Frontier issues on the global agenda – Emerging economy perspective

Following is the Commemorative Oration by Dr. Duvvuri Subbarao, Governor, Reserve Bank of India, on the occasion of the 60th anniversary celebrations of the Central Bank of Sri Lanka, in Colombo on 29 March 2011:

There are also several areas where substantial work needs to be done including in improving resolution regimes for cross-border banks and systemically important non-bank financial companies, addressing the procyclicality of the financial system, and macro-prudential surveillance. We also need an approach for extending the prudential norms on the lines of Basel III to the shadow financial system which lay at the heart of the recent financial crisis.

The financial sector reform agenda is driven by the need to prevent the type of excesses in the financial sectors of the advanced economies that led to the crisis. Even so, EMEs too will have to fall in line and implement these reforms. Some of these reforms entailing higher capital and capital buffers will make the financial sector safer, but they come at a cost and pose implementation challenges. Let me expand on this a little.

Both the Bank for International Settlements (BIS) and the IIF have come out with some preliminary estimate of the macroeconomic impact of the Basel III package. The Basel Committee too is carrying out an extensive impact assessment study. EMEs will need to supplement that with their own self-assessments to more accurately determine the impact of the new norms on their financial and monetary systems.

In all likelihood, EMEs will see the cost of credit going up at a time of growing credit demand arising from strong growth, structural transformation of the economy and financial deepening. The challenge for EMEs will be to balance the tension between implementing Basel III and keeping the cost of credit at an affordable level.

In terms of capital, banks in EMEs typically have higher capital ratios, and can be expected to comfortably meet the higher Basel III capital requirements. However, going forward, as credit expands and bank balance sheets grow, banks will find it necessary to raise further capital to conform to the Basel III requirement. Basel III also poses non-cost challenges. For example, operation of countercyclical buffers will need judgements to be made on the trajectory of the business cycle and on the identification of the inflexion point. Wrong judgements can entail huge costs in terms of foregone growth.

Many of these reforms on the anvil, including some elements of the Basel III package, allow for national differentiation. Should EMEs, keeping in view their national circumstances, decide to deviate from any global standard or norm, the challenge for them will be to communicate the rationale so that the market does not interpret the deviation as regulatory looseness.

Realising that the reform measures designed for the financial systems of advanced economies will have different implications for EMEs, and that the challenges facing the EMEs may be entirely different from those facing the advanced economies, it was decided in the Seoul Summit of the G20 to work towards making the financial regulatory reforms better reflect the perspective of EMEs. The FSB, the IMF and the World Bank have been tasked with working on this agenda and report before the next Summit.

Conclusion

Let me now summarise. In my remarks today, I tried to give you an EME perspective on some of the issues on the global agenda. I started off by giving the big picture – the tectonic shift of global economic power towards emerging economies. EMEs, however, have not completely decoupled from the advanced economies; their economic prospects remain linked to the prospects of advanced economies. Even as multiple growth poles are a better safety-net for the world, we will be collectively better off if all segments of the world grow at a sustainable pace.

I then went on to the issue of global rebalancing which needs to address three inter-related issues: exchange rate flexibility, capital controls and an agreement on a framework for strong, sustainable and balanced growth. A prime source of vulnerabilities at the global level is the single reserve currency and I emphasised the need for global cooperation in finding a viable solution.

An important issue on the global agenda is protectionism and I talked about why protectionist pressures may arise again and what new forms protectionism might take in the years ahead. Finally, I gave a brief status of the reforms in the financial sector and emphasised the need for further work to study the implication of these reforms for EMEs.

The common thread running through all the issues that I raised is the need for global cooperation in solving our most pressing problems of today. The crisis has taught us that no country can be an island and that economic and financial disruptions anywhere can cause ripples, if not waves, everywhere. The crisis also taught us that given the deepening integration of countries into the global economic and financial system, uncoordinated responses will lead to worse outcomes for everyone.

The global problems we are facing today are complex and not amenable to easy solutions. Many of them require significant and often painful adjustments at the national level, and in a world divided by nation-states, there is no natural constituency for the global economy. At the same time, the global crisis has shown that the global economy as an entity is more important than ever.

The global crisis has taken a devastating toll on global growth and welfare. In their painstakingly researched book, ‘This Time is Different: Eight Centuries of Financial Folly’, Kenneth Rogoff and Carmen Reinhart show how over eight hundred years, all financial crises can be traced to the same fundamental causes as if we learnt nothing from one crisis to the next.

Each time, experts have chimed that ‘this time is different’ claiming that the old rules do not apply and the new situation is dissimilar to the previous one. It will be too costly for the world not to heed this lesson. We should cooperate not only to firmly exit from the crisis, but also to ensure that in resolving this crisis, we do not sow the seeds of the next crisis.

Before I finish, I want to compliment CBSL for its significant contribution to the growth and development of Sri Lanka. Over the last 60 years, CBSL has acquired a great reputation for professionalism, integrity and sense of purpose. Moving forward, as central banks of emerging economies, both RBI and CBSL have their tasks cut out for them.

We need to learn from the best in the world, but adapt our learning to the demands and culture of maturing emerging economies. We need to be constantly pushing the envelope, be at the frontiers of domain knowledge, oftentimes reinvent it, but all the time remain sensitive to the core concerns of an encouraging economy.

On behalf of the Reserve Bank of India, I want to wish Governor Cabraal and the management and staff of CBSL all the very best in their endeavour towards growth and development of Sri Lanka.

Footnotes

1.Disaggregated numbers are in Annex Table - 1.

2.Disaggregated numbers are at Annex Table - 2.

3.Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System by Barry Eichengreen.

4.Financial Reform: An Emerging Market Perspective by Martin Wolf, at the Korea-FSB Conference on Financial Sector Reform, Republic of Korea, September 2-3, 2010.

5.“The Era of Cheap Capital Comes To a Close” by Richard Dobbs and Michael Spence, Financial Times, February 1, 2011.