Book Review: Growth with Financial Stability—Central Banking in an Emerging Economy

Good Luck Or Good Policy

Some economic models can have a unique equilibrium while others can have multiple equilibria (‘good’ equilibrium and ‘bad’ equilibrium) for the same set of ‘fundamentals’. So there is a need for careful interpretation if the outcome is good. There are two possibilities. First, a good outcome can be realised as this is the only equilibrium that can be possibly realised as in a model of a unique equilibrium. Second, it is a matter of luck that a good equilibrium is realised, since a bad equilibrium was also possible in the context of multiple equilibria. In the second case, policy makers cannot get complacent if a good outcome has been observed.

The book under review does not seriously consider the possibility that we may have been lucky. This reviewer would like to take a more cautious view. Let us consider an analogy. By 1990 or so we were congratulating ourselves on the achievement of a growth rate that was higher than in the earlier years in India. The financial crisis of the early 1990s in India had come as a surprise to most of us. What this suggests is that this time (in the last few years) it is possible that we have been lucky. It will help in this context if we take a more critical view of policy making here.

Financial Stability Possibly At The Cost Of Financial Repression

There is one easy and convenient way to remove any surprise of a financial crisis. If we carry out a policy of financial repression, then the probability of a financial crisis can be reduced. However, this is not always a good way to taking care of the problem. We do not want to avoid a financial crisis for its own sake. The whole point of avoiding a financial crisis is to avoid the economic costs of such a crisis. But if a financial crisis is avoided by financial repression then this too has its costs. These can be large and persistent.

A financial crisis receives considerable attention in the media, and generates discussion everywhere. From ordinary get-togethers to meetings in parliament, a financial crisis is on the formal or informal agenda. There is also a direct effect felt by many people: asset prices fall, bank loans become difficult and some operations in the real sector get hit. Furthermore, the changes are sudden. This adds to the anxiety and lack of comprehension. Let us now consider the case of persistent financial repression. This does not make any news at all. We tend to take for granted what we continually see. Commentaries are usually on changes, but in this case there is hardly any change. While people do experience the adverse effects of financial repression, the experience is at the individual level (in thought processes) even if there are large numbers of individuals involved. There is, in a sense, hardly any collective response that is well articulated and clearly visible. So, the costs of financial repression are not perceived in the same way in which the costs of a financial crisis are.

The duration of a financial crisis can be anywhere from one or two years to five or six years though there can be some very long lasting ones too. On the other hand, persistent financial repression may last for a few decades. Ironically, this feature does not add to the urgency of the problem, but tends to prolong it. So the total costs of financial repression can be very large, possibly even more than the costs of a financial crisis. In the light of the above discussion, there can be then two different objectives of a central bank:

One often gets the impression that the objective amongst the policy makers seems to be the first (which is also the title of the book under review). However, we need to emphasise the second. This can further increase the economic growth rate as financial repression can drag the growth rate. There are reasons to believe that there is considerable and persistent repression in parts of the financial system.

A Brief Review Of Chapter 5: ‘Development Of The Indian Debt Market’

We now provide a brief review of Chapter 5, which is topical given the debt crisis in Europe and the current serious concerns over the fiscal deficit in India. The Government of India (and state governments) has not faced any fiscal crisis, but there can be large and persistent social costs of financing fiscal deficits by commercial banks under the SLR regulation. Although the ratio of debt to GDP in India is not very high, the ratio of debt to revenues is quite high in India. Usually the former measure is used but there are good reasons to use the latter measure (Reinhart and Rogoff, 2009). If this is used, then the story is more pessimistic than it appears in Mohan (2011).

A part of the investment in government bonds comes from institutions other than the RBI, banks and the Life Insurance Corporation (LIC). This was 18.9 per cent in 2009 (Mohan, 2011). However, a part of this comes from corporate investments in money market mutual funds which ‘choose’ to invest in government bonds, given the regulation that commercial banks cannot pay interest on current accounts issued by commercial banks. So again we have a policy-push to private investment in government bonds (over and above the SLR regulation that pushes investment in government bonds).

Consider next a related aspect of the debt market. The fact that the corporate debt market has not developed well in India has received considerable attention in recent years. This is in contrast to the fact that the market for government debt is well developed. Many observers have not considered the possibility that the market for government debt may owe its existence to the SLR and other regulations.

