This article discusses the Raghuram Rajan Committee's draft report on reforms for the Indian financial sector with reference to the committee's philosophy on financial reforms, and its macroeconomic and regulatory frameworks.
DRAFT RAGHURAM RAJAN COMMITTEE REPORTAugust 9, 2008 EPW Economic & Political Weekly14Committee on Financial Sector Reforms: A Critique D M NachaneD M Nachane (nachane@hotmail.com) is at the Indira Gandhi Institute of Development Research, Mumbai.This article discusses the Raghuram Rajan Committee’s draft report on reforms for the Indian financial sector with reference to the committee’s philosophy on financial reforms, and its macroeconomic and regulatory frameworks.In the last two years there has been in evidence a sense of urgency, bordering on desperation on the part of the United Progressive Alliance (UPA) government to place the ongoing process of marketisa-tion and globalisation on an irreversible footing, so that whatever be the ideologi-cal complexion of any succeeding govern-ment, the economy is confined like the proverbial snake in the tunnel to an inexo-rable groove. In this endeavour, the financial sector has received the maxi-mum attention both because reforms in this sector meet with relatively little politi-cal resistance and are thus easy to push through and also because of the crucial command over resources that the finan-cial sector represents in a large emerging market economy (EME) like India. Reflecting this overall thrust, two com-mittees have been constituted in the past two years – the High-Powered Expert Committee (HPEC) on making Mumbai an International Finance Centre (IFC) under the chairmanship of Percy Mistry and the Committee on Financial Sector Re-forms (CFSR) under the chairmanship of Raghuram Rajan. The latter report is a far more nuanced and detailed examination of the Indian financial sector, and carefully refrains from taking the supercilious atti-tude to Indian bureaucrats, regulators and academics, which heavily permeates the former and also often characterises much of the writings of financial liberalisation enthusiasts in the Indian business press. As a matter of fact, there are several issues taken up by the CFSR with which I am in broad agreement, such as those related to broadening access to finance (chapter 3), level playing field (chapter 4) and develop-ment of credit infrastructure (chapter 7). Hence, the CFSR recommendations do merit a serious and dispassionate scrutiny. However, it must be said that the two reports share the same basic philosophy towards financial sector reforms and my reservations are essentially directed at the conclusions stemming from such a philosophy.Let me begin by commenting on three general features of the CFSR, which are puzzling and have not received the atten-tion that they deserve in a country, which prides itself on its democratic traditions of transparency and fair play. Firstly, the fact that the committee has been appointed by the Planning Commission rather than the finance ministry or the Reserve Bank of India (RBI), under whose umbrella one hitherto presumed such matters fell. Secondly, that there is no representation on the committee of any regulatory body such as theRBI, National Housing Bank (NHB) or Securities and Exchange Board of India. Finally, that it is chaired by a non-resident Indian professor from the Univer-sity of Chicago. Being a total outsider to the highly non-linear and time-varying personal equations governing the behav-iour of our political, industrial and eco-nomic mandarins, it is difficult for me to speculate on the constellation of circum-stances responsible for these bizarre fea-tures. Hence, instead of pursuing these speculations further, let me turn to some of the substantive issues that have been raised in theCFSR.Committee’s Philosophy To begin at the beginning, the MacKinnon-Shaw thesis essentially viewed financial liberalisation as an integral component of overall liberalisation, in the twin beliefs that (i) liberalisation in the real sector could not proceed satisfactorily in the absence of financial liberalisation; and (ii) financial liberalisation was an “ena-bling condition” of faster economic growth, as it increased competition, trans-fer of know-how and transparency.TheCFSR adopts this view as a starting point putting it beyond question, when in fact the issue is an unsettled one and the subject of furious current debates in aca-demic literature as well as in policy circles. While the report is hardly expected to survey all the dimensions of this vast literature, it should have at least recognised that there is an obverse side to the picture.
DRAFT RAGHURAM RAJAN COMMITTEE REPORTEconomic & Political Weekly EPW august 9, 200815Thus, in direct opposition to the MacKinnon-Shaw view, several authors have under-scored the likely harmful effects of finan-cial liberalisation in triggering financial crises and in misdirecting the allocation of capital [see Saidane 2002; Eichengreen and Leblang 2003] etc, buttressing their theoretical arguments with episodic evi-dence from the Latin American crises of the 1980s, the Asian crisis of 1997 and the Russian crisis of 1998.Considerable econometric as well as case study evidence seems to be accumu-lating on several of these aspects. Recent studies such as those by Rodrik et al (2002), Alcala and Ciccone (2004) and Kaufmann et al (2007) clearly indicate the importance of institutional features such as corruption, rule of law and general gover-nance issues (such as political accounta-bility, quality of bureaucracy, etc) in deter-mining whether the outcomes of liberali-sation in general (and financial liberalisa-tion in particular) would be beneficial or otherwise. This could be an important part of the explanation as to why liberali-sation usually succeeds in developed countries but often fails in the developing world. It also throws up, in retrospect, the fallacy implicit in the reform advocacy of the 1990s, which urged developing coun-tries with weak institutions to undertake economic reforms, under the implicit assu-rance that political progress and good gover-nance would follow as a consequence.Macroeconomic FrameworkThe two aspects of the macroeconomic frame-work suggested by the CFSR, which have at-tracted the maximum attention are inflation targeting and capital account convertibility. Inflation Targeting: The main policy recommendation of the CFSR as regards a suitable monetary policy regime for India pertains to the announcement of a “low in-flation objective – a number, a number that can be brought down over time, or a range – over a medium term horizon (say two years) as the primary goal of monetary policy”. In the execution of this objective, the RBI would be granted full operational independence and simultaneously held fully accountable. This recommendation is in tune with current mainstream academic thinking, so in a way the CFSR is only reiterating the orthodox position. To many, including the top brass in the