Christine Lagarde
Managing Director, International Monetary Fund
Reserve Bank of India, 17 March 2015
Introduction
Good
afternoon, Ladies and Gentlemen.
Governor Rajan, thank
you for your generous introduction, and for inviting me to speak before this
distinguished audience today.
It is
indeed a privilege to share the stage with Dr. Rajan, one of the world’s most
highly regarded financial economists, one whom the Fund is fortunate enough to
have had as its Economic Counselor. Raghu certainly has been very busy since he
took over Governor of the RBI in September 2013. He has deftly steered the
Indian economy to safer waters after it was hit by the market turmoil following
the “taper tantrum” episode of mid-2013—a point I will come back to shortly.
More
recently, India has introduced flexible inflation targeting as the new regime
for conducting monetary policy—a very welcome step.
As
India’s monetary policy rests in good hands, let me talk about a topic that I
know has been as important a concern for this central bank—as it has been for
your colleagues in other emerging market countries. I am referring, of course,
to the unconventional monetary easing in the large advanced economies following
the global financial crisis.
We are
perhaps approaching the point where, for the first time since 2006, the United
States will raise short term interest rates later this year, as the first
country to start the process of normalizing its monetary policy. Even if this
process is well managed, the likely volatility in financial markets could give
rise to potential stability risks.
Let us
think today about the risks of such monetary policy “spillovers” – as we have
called them – and what can be done to minimize their potentially adverse
consequences.
1. State of the Global Economy and Challenges
It is
best to begin this discussion by placing it into the context of current global
developments, and the risks that the world economy is still facing.
Global
growth is still fragile and uneven. Despite a boost to global growth from a
decline in oil prices, we now expect the world economy to grow by about 3.5
percent this year, picking up modestly next year to 3.7 percent.
The
outlook differs significantly across countries and regions. Inadvanced economies, growth has rebounded in
the United States and the United Kingdom and is expected to remain above trend
in the near term, but activity is strengthening only gradually.
By
contrast, in the euro area and Japan, domestic demand,
especially credit to private sector and investment, has yet to recover fully.
In emerging markets and developing countries,
growth is projected to pick up from less than 4.5 percent this year to a little
more next year, but it will vary widely across countries as well.
Among
the emerging markets, India is
shining brightly. No doubt India has seen a windfall gain from a sharp drop in
oil prices – as have other oil importing countries. More importantly, however,
India is reaping the benefits of good policies and policy announcements.
My
meetings with Prime Minister Modi and Finance Minister Jaitley yesterday have
left me strongly convinced that the new government is skillfully shifting the
focus to good macroeconomic management, clean and efficient government, and
inclusive development. This has raised business confidence and hopes for all
levels of Indian society, and is borne out by the latest GDP statistics which
suggest a strong pace of economic activity this year and next.
Challenges
Yet
many challenges lie ahead for the global economy, of which two are particularly
relevant for India.
The first challenge is the recent
strengthening of the U.S. dollar that has resulted from the relatively strong
U.S. recovery combined with the divergence of monetary policy paths in advanced
economies. This has put pressure on countries whose exchange rate regimes are
linked to the dollar but yet conduct a substantial share of their external
trade in other currencies, as well as on sovereigns who have borrowed in
foreign currency heavily.
The
appreciation of the U.S. dollar is also putting pressure on balance sheets of
banks, firms, and households that borrow in dollars but have assets or earnings
in other currencies. India’s corporate sector, which has borrowed heavily in
foreign currency, is not immune to this vulnerability. Corporate sector debt
has risen very rapidly, nearly doubling in the last 5 years to about US$120
billion.
The second challenge, and
here we come to the main theme of my remarks, is the prospective normalization
of monetary policy in the United States and its spillovers to emerging markets.
The risk of financial market and capital flow volatility, along with sudden
increases in interest rate spreads, remains a real possibility as U.S. interest
rates begin to rise.
Let us
look at this topic in some detail.
2. Spillovers from Unconventional Monetary Policies—Lessons for
Emerging Markets
Unconventional
monetary policies—including large purchases of government debt—has been used to
provide policy accommodation in advanced economies since the 2007 global
financial crisis. These policies have had both positive and negative
spillovers.
Unconventional
monetary policies helped avoid a financial market meltdown in the initial
stages of the crisis, and later supported a recovery in advanced economies and
elsewhere. I am convinced that these policies were necessary to avert a 1930’s
style global depression. To that extent, the unconventional monetary policies
have had strong positive
spillovers for the global economy, and by implication for India and other
emerging markets.
However,
it is also true that these policies led to a build-up
of risks in this part of the world. Between 2009 and the end of 2012,
emerging markets received about US$ 4½ trillion of gross capital inflows,
representing roughly one half of global capital flows. Such inflows were
concentrated in a group of large countries, including India, which received
about US$470 billion.
As a consequence, bond and equity prices rallied, and currencies strengthened. Recent work by Fund staff suggests that spillovers to asset prices and capital flows in emerging market economies from expansionary unconventional monetary policies were even greater than from earlier conventional policies.
The
danger is that vulnerabilities that build up during a period of very
accommodative monetary policy can unwind suddenly when such policy is reversed,
creating substantial market volatility.
We
already got a taste of it during the “taper
tantrum” episode in May and June of 2013, when most emerging market economies
suffered indiscriminate capital outflows. India was also affected.
