The RBI Governor’s speech at the Brookings Institution on April 10, 2014 garnered a lot of attention from the central bank watchers. A lot was written about what he said, most of it for an audience who feel at ease understanding stuff like
“A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate.“
At the other end, mainstream media spells it out as: “The RBI governor called for greater coordination between the central banks of the world“. Which doesn’t begin to capture the contents of the speech in any meaningful way. In this blog post, I hope to translate the speech into a language you and I can easily understand and comprehend. (The entire speech is available here)
Opening Remarks
Rajan starts by expressing his concern over the US central bank (the Fed) policy of injecting money into the economy through direct purchases of debt, a program called Quantitative Easing (QE). (QE is simply printing up money to buy debt from the market. Demand for debt increases, money supply goes up, and interest rates on debt go down). This has been going on for quite a while now and he is concerned that any policy changes by the Fed will have adverse effects on the emerging economies (i.e. India), namely sudden outflow of dollars leading to a currency crisis, stock market bust, falling asset prices etc. as has happened in the past. And while he notes that India could potentially handle such shocks, it is nonetheless a concern.
Views on prior Fed actions
While acknowledging that the “unconventional” policies that the Fed adopted had their merit at that time, to help save the US economy, he notes that sticking to such policies for the long-term, as the Fed has been doing, could have different, unintended consequences which are negative for the global economy. In other words, QE causes problems for countries which allow US dollars into their economy.
Due to QE, investors flocked to emerging markets and invested there, seeking higher returns. This caused a boom in stocks, real estate etc. Mistaking this boom to mean rising prosperity, governments and institutions borrowed and spent more. All prices were going up, and there was a lot of foreign money running around, hiding any signs of trouble.
Ending the “unconventional” policy
However, ending QE would also cause problems in such countries! This is because with the end of QE, dollars flow out of emerging markets (India) back into the developed world. The sudden exit of investors causes the central bank to lose dollar reserves, deflates asset prices (real estate prices, for example), which prior inflows had caused to rise, and causes stock market decline (single foreign investors who bought Indian stocks are now looking to exit). To make matters worse, Indians who had borrowed using stocks/assets as collateral will be in trouble as the value of their collateral decreases.
In other words, QE caused debt-levels to rise in emerging markets as people borrowed foreign money and invested in India. With the end of QE, investors will want to go back to US with their money, and we’ll face trouble since we have huge foreign debts to repay.
The Solution Offered
Rajan says that in an ideal scenario, all central banks will coordinate their policies to avoid causing harm to other countries by their actions. But given that this will not happen, central banks should at least consider how their actions negatively affect other economies. This is a diplomatic way of saying the Fed should consider the hurt it causes India by its prolonged use of QE, and should be careful in its exit from QE to minimise harm to the Indian economy.
Apart from this, he makes the case that just as a central bank helps out banks which are in trouble, an institution such as the IMF should help out central banks which are in trouble.
My Comments
The issues raised by the current RBI governor signal that we should be prepared for a falling stock market, falling real estate prices and a drop in India’s dollar reserves. However, whether that will happen on not depends on the Fed’s actions.