US Fed and the European Central Bank (ECB), notably Alan Greenspan, Otmar Issing, Donald Kohn, etc, it appears an idea whose time is yet to come but even those who regard it as a desirable long-term goal admit that the devil lies in the details. Where the CFSR falls short of expectations is in its failure to convince the reader of the superiority of inflation targeting (IT) to the existing (dis-cretionary) monetary policy regime in India and the lack of attention to the spe-cific difficulties that would need to be over-come for operationalising such a procedure (in the Indian context). The report is also unnecessarily vague on what exactly it means by the IT concept. Are they referring to a rigid version of the IT in which the op-erating target (such as the repo rate or cash recover ratio) responds via a mecha-nistic rule (of the Taylor, McCallum, etc, type) to deviations of the actual inflation rate from the pre-announced target or are they referring to amore flexible version of IT as practised for example in the ECB? My reading of the CFSR (as well as of some subsequent press interviews of Raghuram Rajan) convinces me that what is being ad-vocated is a milder version of IT but even such a milder version raises a host of issues of which the report takes little cognisance. I have three major reservations about the applicability of IT in India – two related to the idea per se and one stemming from a faulty (in my view) interpretation of IT by the CFSR. First, inflation targeting central banks typically assume that financial stability is a by-product of price stability. The recent sub-prime crisis in theUS, following a long period of steeply appreciating equity and real estate prices, occurring in a period of sustained price stability should serve as a telling refutation of this position. But this case is by no means unique. The literature [Bordo et al 2000; Borio and Lowe 2002] furnishes several such instances – Japan (1985-89), Korea (1990-97),US (1925-29), etc. Even the Indian situation of 2005-07 appears similar. The fact of this possible disconnect between asset prices and general inflation could mean that typically an IT central bank may allow credit to expand and feed an asset price boom for too long. Ultimately when the asset price boom feeds into general inflation (via a wealth effect) the central bank would be forced to apply the brakes abruptly, which could result in a prolonged asset price de-flation (to wit Japan’s “lost decade” of the 1990s) and a general recession. Thus, an IT central bank will always intervene too late to prevent a crisis.Second, there is an implicit supposition in theCFSR that the adoption of IT guards against a balance of payments crisis. This need not necessarily be so. IT does not insulate a country against balance of pay-ments crises [see Calvo and Vegh 1999; Mendonza and Uribe 2001; Kumhof et al 2007, etc]. Such vulnerability could arise from a weak fiscal revenue base, implicit financial bailout guarantees, contingent government liabilities, etc. In short, if fiscal discipline is relatively lax, then achieving macroeconomic stability by strict monetary discipline can be counter-productive. The Fiscal Responsibility and Budget Management (FRBM) Act in India does seem to promise an era of fiscal disci-pline in the future but in general fiscal discipline seems to be far more difficult to achieve than monetary discipline.Third, the CFSR’s advocacy of inflation targeting slurs over a very important issue, viz, the choice of the target rate. According to the report, “the RBI should have a sin-gle objective, to stay close to a low infla-tion number or within a range, in the medium term” (p 5). This ignores the crucial role played by the concept of the optimum long-run inflation rate (OLIR) defined as the long-run inflation rate that achieves the best average economic performance over time with respect to both the inflation and output objectives [Bernanke 2004]. The logic of the OLIR is the creation of a buffer zone against deflation. Contrast this with the following statement in the CFSR – “The argument against the emphasis on an inflation objective is based on a deep fallacy that there is a systematic trade-off between growth and inflation” (p 11). As a matter of fact, such a trade-off does exist at low infla-tion rates where the benefits from reduced microeconomic distortions emanating from further lowering of rates are counter-balanced by the costs of an increased prob-ability of setting off a recession [Meyer 2004]. In other words, the target rate cannot be any low inflation rate, as the CFSR supposes but has to be based on an
DRAFT RAGHURAM RAJAN COMMITTEE REPORTAugust 9, 2008 EPW Economic & Political Weekly16assessment of the OLIR for the Indian eco-nomy [say, along the lines of Coenen et al 2003 for the Euro area].1 Array of Minor ProblemsApart from the three major problems noted above, there is an entire array of minor problems associated with the practical im-plementation of IT and a minimal list would include the following: the first pro-blem relates to the fact that in practice be-cause of a variety of operational reasons, IT reduces to inflation forecast targeting. However, further questions arise – some purely econometric (such as model mis-specification) and others more fundamen-tal (such as whether the appropriate model to use is that of the central bank or finan-cial markets). Besides as argued by Issing (2004), inflation forecasts of themselves do not capture all the threats to price stability especially in the presence of supply shocks.The second is that lags in the transmis-sion of monetary policy can be particularly long (anywhere between 17 and 30 months in the Indian context). Should current monetary policy then be relaxed if inflation is high now but expected to slide down in the medium term? The costs of getting the monetary policy lag wrong can be substan-tial as shown recently by Thoma (2007).Third, there are also formidable political and legal problems involved in the IT pro-cess. Should the target (or a target band) be set by the RBI, the finance ministry or Parliament? What should be an appropri-ate incentive-cum-penalty system for success or failure on the part of the central bank in achieving the target? Will the RBI ever enjoy the appropriate degree of goal and instrument independence from the finance ministry as long as senior office-bearers of the RBI are appointed by the government?Finally, the empirical evidence on the suc-cess of IT regimes is mixed.2 Ball and Sheridan (2003) come up with the finding that “there is no evidence that inflation target-ing improves performance”, whereas Levin et al (2004), Hyvonen (2004), Vega and Winkleried (2005) report a lowering of in-flation persistence and an anchoring of infla-tionary expectations for inflation targeters.Capital Account Convertibility: Discus-sions on Capital Account Convertibility (CAC) in the Indian context are partly in the nature of flogging a dead horse, since the capital