I am afraid this may not be a one-off episode. This
is so, because the timing of
interest rate lift-off and the pace of
subsequent rate increases can still surprise markets.
As
economic conditions improve in at least some advanced economies, portfolio
rebalancing out of emerging market economies can be expected, and some
volatility cannot be ruled out. Emerging markets need to prepare in advance to
deal with this uncertainty.
Lessons for the international community and emerging markets
There
are many important lessons we have already learnt from the “taper tantrum”
episode that I would like to share with you.
First and foremost, advanced economies can help. Clear
and effective communication of policy intentions can reduce the risk of creating
very large market volatility. While admittedly it is a difficult task, I would
also agree that there is scope for greater international policy cooperation to
minimize the negative spillovers.
Second, emerging markets need to prepare well in advance. Evidence
from our research suggests that emerging markets that had already addressed
their economic vulnerabilities before the taper tantrum fared better during
episodes of market volatility.
In
particular, higher GDP growth, stronger external current account positions,
lower inflation, and more liquid financial markets helped dampen market
volatility. In addition, more resilient financial sectors contained the effects
of such volatility. The reforms initiated here in India are therefore going in
the right direction, are very timely, but will also need to be pursued with the
utmost speed.
Third, if market volatility materializes, central banks need to
be ready to act. Temporary—though aggressive—domestic liquidity support to
certain sectors or markets may be necessary, along with targeted foreign
exchange interventions. Moreover, cross-country foreign currency swaps lines
have proven helpful in enabling necessary access to foreign exchange liquidity
at times of market stress.
There
are a few examples where good
fundamentals, as well as decisive and swift
policy responses, helped countries reduce, and cope with, market volatility.
Think of Korea, which improved the resilience of its financial sector with
measures that reduced banks’ short term external debt by half—to 27
percent—between 2008 and 2013. Other countries such as Brazil, Uruguay, and
Indonesia used some form of capital flow management measures to discourage
short term inflows and thus decrease the build-up of risks. Peru intervened
directly, though temporarily, in the foreign exchange market to limit excessive
volatility.
Here in
India too, the RBI took
decisive action during and after the taper tantrum episode. It provided foreign
currency liquidity support to key sectors, allowed the rupee to depreciate, and
provided judicious foreign exchange interventions to minimize disruptive
movements in the rupee. The RBI also arrested the surge in gold imports,
narrowed its current account deficits sharply, and started to rebuild foreign
exchange reserves.
So I am
very pleased to say that, in a very short time span, India successfully
contained its domestic and external vulnerabilities more than in many other
emerging economies.
Does
this mean the work is done? Well, you would be surprised if I answered “yes” to
this question.
3. Rethinking Financial Development
Indeed,
there is more work to be done. Apart from short term policy responses to deal
with acute economic crises, it is equally important to continue building a safe and inclusive financial system—which will
serve well in good times in supporting broad based growth and provide an
effective buffer in bad times in ensuring financial stability.
But
there are questions about the extent and speed with which financial development
should be pursued. The experience of advanced economies has shown the dangers
that can arise from oversized financial systems.
IMF
economists have done some work on rethinking financial development and its
implications for stability and growth in emerging markets. This work is still
being finalized and will be published in the next month or so. Allow me to
share with you a few encouraging findings.
First, there are many benefits still
to be reaped from further financial development in most emerging markets,
including India. By financial development, I mean greater depth and efficiency
of institutions and markets, as well as higher access of all its citizens to
banks and financial instruments.
The RBI
has taken several encouraging steps. By allowing for a greater role for the
private sector in India’s public sector banks, there will undoubtedly be a
striking increase in efficiency in the banking sector. Moreover, Prime Minister
Modi’s commitment to broadening access to formal finance to all segments of the
population through the ambitious Jan Dhan Yojana is
impressive, and so are the results which were achieved in just a few months.
The second and related finding of
the IMF study is that when it comes to financial deepening, there are speed limits! When
done too fast, deepening financial institutions can lead to more instability,
both economic and financial. It encourages greater risk-taking and high
leverage, particularly when poorly regulated and supervised.
This
puts a premium on developing good institutions and regulatory frameworks.
India’s
record in promoting good practices has been positive in recent times. It is
making progress toward addressing bad loans in public sector banks, and in
developing a sound regulatory and supervisory regime for banks, insurance, and
securities market.
Best
international practices are also being adopted. For example, India is well
ahead of many countries in implementing Basel III standards. The government’s
recent announcement to introduce legislation on a new Indian Financial Code,
which will simplify and revamp India’s financial regulatory architecture, is a
revolutionary step.
The third finding of the IMF study
relates to potential
tradeoffs of financial regulations. One view is that
tighter and more regulations to help safeguard financial stability can hamper
financial development.
The IMF
study provides a new angle. It finds that, among a large number of regulatory
principles, there is a small subset that is truly critical for financial
development as well as for financial stability. Some examples include
regulations related to capital buffers, non performing loans, financial
disclosures, and compensation. And, it is essentially the same small
subset that matters for both!
In
other words, there is very little or no
conflict between promoting financial stability and financial development if you
choose the right regulations to focus on.
On this
note, let me conclude.
4. Conclusion
I am
fascinated by the vibrance I see wherever I go in India. I see hope in the eyes
of the small sellers by the street side. I see dreams in the eyes of young
people, and there are so many young people! But above all I see change, change
for the better.
The
world is looking to India to lead the path to higher, sustainable, and
inclusive growth.
Thank
you.
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