RBI’s Rajan sounds alarm over breakdown in global coordination
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RBI’s Rajan sounds alarm over breakdown in global coordination

A lack of international monetary policy coordination and efforts to beef up the IMF to reflect the newfound clout of emerging markets (EMs) raises the risks of trade protectionism and market volatility, Reserve Bank of India (RBI) governor Raghuram Rajan tells Euromoney.

IMF Global Financial Stability Report 2014
Press Conference for the Global Financial Stability Report during the 2014 IMF/World Bank Annual Meetings October 8, 2014 at IMF Headquarters in Washington. © IMF Photo

In a wide-ranging interview, RBI’s Rajan is outspoken about the western-centric global financial architecture, from EM vulnerability to the Fed’s tightening cycle, to the lack of reform of the IMF’s quota amid intransigence from the US House of Representatives.

“As a former IMF official [chief economist] myself, it would be good, and beneficial for the world, if we could strengthen IMF governance, make it impartial and use its undoubted resources as a stabilizing force.”

Rajan’s comments were echoed by the Institute of International Finance chief economist Charles Collyns, who told Euromoney during the IMF meetings in Washington DC this week that the US’s failure to ratify the 2010 agreement to boost the IMF’s resources and modernize its governing structure continued to undermine its moral authority in international negotiations.

The IMF’s Global Financial Stability Report on Wednesday, published on the occasion of the annual meeting, urged EM policymakers to beef up financial regulation, root out currency mismatches and establish central-bank swap lines, amid expectations of greater market volatility next year as the Fed pushes ahead with rate hikes.

Rajan warns a failure to establish global safety nets through the IMF – to give policymakers confidence about the provision of emergency short-term balance-of-payment or liquidity support – will trigger trade mercantilism and encourage a futile dependence on export-led growth.

“Without safety nets, current-account surplus countries will continue as they are, and countries will feel more weary about running deficits and so placing pressure on reserve-holding countries to stimulate global demand [such as the US consumer].”

He adds: “Without safety nets, volatile credit and demand cycles will be reinforced and pressure points in the global economy will remain. And yet, sometimes speaking from an emerging-market perspective, you sound shrill when you are actually trying to oppose any degeneration into mercantilism.”

As EMs brace themselves for further market volatility amid dollar strength and expected US rate hikes next summer, Rajan says renewed faith in the integrity of the international financial system, and a global safety net of sorts, would speed up the shift to open capital accounts and freely floating exchange rates in EMs. This would generate new sources of demand for a disinflation- and debt-ravaged west seeking new export markets, he says.

Rajan says the Brics nations’ establishment of the New Development Bank, which includes a $100 billion central bank swap loan, the contingent reserve arrangement, is a step in the right direction to generate an international liquidity backstop to combat future crises, in the absence of a lack of political support in the west to beef up the IMF’s stabilizing role.

In 2009, with much fanfare, the IMF launched its flexible credit line facility, designed to provide emergency assistance during bouts of market contagion to well-governed sovereigns. However, the facility’s restrictive criteria for access and stigma attached to the policy lender has capped adoption, with only Mexico, Poland and Columbia applying for access.

India’s volatility in the global EM storm – sparked by the Fed-taper tantrum – last year underscored the negative spill-over effects of US monetary policy.

Domestic policies in many EMs remain in a bind, given the challenge of managing exchange rates, allowing the free movement of capital and boasting an independent monetary policy all at the same time, known as the Triffin dilemma.

While even countries with fully floating exchange rates and strong prudential regulations are at the mercy of the US monetary cycle, Rajan – Euromoney’s Central Bank Governor of the Year 2014 – says: “The whole mantra used to be ‘let your exchange rate be flexible and then you will have no problem’. That is not useful advice.

“Sure, you have to allow some flexibility, but that alone won’t protect you when you have crazy credit cycles overlaid to this macro policy challenge.”

The governor – who formally nailed his colours to the mast of capital-account liberalization as an independent economist – is still relatively bullish compared with previous RBI governors.

He says he would like to see the rupee as a truly global reserve currency in 10 years’ time, with the International Finance Corporation’s Rs6 billion bond in September – the first foreign issue in local currency, a format akin to China’s Panda bonds – a baby step on this journey.

The RBI will remove limits on foreign participation in the domestic bond market “once the world becomes excited in a more substantial way about the India story”, Rajan says. This could happen once the economy reaches potential output over two consecutive years, and foreigners move to long-end maturities, giving regulators a degree of confidence about the stickiness of flows, he argues.

Rajan, a former Chicago economist, also fears a breakdown in global monetary coordination has taken root, with a disconnect between bullish G7 financial cycles and anaemic real economies as central banks engage in competitive-easing wars at the mercy of financial markets and fiscal reform-inertia.

“The politics are not working in a number of areas in industrialized countries,” he says. “The pressure has been on the central banks to do all the heavy lifting in an environment when demand can’t be generated through normal means.

“What you see now is extraordinary monetary policies creating pressure on exchange rates to be lower than would otherwise be the case. Pressure for competitive exchange-rate easing is taking place while financial markets get overly boosted without meaningful investment.”