account is now virtually open. This has happened in spite of several cau-tionary notes by economists in India and abroad.3 TheCFSR view seems to be then that since we have already disrobed to the bare essentials, why not discard the remaining fig leaves and do the “full monty”? In this context, it may be worth-while to iterate an alternate point of view that differs substantially from the CFSR. Let us take as the starting point the in-famous trilemma[see Bernanke 2005 for a recent exposition] with reference to the impossibility of maintaining in simul-taneous operation (for a given country) all three of the following policy regimes: (i) an open capital account, (ii) a fixed exchange rate, and (iii) an independent domestic monetary policy.4 TheEU is a standard illustration where countries have opted for a substantial degree of fixity of their exchange rates5 (vis-a-vis each other) with free capital mobility in place but monetary policy independence sacrificed. This is partly attri-butable to theEU constituting an optimum currency area in Mundell’s (1961) sense and also to their being subject to similar “shocks” [Bayoumi and Eichengreen 1993]. But this must be regarded as an exceptional case. Typically, countries would be reluctant to sacrifice monetary policy autonomy for reasons of national sovereignty and national pride and the effective choice thus narrows down to that between capital mobility and a fixed exchange rate regime. For the advanced economies the choice seems to be clear (at least to most acade-mics and policymakers), viz, the benefits of capital mobility and independent monetary policy exceed whatever costs may be asso-ciated with a system of freely floating ex-change rates. For the less developed coun-tries (LDCs) and EMEs, the picture becomes more hazy. One view [Vegh 1992; Dorn-busch and Warner 1994; Bernanke 2005] maintains that the best course for such eco-nomies is to overcome their deeply ingrained fear of floating and let the exchange rate float freely. A firm central bank commit-ment to gear monetary policy exclusively to maintaining a low and stable inflation rate, would then provide the much needed “nominal anchor” for the macroeconomic system. This is essentially the CFSR view too. There are two major arguments against a free float for such economies. Firstly, as Sargent (1982) has noted, a fixed (or heavily managed) exchange rate can be a suitable guard against high inflation and can even act as a strong brake on persistent hyperinflations.6 A fixed exchange rate com-mands visibility and is more credible than a direct inflation target (both because the former is observable instantaneously unlike the inflation rate, which suffers from a lag of at least a few weeks and also because its measurement is non-controversial in con-trast to the several competing measuressug-gested for the inflation rate in the literature). Secondly, Calvo and Reinhart (2000) have drawn attention to the low credibility of policymakers in severalLDCs, which could mean that a flexible exchange rate could exhibit high volatility (both short-term and long-term). The latter is usually recognised as exports inhibiting and could also lead to volatility of capital inflows and in domestic interest rates (if these are unregulated) via the covered interest parity [Calvo 1996; Kwack 2003]. Capital account liberalisation introduces several other potential sources of distortion, which are, for example, noted in Sen (2007), Williamson (2006), Nachane (2007), etc. All in all, the fact is inescapable that CAC con-tributes towards increased financial fragil-ity and that the consequences of a finan-cial crisis are more pronounced in LDCs and EMEs because of poor financial super-vision and regulation, corruption, opaque-ness in legal provisions, etc – the empirical evidence in this direction is also too strong to be cavalierly disregarded [see, for exam-ple, Wyplosz 2001]. There is also an ele-ment of moral hazard in the CAC – the ben-efits are likely to accrue in the immediate aftermath of the liberalisation, partly be-cause CAC measures are usually initiated when the forex reserves situation is very comfortable. The timing of any likely crisis is however uncertain and often well into the future, so that the mopping up usually falls on some subsequent government. Regulatory ArchitecturePrinciples versus Rules-based Regula-tion:The principles vs rules mode of regu-lation was first brought into the picture (in the Indian context) by the HPEC on making
DRAFT RAGHURAM RAJAN COMMITTEE REPORTEconomic & Political Weekly EPW august 9, 200817Mumbai anIFC. The committee predicta-bly chastised the RBI for the plethora of rules that financial institutions are re-quired to follow and strongly advocated a switchover to a principles based system. TheCFSR reiterates the same position but with less rhetoric and greater attention to detail. It is the CFSR’s contention that the current rules-based system in India dis-plays “low tolerance for innovation and excessive micro-management” (chapter 6, p 2). It therefore recommends a gradual but time bound movement in the direction of principles-based regulation.The Financial Services Authority (FSA) in theUK has been engaged in putting into operation a principles-based system of regulation for the UK financial system since 2001. The system was rendered fully operational only in 2007, so it is too early to claim any success for the same. But before extrapolating the UK experience to other countries, it is best to remember two special circumstances prevailing in theUK– firstly, a strong tradition of oral convention and unwritten legislation (even theConstitution is largely unwritten) and secondly, an already existing risk-based and evidence-based system of regulation, for the principles-based system to be built upon. There are several imminent problems with the adoption of a principles-based approach for India. At least a few of these deserve to be mentioned. One, in a principles-based system, the interpreta-tion of principles is often with the regu-lator, in contrast with a rules-based system, where interpretation lies equally with regulator and regulated, with well-defined mechanisms for resolving con-flicts of interpretation. Thus ironically, a principles-based system implies a greater discretionary role for the regulator, as compared to a rules-based system. Two, in a litigious country like India, the institution of a principles-based system is likely to overwhelm the arbitration/ judicial system with public interest liti-gation, right to information queries and private class actions. Finally, as noted by Wallison (2007), there is the safe haven effect of a rules-based system. Compliance with rules, which are fully transparent give the regulated entities a sense of absolution, which is never present in a principles-based system.Instead of a switchover to a principles-based system, a far better alternative is to impart flexibility and dynamism to the existing rules, making them more