He also stressed that capital inflows cannot be looked at in isolation and divorced from monetary policy. India was able to survive the Asian crisis as we had capital controls.
Below is the edited transcript of his interview to CNBC-TV18.
Q: You don't agree with the FSLRC recommendation that power over imposing capital controls must be taken away from the RBI and given to the finance ministry. Why do you disagree?
A: Capital controls can either be managed completely by the government or they could be managed completely by the central bank. Certain problem arises when there is a distinction between the two. So how do you make this distinction?
To make a distinction on the basis of capital inflows and outflows is illogical. I prefer that if everything was managed by the Reserve Bank then they would manage all capital inflows and outflows.
However, I also recognise that capital inflows to the extent arise out of foreign direct investment (FDI), which results in the ownership of Indian assets by non-residents and that is an issue, which is not just limited to the question of foreign exchange. It has political and other implications. All the controversy, regarding FDI in retail business or the extent of participation in insurance business should be left to the government to decide.
Therefore, foreign direct investment which is inward should be managed by the government because of its implication on ultimate ownership of Indian assets by non-residents, but the rest should remain with the Reserve Bank.
I think capital inflows cannot be looked at in isolation. It is a part of monetary policy. If there is volatility, it affects the exchange rate and affects the financial stability. If excess foreign exchange comes in, it may result in a need to de-monetise the excess liquidity, which is created. All these issues cannot be divorced from the ambit of the Reserve Bank. I thought that would be a more logical way of dealing with it.
Q: Can you give us more detail on what the dominant international practice is on capital controls, not only in developed countries but also in emerging markets like India?
A: One has to first make a distinction between countries, which have complete capital convertibility and those, which don't have capital convertibility. If there is capital convertibility then the problem does not arise.
Those countries, which don't have capital convertibility and some of the countries, which had capital convertibility, are now imposing some form of capital controls. If you just allow freedom to non-residents to bring in money and pull it out at their own will then it does have certain implications on the exchange rate and it will have implication on the amount of currency, which is in circulation.
Sometime back we had the East Asian crisis. The survived that crisis because we had limited capital controls.
Even in the last financial crisis of 2008, our capital controls to some extent prevented an outflow of foreign exchange. Importantly, even the International Monetary Fund (IMF), which originally was a strong advocate of total capital convertibility has now recognised that no limited capital controls have some validity.
Once you recognise that there is a need for limited capital controls for most countries then the question, which arises is, who will monitor those capital controls? Would it be left to the government where decisions maybe taken on political grounds, on short-term basis, under political compulsions or should it be left to a professional body like the central bank, which takes a long-term view and has no political overtones in this.
Q: So that is according to you the dominant way in which things are being managed in emerging markets largely today?
A: The present position is that even today under Foreign Exchange Management Act (FEMA), though the RBI is the ultimate authority for all capital controls, in practice for FDI the government formulates the policy in consultation with the RBI but substantially it is the government which formulates the policy. And for all other matters it is the RBI which formulates the policy.
Now this is a system which has worked well. The criticism which has been advanced and which is also mentioned in the report is the tendency of the government to issue press notes and there is no certainty about the policy mainly concerned with FDI, not with other issues. Therefore if that is not operating as it should be operating, the solution is not to then move it away from the RBI and give it completely to the government. The solution is to ensure that what is today done and practiced is codified into law and therefore a certain degree of responsibility is given to the people who have to administer that law.
Q: FSLRC wanted the RBI to regulate only the banks, not Non Banking Financial Companies (NBFCs) or housing finance companies? You had opposed that move, why did you do so?
A: In some countries there is a single regulator and some countries have multiple regulators. We took a conscious decision that we would have two regulators, one for the banking system and the other for the residual entities. The rational for doing this was that we feel that at least for the moment the banking system is substantially different from other regulated entities and therefore the RBI should continue to regulate the banking system.
The problem arises, how do you define the banking system? Do you define the banking system only as consisting of banks or as consisting of all bank-like entities or entities, which are doing banking business?
Today's NBFCs which are asset financing companies', they are higher purchase companies', leasing companies', and investment companies'. Their asset side is not different from asset side of banks.
If one look at the portfolio of housing finance companies, 64 percent of the portfolio is with banks and 36 percent with the housing finance companies. Will there be a system where 64 percent of the activity will be regulated by the RBI and 34 percent would be regulated by another regulator.
You look at the other position. What is the size of the NBFC? The assets of the NBFCs are almost about 10 percent or more of the total assets of the commercial banking sector.
There are 42 NBFCs, which in size are larger than the smallest commercial bank. There are two NBFCs, which are larger in size than the smallest public sector bank. So, it is not a small area.
The literature which has come out after the global financial crisis of 2008, almost without exception mentioned that major problems was created because of shadow banks, which were acting in the same sphere without the regulations or the supervision of the main regulator. Therefore, a regulatory arbitrage was created.
One cannot deny that NBFCs are shadow banks and a substantial force in the financial system. So if you accept that proposition then are you not opening yourself out to the same risk, which created the financial crisis of 2008, where one regulator manages the banks and another regulator manages the non-banks, which are doing this business.
Q: Another dissenting member has said that giving the Financial Stability and Development Council (FSDC) statutory powers and making the finance minister its chairman, is a reversal of the process of regulatory independence. You did not object to that. You don't think a future statutory FSDC will threaten regulatory independence?
