Lessons for advanced economies from developing countries' experience of the last few decades

If the Central Bank is reduced by convention or statute to a single focus on inflation in the market for goods and services, it will lack the flexibility it critically needs to ensure macroeconomic stability in a globalised world.  Asset market prices are not among those recommended by conventional wisdom to be on the watch list of a Central bank, whether for monetary policy or regulatory purposes. The Reserve Bank of India flouted these conventions, and so effectively faced off a capital inflow surge and the threat of a real estate bubble, to preserve financial stability in the years preceding the great crash of 2008.  Thereby, the financial sector was well-positioned at the time of the crash itself.  Monetary policy transparency remains of paramount importance, but it should be correctly defined to require full prior disclosure of policy decisions, with effective dates, and pre-announced finite, or indefinite, durations, and full post-facto disclosure of all interventions in any market.  Transparency should not be subverted to require a prior policy straitjacket, limiting the focus or instrumental options of monetary policy.

Arguably the most important institution protective of macroeconomic stability in any country is its central bank.  The experience of developing countries where central banks had flexibility with respect to policy and instruments, and where as a consequence the great crash of 2008 inflicted minimal damage, could perhaps carry some lessons for advanced economies. A central bank needs to shape its objectives and instruments to the macroeconomic need of the hour, which can change by the hour in a globalised world.

Flexibility of this kind runs counter to received wisdom on the sanctioned objectives and instruments of macroeconomic policy. Monetary policy relies on the control of levers affecting private market players. The issue of what should be revealed therefore becomes amenable to theorizing on the reactions of market players to information. 

Present-day prescriptions for monetary policy transparency are based on stylized models. A typical stylized model (Geraats, 2002) runs as follows.  The central bank maximizes the objective function:

            W = - ½ α (π -  t)²  -  ½(1 - α ) (y - k)²

                Inflation target:           t (actual inflation is π)

                Output gap target:           k (actual output gap is y)

The actual output gap y is impacted by the rate of interest, r, and unanticipated demand shocks, d, thus:

            y =  - r + d

The economy is defined by the following expectations-augmented Phillips equation, which accommodates unanticipated supply shocks, s, thus:

             π =  π^e + y + s

The optimal (policy) rate of interest in such a system will be given by the first order condition for maximisation of the objective function W of the central bank with respect to r, thus (given π^e):

             r = α (π^e - t) - (1 - α) k + αs + d

If there is a credible inflation target to which inflationary expectations in the economy get equated, so that the first term in the above equation disappears, that leaves (for unchanged output targets) a rate of interest that needs to be changed only for adjustment to unanticipated supply and demand shocks. It is this first order condition which underlies the diktat that credible prior disclosure of t, the inflation target, should be the core component of monetary policy transparency.  When inflationary expectations are set, the policy rate of interest is free to target adjustments to supply and demand shocks to the system, and therefore reduce output volatility.  Note that the transparency definition so obtained is not an end in itself, but is justified because it subserves the larger cause of macroeconomic stability.

The problem with this formulation of course is that the exogenous shocks s and d in the equation are all real shocks, and inflation stability refers uniquely to prices of real goods and services.  Exogenous developments in the financial sector do not have any play in this model.  An example of the kind of exogenous financial shock that could destabilize the real system might be, say, a capital inflow surge, in a world of free capital flows.  In the face of such a surge, the single-minded pursuit of stable (inflation in) prices of goods and services could lead to disastrous volatility in another price, the exchange rate of the domestic currency. An appreciation spike in the exchange rate could then lead to a follow-on negative real (external) demand shock, d, which will be endogenous to policy pursuit of the inflation target.  In a friction-free world, the directionality of correction would of course be perfectly aligned with what it should be to restore the system to the pre-surge equilibrium.  The interest rate r will be lowered to correct the negative external demand shock, and it will reinforce the exchange rate appreciation to choke off the capital inflow surge which caused the problem in the first place. 

The central problem is that the world as we know it is not friction-free, and this process of adjustment will not be instantaneous. If it ruptures links between exporters and buyers which cannot quickly get restored, there could be a long-term demand shock which does not get corrected with lower interest rates.  The extent to which this is likely would be a function of the concentration of products and destinations in the export basket; the importance of exports in aggregate demand; and whether the export production vector is aligned with the domestic demand vector. There could arise situations in which large-scale defaults by exporters could seriously destabilize the banking system.  Single-minded pursuit of price stability could result in disastrous instability, both real and financial.

Although the objective function maximized in the model allows two goals, the analysis in the paper takes each of these targets sequentially, holding the other constant, and the advantages of prior disclosure apply unambiguously in the case of t alone.  Indeed, the paper shows that prior disclosure of k alone, without prior disclosure of t, would mean that inflationary expectations are not anchored, and could require movements in the rate of interest opposite in direction to that required to correct the output gap.

Based on the above model, Geraats advanced a monetary policy transparency index, providing for a rating of central banks on a scale of 0-15.  One component of the index is “a formal statement of objectives, including an explicit prioritization in case of multiple goals, (and) a quantification of the primary objective(s)...”  In the simple two-goal monetary policy objective function used in the Geraats paper, this calls for disclosure of both t and k, and further prioritization of these (the parameter α in the model). As described earlier, the only unambiguous prescription flowing from the model applies to the disclosure of the inflation target.  The impact of disclosure of multiple objectives is not addressed, and clearly the quantification of both could in practice raise serious issues of mutual compatibility.