transparent and installing a system of quick incentives/ penalties for compliance/non-complaince. Regulatory and Supervisory Independ-ence:The issue of regulatory and supervi-sory independence (RSI) is often confused with central bank independence (CBI), though as stressed in the literature [see Lastra 1996; Taylor and Fleming 1999; Quintyn and Taylor 2002, etc], the two are conceptually distinct and need not neces-sarily coexist even when the regulation and supervision functions and monetary policy functions are vested in the same authority. In a sense,RSI is to financial stability what CBI is to monetary stability. Unfortunately the academic literature on regulation has been almost exclusively focused onCBI, to the virtual neglect of RSI. The CFSR also fails to touch on this aspect at all, though of course it does pay a great deal of attention to the issue of single versus multiple regulators.7 The neglect ofRSI assumes importance when one considers the fact that almost all episodes of financial distress have been associated with a weakRSI.8RSIrefers to independence of the regulatory and super-visory structure from not only the govern-ment but also from the industry and finan-cial markets. In India, the financial regu-latory and supervision functions are dis-tributed between the RBI (banks and non-banking financial companies – NBFCs) state governments (for cooperative finan-cial institutions jointly withRBI) and National Bank for Agriculture and Rural Development (for regional rural banks). For the purpose of this discussion, let us confine ourselves to the regulation and supervision of the banking sector and NBFCs. The RBI discharges this function under the guidance of the board for finan-cial supervision (BFS), which comprises four directors from the RBI’s central board, theRBI governor (as chairman) and four deputy governors. So far as independence from the govern-ment on regulatory and supervisor fronts is concerned, this is ensured to a large ex-tent by the fact that theRBI (acting under the guidance of the BFS) is authorised to issue directives in all areas of regulation and supervision. However, this realisation has to be tempered by the fact that an ele-ment of indirect control of the government does exist by virtue of the fact that theRBI directors (from whom the four of the BFS members are drawn) are appointed by the central government. Incidentally, the CFSR’s recommendation to set up the Financial Development Council under the chairmanship of the finance minister “for macroeconomic assessment and develop-ment issues” (proposal 26), if implement-ed, will strongly limit the existing inde-pendence of the regulators and super-visors, as it will provide a legitimate plat-form for the finance ministry to intervene in these matters and further accentuate the coordination problems between the RBI and finance ministry.But the other major dimension of RSI, viz, independence from markets is equally important but has not received the atten-tion it deserves. In the words of a very famous US central banker “…it is just as important for a central bank to be inde-pendent of markets as it is to be independ-ent of politics” [Blinder 1997, 2000]. Inde-pendence from markets is more difficult to ensure than independence from politi-cians, since the forces operative here are extremely subtle. There are primarily two channels, through which markets can influence regulators, both of which have been operative in the Indian context. Firstly, an overwhelming preponderance of financial sector and industry represent-atives in official committees and bodies, concerned with the designing of the regu-latory architecture. This usually takes place at the instance of a government strongly committed to reforms and is usually done with the ostensible purpose of knowing the financial industry point of view. Secondly, large sections of the media are strongly aligned with corporate sector interestsand hence, by extremely ingeniouspropaganda manage to create a general impression that national interests are closely conflated with financial sector interests. A grading system is then set up, whereby supervisors and regulators are rated publicly on how friendly they are to markets. I concede that we are treading on thin ground here. On the one hand, financial stability is a public good and financial
DRAFT RAGHURAM RAJAN COMMITTEE REPORTAugust 9, 2008 EPW Economic & Political Weekly18market development contributes to real development. Yet it is undeniable that exu-berance, animal spirits and general short-termism strongly pervade financial markets. A regulatory authority overtly sensitive to financial market demands could be a classic case of what Stigler (1971) has termed regulatory capture. Unfortunately theCFSR observes a deafening silence on this vital issue. ConclusionsA recent article inTheEconomist (June 21-27, 2008) talked about residential segre-gation in the US in the following terms “We now live in a giant feedback loop…hearing our own thoughts about what’s right and wrong bounced back to us by the television shows we watch, the news-papers and books we read, the blogs we visit online, the sermons we hear and the neighbourhoods we live in”. I wonder whether a similar description applies to today’s reform enthusiasts, who seem to be all living in a similar intellectually segregated world of their own creation. The routine lines of thinking of this establishment have been rendered all too familiar to us via a plethora of official reports that have surfaced in the last few years. The CFSR chaired by an economist of distinction had raised expectations of giving us something refreshingly different. In one sense, it has fulfilled these expecta-tions to some extent by producing a report, which is both comprehensive and very readable with some useful suggestions. However, it largely disappoints by coming up once again with the standard remedies in the average reformer’s medicine bag (suchas capital account liberalisation, inflation targeting, privatisation of banks, etc), without much attention to the speci-ficities of the Indian context. A discerning reader can also detect a distinctly partisan bias in the report, so that at several places it partakes more of the character of a charter of demands of the financial sector. Hopefully, the final version will rectify such biases, go into greater details and bring on board more adaptation to the Indian specificities.Notes 1 Incidentally, one of the major limitations of the report is that it does not take any cognisance of the substantial empirical work done by (resident) Indian scholars on several macroeconomic issues relating to the Indian economy but alas published in Indian journals. 2 Countries using some form of IT currently include: Australia, Brazil, Canada, Chile, Colombia, Finland, Mexico, New Zealand, Poland, Sweden, UK. 3 See Nachane (2007) for a summary of the debate and also for my own views on the subject. 4 Of course, in practice, concepts like “openness”, “fixity” or “independence” are not absolute, but relative or even fuzzy. 