A: No, it does not worry me. It was a compromise decision and I accept that. Let us look at it as it exists today. Today, though it is not codified, the position we have FSDC, which is chaired by the finance minister and a sub-committee of the FSDC, is chaired by the RBI governor.
It was proposed that FSDC will be a separate entity and not just a committee. Its board would consist of RBI governor, the chief executive of the second regulatory authority, resolution cooperation and FSDC itself.
Its sub-committee will now become an executive committee and all the powers of the FSDC will be in fact controlled and regulated by that executive committee. So in effect we are virtually empowering today's sub-committee with the complete control to run the FSDC.
There are two exceptions, first, if there is a disagreement between the regulators then someone has to resolve, then it goes to the main board. The second exception, if there is a financial crisis then the funding of the crisis may involve the use of public sector funds or government money in which case it is only fair that it should go to the board.
I feel that the actual role of the FSDC hasn't changed very much. It is codified. It will remain a coordinating agency. It will have two additional roles - one role will be that it becomes a repository of all information. So that is the database, which can be accessed by both the regulators.
The next difference is that, will the FSDC be able to identify systematically important entities, which today may not be regulated by individual regulators, but which needs some sort of regulation if for the financial stability.
Q: So it may not just be recodifying, it may end up truncating powers of some regulators for instance at the moment the RBI doesn't have an appellate authority and in some cases it may help for instance when Global Trust Bank got merged with OBC it had to be done swiftly to protect depositors. Now such decisions can't be reviewed and certainly can't be turned back?
A: Today, a regulator does not have within the regulators own administration segregation between the person who enforces the regulation and someone who adjudicates on it. Now what is being provided is that every regulator will have within that regulator itself an entire section which is an adjudication section. For example there will be a member of the board who is an adjudication member, he has no administrative responsibilities. His job i s only to administer the adjudication portion. And within the organisation there will be adjudicating officers.
So let us assume for example that in the RBI, the DBOD decides that there has been a violation and if a penalty is to be levied, may be a committee of deputy governors will levy the penalty. In future what will happen is the DBOD will say there has been a violation. Then that matter goes to the adjudicating officer. Now, since he has not got any views on the matter, he will see if there is a violation and whether it calls for a penalty. He will then impose a penalty and his work will be reviewed by the member of the board. Having done that thereafter, if someone wants to appeal, that appeal will be there. But this process itself wi ll ensure that too many issues will not go through and this will ensure that the problems which you are thinking of will be internally sorted out without going outside.
Q: The commission wants Reserve Bank to be given targets by the government and if they fail to fulfil them, then the RBI will have to explain the reason for that and by when it will achieve them. Firstly, doesn't this look like bulldozing the Reserve Bank's independence? Secondly, many countries have actually moved away from targeting and thirdly, often the Reserve Bank cannot achieve targets because it is the government which holds so many of the cards in its hand?
A: This needs to be clarified. The monetary policy can have several objectives; you could have price stability as an objective, you can have growth as an objective, and you can have foreign exchange management as an objective. So, we have acce pted that there can be many objectives and price stability is not the only objective though that maybe one of the more important objective.
The question was who will determine those objectives ultimately. The government is answerable to parliament and even today objectives are debated and discussed between the monetary authority and the government. But the important point is that the objectives will have to be determined in the medium-term. It is not that you are going to determine an obective for a particular year and say that we believe over the next 3 or 5 years price stability is important or that we believe growth is important. So you determine a policy for the medium-term.
Now, if you determine a policy for the medium-term then how do you evaluate whether that policy has in fact been fructified or achieved? So, you set medium-term targets, you don't set the target, you don't say that next year you will have inflation of 6.5 percent. In fact, you say our goal is that inflation should be brought down over a medium-term to 5 percent or 4 percent or whatever. Then the question arises that if you have this sort of a goal then you are asking the Reserve Bank to implement that policy and therefore you are giving the Reserve Bank the freedom to take whatever steps are needed to implement that policy. The government does not interfere with the steps that are taken, but the question that still arises is that monetary policy alone cannot achieve many of these targets.
There are other factors, which may come in, whether it is a question of fiscal deficit, whether it is in terms of current account deficit (CAD) and many other issues. Therefore, you should give an opportunity to the Reserve Bank to explain the reason for not achieving the target and therefore to identify the factors, which were there.
We had suggested one important thing that happens even in Bank o f England. One, we have asked for a monetary policy committee. Today there is an advisory committee, but it is purely advisory committee. So we suggested a certain amount of discipline is to be brought on this committee and the members of the committee have to virtually go on record with what their view is, record their vote and so on.
Second, we have provided that even if the governor does not agree with the majority view of that committee, he is free to differ from them and implement the policy as he wants it. However, in all fairness as a matter of transparency, he must explain why he does not agree with the view of the committee.
I thought, this was a reasonable compromise to be reached between the two extreme positions; on one hand you say monetary policy is only the function of the Reserve Bank and government has nothing to do with it or on the other hand, it is the government which will direct the Reserve Bank to execute a monetary policy and Reserve Bank becomes only an agent for implementation. So, this was the sort of compromise, which was reached between the two views.
Q: Given the seminal and vast changes proposed by the commission, how much time do you think it will take to implement all these recommendations?
A: We have not debated this but I would be very surprised if the whole thing is achieved within next five years.
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