The Geraats index therefore subverts the term “transparency” to mean:

·        adherence to a preferably single objective like stability of price levels in the market for goods and services, with admissibility of other objectives if there is quantification of both the targets themselves as well as their relative priority with respect to price stability, when what developing countries (and arguably developed countries as well) need is macroeconomic stability, where the components of that objective are not possible to specify a priori, independently of context;

·        rigidity in central bank objectives, when flexibility is needed to respond to unforeseen eventualities as developing countries open up;  and

·        predictability in central bank actions, which denies discretionary actions towards ensuring real and financial stability.

In an exercise by Dincer and Eichengreen, which assigns transparency scores to 100 central banks using the Geraats index, for each year of the eight-year period 1998-2006, the Reserve Bank of India (RBI) scored 2 out of 15 marks in 1998 and stayed there, among the lowest scores in the whole set, and the lowest in South Asia.

This central Bank, rated as hopelessly non-transparent, acted firmly to keep a lid on the appreciation pressure on the Indian rupee through sterilized purchase of dollars during the unprecedented quadrupling of capital inflows over the four years preceding the great crash.  By so doing, the RBI effectively protected the Indian economy from the disastrous financial instability that would have been the consequence of an unconstrained appreciation of the Indian rupee.

Without in any way having to assess whether the actions taken by the RBI were correct in quantum or direction, the freedom of the RBI to determine its course of action in response to contingencies as they arose was unquestionably preferable to tying its hands by a prior quantified commitment to price stability.   The impact on exports of a volatile exchange rate driven by capital inflows over 2004-08 would have led to widespread exporter defaults, and thereby destabilized the banking system.  The retention of multiple options in monetary policy was surely more reassuring to markets than a policy straitjacket that ruled out some options altogether.  That policy straitjacket, as was clear from the model, is not lacking in internal consistency or coherence.  The element missing is that the comparative statics of the model do not factor in the time intervals between equilibria, and the economic (and possibly political) turbulence during those intervals.

Another strand in the literature that has fed into the recommendation to bind the flexibility of central Banks was the empirical finding that inflation control was most effective when central banks were independent of the executive arm of government (Cukierman, 1992).  This empirical finding, supporting freedom from oversight and supervision by the executive, led to worries about the accountability of an institution not answerable to the electorate.  In some countries, as in India for example, the central Bank is even free of audit of its accounts by the national auditor.  These accountability issues undoubtedly strengthened the case built up from monetary policy models for statutory binding in terms of objectives and instruments.

But rigidity in central bank targets and instruments cannot be used as a solution to the accountability issue.  A central bank cannot, in pursuit of a good transparency reputation, be reduced to a predictable and mechanical element in the policy structure, with no range of instruments with which to handle unforeseen eventualities that could threaten macroeconomic stability.  Fortunately, this is endorsed by the Code of Good Practices on Transparency in Monetary and Financial Policies of the International Monetary Fund, which does not envisage any particular objective for monetary policy. 

Asset market prices are not among those recommended by conventional wisdom to be on the watch list of a central bank, whether for monetary policy or regulatory purposes. Differentiated risk weight enhancements are not supported by conventional wisdom on bank regulation, on the grounds that monitoring end-use of a loan is intrusive and easily violated.  Once again, the RBI violated both these conventions, in its function as the banking regulator, and effectively contained the build-up of a real estate bubble over 2005-08, concomitant with the capital inflow surge.

The RBI document on Securitization of Standard Assets issued in February 2006, as a safeguard against the abuse of originate-to-distribute practices, which were at the heart of the financial collapse of 2008, is an exemplary prudential document, which can with advantage serve as a model for the world.  Its distinctive feature was the careful distinction drawn between “true sale” of a housing loan, under which the originator would not be required to maintain any capital against the value of assets transferred out, and transactions where the originator carried first and second loss credit enhancement facilities so as to give comfort to the buyer.  Both these facilities were to be deducted from Tier I and Tier II capital of the originating bank, at the amounts the bank would have been required to hold for the full value of the assets, had they not been securitized. Detailed provisions applied also to liquidity and underwriting facilities. 

The RBI also took pre-emptive action against the possible build-up of a bubble by raising risk weights on commercial real estate loans in stages, starting in July 2005.  They were lowered back to pre-existing levels in November 2008.  These hikes did not affect housing loans to individuals; indeed, at the same time as the risk weight hikes for commercial real estate, those applying to individual housing loans were actually reduced for some classes of borrowers as a function of the loan to value ratio.  However, provisioning requirements were raised for individual loans along with those for commercial real estate, although not to the same levels.  Fortunately, Pillar 2 of the Basel II norms, which sets rules for supervisory review of capital adequacy, supports freedom of this kind, for the regulator to set supplementary levels of minimum regulatory capital for risks not covered, or inadequately covered, under Pillar 1.

The accountability issue remains.  That can be assured only through transparency, with transparency correctly defined to require full prior disclosure of policy decisions (whatever they may be), with effective dates, and pre-announced finite, or indefinite, durations, and full post-facto disclosure of all interventions in any market.  At the end of the day, the credibility of a central bank is a function of the financial stability it is able to deliver, not a function of prior straitjackets adopted.

This article includes many passages from a paper by the author in Sameer Kochhar, ed., 2010 India on the Growth Turnpike (Delhi: Academic Foundation); Chapter 3.

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