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DRAFT RAGHURAM RAJAN COMMITTEE REPORTAugust 9, 2008 EPW Economic & Political Weekly14Committee on Financial Sector Reforms: A Critique D M NachaneD M Nachane (nachane@hotmail.com) is at the Indira Gandhi Institute of Development Research, Mumbai.This article discusses the Raghuram Rajan Committee’s draft report on reforms for the Indian financial sector with reference to the committee’s philosophy on financial reforms, and its macroeconomic and regulatory frameworks.In the last two years there has been in evidence a sense of urgency, bordering on desperation on the part of the United Progressive Alliance (UPA) government to place the ongoing process of marketisa-tion and globalisation on an irreversible footing, so that whatever be the ideologi-cal complexion of any succeeding govern-ment, the economy is confined like the proverbial snake in the tunnel to an inexo-rable groove. In this endeavour, the financial sector has received the maxi-mum attention both because reforms in this sector meet with relatively little politi-cal resistance and are thus easy to push through and also because of the crucial command over resources that the finan-cial sector represents in a large emerging market economy (EME) like India. Reflecting this overall thrust, two com-mittees have been constituted in the past two years – the High-Powered Expert Committee (HPEC) on making Mumbai an International Finance Centre (IFC) under the chairmanship of Percy Mistry and the Committee on Financial Sector Re-forms (CFSR) under the chairmanship of Raghuram Rajan. The latter report is a far more nuanced and detailed examination of the Indian financial sector, and carefully refrains from taking the supercilious atti-tude to Indian bureaucrats, regulators and academics, which heavily permeates the former and also often characterises much of the writings of financial liberalisation enthusiasts in the Indian business press. As a matter of fact, there are several issues taken up by the CFSR with which I am in broad agreement, such as those related to broadening access to finance (chapter 3), level playing field (chapter 4) and develop-ment of credit infrastructure (chapter 7). Hence, the CFSR recommendations do merit a serious and dispassionate scrutiny. However, it must be said that the two reports share the same basic philosophy towards financial sector reforms and my reservations are essentially directed at the conclusions stemming from such a philosophy.Let me begin by commenting on three general features of the CFSR, which are puzzling and have not received the atten-tion that they deserve in a country, which prides itself on its democratic traditions of transparency and fair play. Firstly, the fact that the committee has been appointed by the Planning Commission rather than the finance ministry or the Reserve Bank of India (RBI), under whose umbrella one hitherto presumed such matters fell. Secondly, that there is no representation on the committee of any regulatory body such as theRBI, National Housing Bank (NHB) or Securities and Exchange Board of India. Finally, that it is chaired by a non-resident Indian professor from the Univer-sity of Chicago. Being a total outsider to the highly non-linear and time-varying personal equations governing the behav-iour of our political, industrial and eco-nomic mandarins, it is difficult for me to speculate on the constellation of circum-stances responsible for these bizarre fea-tures. Hence, instead of pursuing these speculations further, let me turn to some of the substantive issues that have been raised in theCFSR.Committee’s Philosophy To begin at the beginning, the MacKinnon-Shaw thesis essentially viewed financial liberalisation as an integral component of overall liberalisation, in the twin beliefs that (i) liberalisation in the real sector could not proceed satisfactorily in the absence of financial liberalisation; and (ii) financial liberalisation was an “ena-bling condition” of faster economic growth, as it increased competition, trans-fer of know-how and transparency.TheCFSR adopts this view as a starting point putting it beyond question, when in fact the issue is an unsettled one and the subject of furious current debates in aca-demic literature as well as in policy circles. While the report is hardly expected to survey all the dimensions of this vast literature, it should have at least recognised that there is an obverse side to the picture. 
DRAFT RAGHURAM RAJAN COMMITTEE REPORTEconomic & Political Weekly EPW august 9, 200815Thus, in direct opposition to the MacKinnon-Shaw view, several authors have under-scored the likely harmful effects of finan-cial liberalisation in triggering financial crises and in misdirecting the allocation of capital [see Saidane 2002; Eichengreen and Leblang 2003] etc, buttressing their theoretical arguments with episodic evi-dence from the Latin American crises of the 1980s, the Asian crisis of 1997 and the Russian crisis of 1998.Considerable econometric as well as case study evidence seems to be accumu-lating on several of these aspects. Recent studies such as those by Rodrik et al (2002), Alcala and Ciccone (2004) and Kaufmann et al (2007) clearly indicate the importance of institutional features such as corruption, rule of law and general gover-nance issues (such as political accounta-bility, quality of bureaucracy, etc) in deter-mining whether the outcomes of liberali-sation in general (and financial liberalisa-tion in particular) would be beneficial or otherwise. This could be an important part of the explanation as to why liberali-sation usually succeeds in developed countries but often fails in the developing world. It also throws up, in retrospect, the fallacy implicit in the reform advocacy of the 1990s, which urged developing coun-tries with weak institutions to undertake economic reforms, under the implicit assu-rance that political progress and good gover-nance would follow as a consequence.Macroeconomic FrameworkThe two aspects of the macroeconomic frame-work suggested by the CFSR, which have at-tracted the maximum attention are inflation targeting and capital account convertibility. Inflation Targeting: The main policy recommendation of the CFSR as regards a suitable monetary policy regime for India pertains to the announcement of a “low in-flation objective – a number, a number that can be brought down over time, or a range – over a medium term horizon (say two years) as the primary goal of monetary policy”. In the execution of this objective, the RBI would be granted full operational independence and simultaneously held fully accountable. This recommendation is in tune with current mainstream academic thinking, so in a way the CFSR is only reiterating the orthodox position. To many, including the top brass in the US Fed and the European Central Bank (ECB), notably Alan Greenspan, Otmar Issing, Donald Kohn, etc, it appears an