Discussion on resource mobilisation by the corporate sector shows that the share of debt in total resource mobilisation has ranged from a low of 59.36 per cent in 1995–96 to a high of 98.92 per cent in 1998–99 (the last year for which data is reported, i.e., for 2007–08, the figure was 69.01 per cent). It is interesting that these figures are very high given that the corporate debt market, as the author discusses at length, is not well developed. How does one reconcile the two features of the corporate debt market? Note the following: the author considers the primary market for equity issues and that for debt issues. It is well known that resource mobilisation by new issues of equity is small and that by debt issues is large. However, one reason for this is that debt is typically redeemed or rolled over at the end of the maturity period and so there are frequent new and large issues. The same does not happen in equal measure in the case of equity. So there is a mirage of considerable size of debt issues relative to equity issues. The corporate sector has considerable retained earnings which are an important source of funds and these are in the context of equity only. To avoid any confusion, it is more appropriate to use stock figures from balance sheets (the above analysis in Mohan, 2011, is based on flow figures). These would provide a more correct picture and indeed show that funds raised by way of corporate bonds are small compared to the equity capital of the corporate sector (see Tirole, 2006, Theory of Corporate Finance for more on this).

Mohan (2011) writes, ‘The entire market borrowing of the Government of India is now being raised at market-determined rates …’ (p. 166). This claim is not quite correct. Interest rates are not truly market determined, since there is a captive market for government bonds given SLR regulation. The book does say elsewhere, ‘The SLR requirement clearly affects the operation of debt markets: government interest rates could presumably be higher if such a stipulation did not exist, or if it was significantly lower’ (p. 190). So the book takes two different positions.

The book points out that the nominal interest rates on government securities have fallen over time (see pp. 167–68). However, it does not consider real interest rates, so it is not clear whether the interest burden has decreased or increased in real terms.

Mohan writes, ‘Given the low levels of income in India, the ability of households to bear downside risk is low, and hence the preference for risk-free instruments [government securities]’ (p. 184). The book treats government securities as risk-free, but this does not reconcile with the fact that the rating of Government of India debt by international rating agencies is low. Furthermore, the book does not distinguish between safety in nominal terms and safety in real terms. While there are reasons to believe that there is a high probability of safety in nominal terms, the same cannot be said for safety in real terms. The government and the RBI can always tolerate, if not engineer, inflation and thus default in real terms. Indeed, this may be an important reason for the Government in India (and elsewhere) for not issuing and aggressively marketing ‘indexed bonds’.

A More General Review Of The Book

Let us return to a more general review of the book. First, though the book does cover housing and real estate (the most important asset), there is not adequate coverage in the form of a whole chapter on the subject. ¹ Though we have not had a ‘crisis’ in the real estate sector in India, housing if of low quality and unaffordable for many, even after adjusting for low per capita income and even if we do not consider an exchange rate based on purchasing power parity (PPP). Thus, it is ironical, when one states that the US has gone through a housing crisis and India has not. The problem in the US housing sector is in a sense unusual and temporary (even if it takes several years to sort out these problems), whereas the problem in India is usual and persistent (for decades). Prices can remain high or rise even further if the Government of India and state governments continue with the ‘license-permit-quota raj’ in real estate development (there has not been much effective liberalisation in real estate development in early 1990s or later). The claim of absence of a real estate crisis in India can be deceptive (see the works of Shiller, 2009 and Glaeser and Gyourko, 2008 for more on this). It has now been established that real estate prices crucially depend on the regulatory regime in place. This again does not receive the attention it deserves in Mohan (2011).

Second, the book shows that the capital to risk-weighted assets ratio (CRAR) has ranged from 12.3 per cent to 13.6 per cent in the period 2004–05 to 2009–10. While this is indeed a respectable figure, there are a few points that need to be considered in this context. Indian banks hold 24–29 per cent of their assets in the form of government securities, which are actually risky, as has become increasingly clear from the experience of several developed countries in Europe (and elsewhere). Accordingly, there is a need for more capital with banks than is usually considered adequate. Indeed, under the forthcoming Basel III norms, banks will need to hold more capital in view of the risk attached to government securities. So while banks at present do meet the currently prescribed capital adequacy norms, there is actually an inadequacy. It is important that we recognise this in India. This is, however, missing in the analysis in Mohan (2011).

Third, there is considerable risk in India due to ‘home bias’. Mohan writes, ‘Individuals can also invest abroad but within specified quantitative limits’ (p. 277). However, this (limited) liberalisation on outflows is not very meaningful. There are operational difficulties in practice for most investors who may wish to invest abroad. Furthermore, there are higher taxes on returns earned abroad in some cases (returns on funds invested in equity funds abroad are taxable whereas those invested in domestic funds are exempt from taxes).

Fourth, there is an ongoing vulnerability due to sudden capital outflow from the economy. Though the RBI has foreign exchange reserves (and some capital controls), these can be costly (assuming that they are adequate). So there is a need to seriously consider purchase of an international credit line. ² There is no mention of a credit line in Chapter 8, ‘Managing the Impossible Trinity’.

Briefly, then, in the context of financial stability in India, there is a need in the view of this reviewer to:

These criticisms aside, this book is amongst the very best articulations of the view that India has achieved high growth with financial stability. This book is a must read for all those interested in the subject, including those who subscribe to this view and those who do not.