring financial stability are intolerably high and that financial stability has to be an explicit variable in their objective functions. A clear outcome of this has been the post-crisis trend around the world of entrusting central banks larger and more explicit responsibility for financial stability and adding macroprudental policies to their toolkits.

This has raised some complex questions: 

1. s macro prudential policy, by itself, always potent enough to address financial stability risks?
2. n dealing with capital flows unrelated to fundamentals, can Ems depend entirely on macro prudential policies without resorting to capital flow management measures?
3. What is the role of monetary policy in preventing asset bubbles?
4. hen and how to supplement macro prudential policies with monetary policy?; and
5. Will the responsibility for financial stability compromise the autonomy of central banks?

A final comment before I conclude my response to this question: even as the central bank toolkit has expanded post crisis in a fundamental way and QE has been used to an unprecedented extent by AE central banks, all of them have stopped short of a pure helicopter drop. Are we to conclude that a helicopter drop of money is a theoretical construct with no practical relevance?

Where should we be looking for financial stability risks?

Governor Subbarao: There are many unknown unknowns in the financial space that could potentially threaten financial stability at the individual country as well as the global finance level. I will list four areas that, to my mind, are the major areas where we should be looking for financial stability risks.

Risks from Outside the Banking System. First, we should be alert to financial stability risks across the entire financial system instead of narrowly focussing on banks. Another powerful lesson of the crisis has been to remind us that the financial system is interconnected in a complex way with the possibility of systemic risks arising anywhere in the system and the contagion rapidly spreading across the entire system and then transmitting to the real economy in unpredictable ways.

Post crisis, the Basel III framework has tightened the regulatory framework governing banks, entailing higher and better quality capital, limits on leverage and liquidity safeguards. However, the progress of regulatory reforms in the non-banking sector, especially the shadow banking sector, remains slow and inadequate, raising concerns about the possible threat to financial stability.

Risks from the Payment and Settlement Systems. One of the remarkable, if also reassuring, features of the global financial crisis has been that the even at the depth of the crisis, the payment and settlement system held up. But we cannot afford to be complacent in this regard. It is not clear that the Basel III Framework, by itself, is a sufficient safeguard against preventing any breakdown in the payment and settlement system and we need to ensure that safeguards are built into the regulation of the payment and settlement systems, including protocols governing when and how clearing houses will have access to central bank backstops.

Risks from the Asset Markets. The third area where we should be looking for risks is in asset markets. The size and duration of QE has driven down interest rates in advanced economies, in some cases even into the negative territory. This has triggered a search for yield, investment in riskier assets and overpricing of assets. The longer the low interest rate regime persists, the larger is the threat to financial stability. The success of QE is contingent upon investors taking more risks. Paradoxically, in that very success lie the roots of financial fragility reminding us of the importance of carefully calibrating policy.

Risks from the Currency Markets. The last area we should be looking for risks to financial stability , as the Managing Director of the IMF said in a lucid speech recently (see Largarde: Prevent "New Mediocre" From Becoming "New Reality", April 9, 2015), is in the currency markets. The standard problem of 'double mismatch' in borrowing in foreign currencies is exacerbated by the divergence in the business cycles across different parts of the world. In as much as globalization of finance is going to remain with us, foreign currency borrowing is going to stay. This can threaten financial stability if exchange rates remain volatile. What we need so as to prevent currency markets from derailing the financial system is a global code of conduct on managing exchange rates.

What should we do to preserve the benefits of global finance?

Governor Subbarao: One of the most remarkable features of the current phase of globalization has been the phenomenal expansion of global finance which has outpaced global trade. Globalization, as we now well know, comes with costs and benefits. The challenge is to minimize the costs and maximize the benefits.

The key to preserving the benefits of global finance is to understand and acknowledge that global financial stability is global public good. In a world divided by nation states, global finance is becoming hostage to purely domestic interests, and even 'beggar thy neighbor' policies, resulting in a global suboptimum. This is something we cannot afford. Both as individual jurisdictions, and collectively as the global system, we need to accept our obligations in a financially interconnected world. This requires clear commitment in three specific directions.

Accept Responsibility for Cross-border Spillovers. First, every country, particularly systemically important advanced economies, have to accept responsibility for the cross-border spillover impact of their policies and agree to commit to global cooperation in monetary policy, regulation of financial institutions and financial markets, and resolution of cross border institutions.

Strengthen Global Safety Nets. Second, we need to strengthen the global safety nets. Even as the volume of global finance has multiplied several fold, the size of the global financial safety nets remains relatively small. In particular, we need to buffer the financial resources of the IMF and improve its governance such that it inspires the trust and confidence of every member, no matter how small economically.

Alternate Reserve Currency. Third, we need to reduce our dependence on the dollar as the world's sole reserve currency.  During the crisis, we all realized how that dependence can jeopardize global financial stability. It is, of course, nobody's case that an alternate reserve currency can be anointed through a conference decision or by global agreement.  An alternate reserve currency has to emerge on the strength of the currency-issuing economy's size, resilience and openness. But it is an endeavour that we must seriously pursue.