idea whose time is yet to come but even those who regard it as a desirable long-term goal admit that the devil lies in the details. Where the CFSR falls short of expectations is in its failure to convince the reader of the superiority of inflation targeting (IT) to the existing (dis-cretionary) monetary policy regime in India and the lack of attention to the spe-cific difficulties that would need to be over-come for operationalising such a procedure (in the Indian context). The report is also unnecessarily vague on what exactly it means by the IT concept. Are they referring to a rigid version of the IT in which the op-erating target (such as the repo rate or cash recover ratio) responds via a mecha-nistic rule (of the Taylor, McCallum, etc, type) to deviations of the actual inflation rate from the pre-announced target or are they referring to amore flexible version of IT as practised for example in the ECB? My reading of the CFSR (as well as of some subsequent press interviews of Raghuram Rajan) convinces me that what is being ad-vocated is a milder version of IT but even such a milder version raises a host of issues of which the report takes little cognisance. I have three major reservations about the applicability of IT in India – two related to the idea per se and one stemming from a faulty (in my view) interpretation of IT by the CFSR. First, inflation targeting central banks typically assume that financial stability is a by-product of price stability. The recent sub-prime crisis in theUS, following a long period of steeply appreciating equity and real estate prices, occurring in a period of sustained price stability should serve as a telling refutation of this position. But this case is by no means unique. The literature [Bordo et al 2000; Borio and Lowe 2002] furnishes several such instances – Japan (1985-89), Korea (1990-97),US (1925-29), etc. Even the Indian situation of 2005-07 appears similar. The fact of this possible disconnect between asset prices and general inflation could mean that typically an IT central bank may allow credit to expand and feed an asset price boom for too long. Ultimately when the asset price boom feeds into general inflation (via a wealth effect) the central bank would be forced to apply the brakes abruptly, which could result in a prolonged asset price de-flation (to wit Japan’s “lost decade” of the 1990s) and a general recession. Thus, an IT central bank will always intervene too late to prevent a crisis.Second, there is an implicit supposition in theCFSR that the adoption of IT guards against a balance of payments crisis. This need not necessarily be so. IT does not insulate a country against balance of pay-ments crises [see Calvo and Vegh 1999; Mendonza and Uribe 2001; Kumhof et al 2007, etc]. Such vulnerability could arise from a weak fiscal revenue base, implicit financial bailout guarantees, contingent government liabilities, etc. In short, if fiscal discipline is relatively lax, then achieving macroeconomic stability by strict monetary discipline can be counter-productive. The Fiscal Responsibility and Budget Management (FRBM) Act in India does seem to promise an era of fiscal disci-pline in the future but in general fiscal discipline seems to be far more difficult to achieve than monetary discipline.Third, the CFSR’s advocacy of inflation targeting slurs over a very important issue, viz, the choice of the target rate. According to the report, “the RBI should have a sin-gle objective, to stay close to a low infla-tion number or within a range, in the medium term” (p 5). This ignores the crucial role played by the concept of the optimum long-run inflation rate (OLIR) defined as the long-run inflation rate that achieves the best average economic performance over time with respect to both the inflation and output objectives [Bernanke 2004]. The logic of the OLIR is the creation of a buffer zone against deflation. Contrast this with the following statement in the CFSR – “The argument against the emphasis on an inflation objective is based on a deep fallacy that there is a systematic trade-off between growth and inflation” (p 11). As a matter of fact, such a trade-off does exist at low infla-tion rates where the benefits from reduced microeconomic distortions emanating from further lowering of rates are counter-balanced by the costs of an increased prob-ability of setting off a recession [Meyer 2004]. In other words, the target rate cannot be any low inflation rate, as the CFSR supposes but has to be based on an 
DRAFT RAGHURAM RAJAN COMMITTEE REPORTAugust 9, 2008 EPW Economic & Political Weekly16assessment of the OLIR for the Indian eco-nomy [say, along the lines of Coenen et al 2003 for the Euro area].1 Array of Minor ProblemsApart from the three major problems noted above, there is an entire array of minor problems associated with the practical im-plementation of IT and a minimal list would include the following: the first pro-blem relates to the fact that in practice be-cause of a variety of operational reasons, IT reduces to inflation forecast targeting. However, further questions arise – some purely econometric (such as model mis-specification) and others more fundamen-tal (such as whether the appropriate model to use is that of the central bank or finan-cial markets). Besides as argued by Issing (2004), inflation forecasts of themselves do not capture all the threats to price stability especially in the presence of supply shocks.The second is that lags in the transmis-sion of monetary policy can be particularly long (anywhere between 17 and 30 months in the Indian context). Should current monetary policy then be relaxed if inflation is high now but expected to slide down in the medium term? The costs of getting the monetary policy lag wrong can be substan-tial as shown recently by Thoma (2007).Third, there are also formidable political and legal problems involved in the IT pro-cess. Should the target (or a target band) be set by the RBI, the finance ministry or Parliament? What should be an appropri-ate incentive-cum-penalty system for success or failure on the part of the central bank in achieving the target? Will the RBI ever enjoy the appropriate degree of goal and instrument independence from the finance ministry as long as senior office-bearers of the RBI are appointed by the government?Finally, the empirical evidence on the suc-cess of IT regimes is mixed.2 Ball and Sheridan (2003) come up with the finding that “there is no evidence that inflation target-ing improves performance”, whereas Levin et al (2004), Hyvonen (2004), Vega and Winkleried (2005) report a lowering of in-flation persistence and an anchoring of infla-tionary expectations for inflation targeters.Capital Account Convertibility: Discus-sions on Capital Account Convertibility (CAC) in the Indian context are partly in the nature of flogging a dead horse, since the capital account is now virtually open. This has happened in spite of several cau-tionary notes by economists in India and abroad.3 TheCFSR view seems to be then that since we have already disrobed to the bare essentials, why not discard the remaining fig leaves and do the “full monty”? In this context, it may be worth-while to iterate an alternate point of view that differs substantially from the CFSR. Let us take as the starting point the in-famous trilemma[see Bernanke 2005 for a recent exposition] with reference to the impossibility of maintaining in simul-taneous operation (for a given country) all three of the following policy regimes: (i) an open capital account, (ii) a fixed exchange rate, and (iii) an independent domestic monetary policy.4 TheEU is a standard illustration where countries have opted for a substantial degree of fixity of their exchange rates5 (vis-a-vis each other) with free capital mobility in place but monetary policy independence sacrificed. This is partly attri-butable to theEU constituting an optimum currency area in Mundell’s (1961) sense and also to their being subject to similar “shocks” [Bayoumi and Eichengreen 1993]. But this must be regarded as an exceptional case. Typically, countries would be reluctant to sacrifice monetary policy autonomy for reasons of national sovereignty and national pride and the effective choice thus narrows down to that between capital mobility and a fixed exchange rate regime. For the advanced economies the choice seems to be clear (at least to most acade-mics and policymakers), viz, the benefits of capital mobility and independent monetary policy exceed whatever costs may be asso-ciated with a system of freely floating ex-change rates. For the less developed coun-tries (LDCs) and EMEs, the picture becomes more hazy. One view [Vegh 1992; Dorn-busch and Warner 1994; Bernanke 2005] maintains that the best course for such eco-nomies is to overcome their deeply ingrained fear of floating and let the exchange rate float freely. A firm central bank commit-ment to gear monetary policy exclusively to maintaining a low and stable inflation rate, would then provide the much needed “nominal anchor” for the macroeconomic system. This is essentially the CFSR view too. There are two major arguments against a free float for such economies. Firstly, as Sargent (1982) has noted, a fixed (or heavily managed) exchange rate can be a suitable guard against high inflation and can even act as a strong brake on persistent hyperinflations.6 A fixed exchange rate com-mands visibility and is more credible than a direct inflation target (both because the former is observable instantaneously unlike the inflation rate, which suffers from a lag of at least a few weeks and also because its measurement is non-controversial in con-trast to the several competing measuressug-gested for the inflation rate in the literature). Secondly, Calvo and Reinhart (2000) have drawn attention to the low credibility of policymakers in severalLDCs, which could mean that a flexible exchange rate could exhibit high volatility (both short-term and long-term). The latter is usually recognised as exports inhibiting and could also lead to volatility of capital inflows and in domestic interest rates (if these are unregulated) via the covered interest parity [Calvo 1996; Kwack 2003]. Capital account liberalisation introduces several other potential sources of distortion, which are, for example, noted in Sen (2007), Williamson (2006), Nachane (2007), etc. All in all, the fact is inescapable that CAC con-tributes towards increased financial fragil-ity and that the consequences of a finan-cial crisis are more pronounced in LDCs and EMEs because of poor financial super-vision and regulation, corruption, opaque-ness in legal provisions, etc – the empirical evidence in this direction is also too strong to be cavalierly disregarded [see, for exam-ple, Wyplosz 2001]. There is also an ele-ment of moral hazard in the CAC – the ben-efits are likely to accrue in the immediate aftermath of the liberalisation, partly be-cause CAC measures are usually initiated when the forex reserves situation is very comfortable. The timing of any likely crisis is however uncertain and often well into the future, so that the mopping up usually falls on some subsequent government. Regulatory ArchitecturePrinciples versus Rules-based Regula-tion:The principles vs rules mode of regu-lation was first brought into the picture (in the Indian context) by the HPEC on making 
DRAFT RAGHURAM RAJAN COMMITTEE REPORTEconomic & Political Weekly EPW august 9, 200817Mumbai anIFC. The committee predicta-bly chastised the RBI for the plethora of rules that financial institutions are re-quired to follow and strongly advocated a switchover to a principles based system. TheCFSR reiterates the same position but with less rhetoric and greater attention to detail. It is the CFSR’s contention that the current rules-based system in India dis-plays “low tolerance for innovation and excessive micro-management” (chapter 6, p 2). It therefore recommends a gradual but time bound movement in the direction of principles-based regulation.The Financial Services Authority (FSA) in theUK has been engaged in putting into operation a principles-based system of regulation for the UK financial system since 2001. The system was rendered fully operational only in 2007, so it is too early to claim any success for the same. But before extrapolating the UK experience to other countries, it is best to remember two special circumstances prevailing in theUK– firstly, a strong tradition of oral convention and unwritten legislation (even theConstitution is largely unwritten) and secondly, an already existing risk-based and evidence-based system of regulation, for the principles-based system to be built upon. There are several imminent problems with the adoption of a principles-based approach for India. At least a few of these deserve to be mentioned. One, in a principles-based system, the interpreta-tion of principles is often with the regu-lator, in contrast with a rules-based system, where interpretation lies equally with regulator and regulated, with well-defined mechanisms for resolving con-flicts of interpretation. Thus ironically, a principles-based system implies a greater discretionary role for the regulator, as compared to a rules-based system. Two, in a litigious country like India, the institution of a principles-based system is likely to overwhelm the arbitration/ judicial system with public interest liti-gation, right to information queries and private class actions. Finally, as noted by Wallison (2007), there is the safe haven effect of a rules-based system. Compliance with rules, which are fully transparent give the regulated entities a sense of absolution, which is never present in a principles-based system.Instead of a switchover to a principles-based system, a far better alternative is to impart flexibility and dynamism to the existing rules, making them more transparent and installing a system of quick incentives/ penalties for compliance/non-complaince. Regulatory and Supervisory Independ-ence:The issue of regulatory and supervi-sory independence (RSI) is often confused with central bank independence (CBI), though as stressed in the literature [see Lastra 1996; Taylor and Fleming 1999; Quintyn and Taylor 2002, etc], the two are conceptually distinct and need not neces-sarily coexist even when the regulation and supervision functions and monetary policy functions are vested in the same authority. In a sense,RSI is to financial stability what CBI is to monetary stability. Unfortunately the academic literature on regulation has been almost exclusively focused onCBI, to the virtual neglect of RSI. The CFSR also fails to touch on this aspect at all, though of course it does pay a great deal of attention to the issue of single versus multiple regulators.7 The neglect ofRSI assumes importance when one considers the fact that almost all episodes of financial distress have been associated with a weakRSI.8RSIrefers to independence of the regulatory and super-visory structure from not only the govern-ment but also from the industry and finan-cial markets. In India, the financial regu-latory and supervision functions are dis-tributed between the RBI (banks and non-banking financial companies – NBFCs) state governments (for cooperative finan-cial institutions jointly withRBI) and National Bank for Agriculture and Rural Development (for regional rural banks). For the purpose of this discussion, let us confine ourselves to the regulation and supervision of the banking sector and NBFCs. The RBI discharges this function under the guidance of the board for finan-cial supervision (BFS), which comprises four directors from the RBI’s central board, theRBI governor (as chairman) and four deputy governors. So far as independence from the govern-ment on regulatory and supervisor fronts is concerned, this is ensured to a large ex-tent by the fact that theRBI (acting under the guidance of the BFS) is authorised to issue directives in all areas of regulation and supervision. However, this realisation has to be tempered by the fact that an ele-ment of indirect control of the government does exist by virtue of the fact that theRBI directors (from whom the four of the BFS members are drawn) are appointed by the central government. Incidentally, the CFSR’s recommendation to set up the Financial Development Council under the chairmanship of the finance minister “for macroeconomic assessment and develop-ment issues” (proposal 26), if implement-ed, will strongly limit the existing inde-pendence of the regulators and super-visors, as it will provide a legitimate plat-form for the finance ministry to intervene in these matters and further accentuate the coordination problems between the RBI and finance ministry.But the other major dimension of RSI, viz, independence from markets is equally important but has not received the atten-tion it deserves. In the words of a very famous US central banker “…it is just as important for a central bank to be inde-pendent of markets as it is to be independ-ent of politics” [Blinder 1997, 2000]. Inde-pendence from markets is more difficult to ensure than independence from politi-cians, since the forces operative here are extremely subtle. There are primarily two channels, through which markets can influence regulators, both of which have been operative in the Indian context. Firstly, an overwhelming preponderance of financial sector and industry represent-atives in official committees and bodies, concerned with the designing of the regu-latory architecture. This usually takes place at the instance of a government strongly committed to reforms and is usually done with the ostensible purpose of knowing the financial industry point of view. Secondly, large sections of the media are strongly aligned with corporate sector interestsand hence, by extremely ingeniouspropaganda manage to create a general impression that national interests are closely conflated with financial sector interests. A grading system is then set up, whereby supervisors and regulators are rated publicly on how friendly they are to markets. I concede that we are treading on thin ground here. On the one hand, financial stability is a public good and financial 
DRAFT RAGHURAM RAJAN COMMITTEE REPORTAugust 9, 2008 EPW Economic & Political Weekly18market development contributes to real development. Yet it is undeniable that exu-berance, animal spirits and general short-termism strongly pervade financial markets. A regulatory authority overtly sensitive to financial market demands could be a classic case of what Stigler (1971) has termed regulatory capture. Unfortunately theCFSR observes a deafening silence on this vital issue. ConclusionsA recent article inTheEconomist (June 21-27, 2008) talked about residential segre-gation in the US in the following terms “We now live in a giant feedback loop…hearing our own thoughts about what’s right and wrong bounced back to us by the television shows we watch, the news-papers and books we read, the blogs we visit online, the sermons we hear and the neighbourhoods we live in”. I wonder whether a similar description applies to today’s reform enthusiasts, who seem to be all living in a similar intellectually segregated world of their own creation. The routine lines of thinking of this establishment have been rendered all too familiar to us via a plethora of official reports that have surfaced in the last few years. The CFSR chaired by an economist of distinction had raised expectations of giving us something refreshingly different. In one sense, it has fulfilled these expecta-tions to some extent by producing a report, which is both comprehensive and very readable with some useful suggestions. However, it largely disappoints by coming up once again with the standard remedies in the average reformer’s medicine bag (suchas capital account liberalisation, inflation targeting, privatisation of banks, etc), without much attention to the speci-ficities of the Indian context. A discerning reader can also detect a distinctly partisan bias in the report, so that at several places it partakes more of the character of a charter of demands of the financial sector. Hopefully, the final version will rectify such biases, go into greater details and bring on board more adaptation to the Indian specificities.Notes 1 Incidentally, one of the major limitations of the report is that it does not take any cognisance of the substantial empirical work done by (resident) Indian scholars on several macroeconomic issues relating to the Indian economy but alas published in Indian journals. 2 Countries using some form of IT currently include: Australia, Brazil, Canada, Chile, Colombia, Finland, Mexico, New Zealand, Poland, Sweden, UK. 3 See Nachane (2007) for a summary of the debate and also for my own views on the subject. 4 Of course, in practice, concepts like “openness”, “fixity” or “independence” are not absolute, but relative or even fuzzy. 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