Yaga Venugopal Reddy, former governor of the Reserve Bank of India, speaks at the annual policy statement for the year 2007-2008 in Mumbai, India (Photographer: Prashanth Vishwanathan/Bloomberg News)

YV Reddy On The Global Financial Crisis, Its Aftermath And The Search For A New Normal

Amidst the chaos unleashed by the collapse of Lehman Brothers in September 2008, began the debate. Is the global monetary system broken? Is the de-facto reserve status of the U.S. dollar a problem? Do multi-lateral institutions like the International Monetary Fund need strengthening and reform?

YV Reddy, former governor of the Reserve Bank of India, had been credited with building buffers which helped India withstand the global financial crisis. His policies and thinking had caught the attention of the global economic community. And so when a committee headed by Joseph Stiglitz was set up under the aegis of the United Nations, Reddy was invited to be part of it.

The final report of the Stiglitz Commission was submitted almost exactly a year after the collapse of Lehman Brothers. Among its recommendations was a proposal to create a new global reserve system.

“This is an idea whose time has come. This is a feasible proposal and it is imperative that the international community begins working on the creation of such a new global reserve system,” the committee had argued.

A few years later the Palais Royal Initiative, of which Reddy was a part again, also recommended changes to the international monetary system. It, too, pushed for a more significant role for the Special Drawing Rights — an international reserve asset maintained by the IMF.

A decade later, has that intellectual debate in the aftermath of the global financial crisis yielded any meaningful change?

“That is something which is being missed in the debate right now,” said Reddy in an interview with BloombergQuint. “The real question is whether there has been any progress on arriving at the new normal after the crisis....it has not happened,” Reddy said.

Reddy acknowledges that the Stiglitz Commission, of which he was a part, was looking more at what was “desirable rather than feasible”. “Therefore, in a way it collapsed because it depended on an agreement between major nations to have a dramatic change, which didn’t happen,” Reddy said.

While everyone agreed that the centrality of the U.S. dollar was equivalent to a monetary ‘non-system’ and the SDR was advocated, the underlying issues were not addressed even through that, Reddy argued.

The U.S. dollar is one national currency functioning as a global reserve currency. But if you have multiple national currencies taking over that role, how does it solve the problem? It’s still not the global currency.....Not only do these issues still remain but they haven’t even been adequately debated to come to a consensus on the new normal.
YV Reddy, Former Governor, RBI

Also read: The Global Financial Crisis, A New Governor And His Trial By Fire

Reddy added that there has not been any significant reform of institutions like the World Bank and the IMF. “The promise was less than satisfactory. The performance is even less than the promise,” Reddy said in his trademark humorous style.

Pointing to the recent instances of trade tariff wars and the possibility of currency wars, Reddy noted that these cannot be divorced from the consequences of the global financial crisis of a decade ago. The crisis was so far-reaching that it has had an impact in many ways, he said.

“What we are seeing is the beginnings of a parallel system where the supremacy of the dollar is being challenged at the margin,” Reddy explained while referring to recent tensions between China and the U.S.

The command of the U.S. dollar has slightly lessened. Because it is being threatened by the real sector. It is being threatened by China trying to circumvent and by-pass it through investments in different countries. China has joined the SDR basket too. It (the U.S. dollar) is being challenged at the margin....But that is causing confusion because you have the beginnings of a parallel system and that can be unsettling.
YV Reddy, Former Governor, RBI

Should a bipolar world emerge, Reddy feels that it could manifest through symptoms like trade wars and currency wars. “These are signs of the relatively unstable environment, which is a result of the financial crisis and the way it was handled in some ways.”

Mistakes Of The Past And Confusions Of The Future

Domestically and globally, Reddy has not been a big votary of an exclusive focus of central banks on price stability.

It is now widely believed that too much emphasis on price stability and inadequate focus on asset markets and financial stability allowed the build-up of risk in the pre-2008 era. Despite that recognition, below target inflation has been cited as a reason for central banks continuing with unconventional monetary policies like quantitative easing.

Are global central banks repeating their mistakes?

“One lesson which has been learned from the earlier crises is that too much of concern about price stability and inflation is not good for your health,” said Reddy while adding that central banks recognise this but are confused about what other factors matter and to what extent.

At that time, it was a mistake. Now it is a confusion. At that time, central banks believed that price stability is the main job of central bank and through that everything be solved. Now they know that price stability is not the only thing and other things matter. But they are not able to agree how it matters.
YV Reddy, Former Governor, RBI

Reddy added that inflation is a result of many factors and not just monetary policy. “Central banks should have developed some humility by now.”

In Reddy’s mind, while quantitative easing has worked in some aspects, many unanswered questions remain. QE has helped in bailing out financial institutions but underlying problems have not been resolved and there is no new normal yet, he said.

It has been successful in solving some problems but unsuccessful because not only did it not solve underlying problems but it has created new problems. The new problem is that they don’t know how to get out of unconventional measures.
YV Reddy, Former Governor, RBI

India’ Strength Then And Its Vulnerabilities Now

As global central banks move ahead with unwinding unconventional monetary policy measures adopted in the aftermath of the Lehman crisis, emerging markets like India will undoubtedly face bouts of volatility.

In 2013, India was at the receiving end of the taper tantrum. At the time, high inflation and the twin-deficits were cited as reasons for India being placed in the ‘fragile five’ basket of economies.

In 2018, when India’s growth-inflation fundamentals are far stronger, its the country’s current account deficit which has come back to haunt it.

What are India’s vulnerabilities?

Reddy doesn’t want to use the word ‘vulnerabilities’ but says that India may not have used the period of low oil prices to its fullest.

When oil prices went down we got good results on the fiscal side and the external side...We thought it is normal. In good times, you should have improved your position. I don’t think we did it. We could have taken advantage for fiscal strengthening. So, now you have less headroom if there is pressure.
YV Reddy, Former Governor, RBI

To be sure, there have been some fundamental reforms like the implementation of the Goods and Services Tax and the Insolvency and Bankruptcy Code, said Reddy.

Reddy also cautioned government officials and functionaries from playing fast and loose with comments related to the exchange rate markets.

“In terms of market sentiment, my philosophy is very simple. If you allow the market to think that depreciation is due, it is warning signal. Anytime the market feels that it is due, it will happen sometimes later,” said Reddy.

Raising a wider systemic issue, Reddy said that the exchange rate regime and exchange rate management are two different things. While the political leadership of the day determines the exchange rate regime, the management of the exchange rate should be left to the RBI.

I am worried. Exchange rate is so sensitive and the sentiments are very important. Giving mixed signals, it may happen on inflation sometimes, but certainly not on exchange rate. It is appropriate for government to ensure that there are no double signals as far as possible.
YV Reddy, Former Governor, RBI

Reddy continues to believe that there is no crisis in the Indian banking sector, 70 percent of which is owned by the government which can provide capital if it chooses.

“It is not banking crises, but it is related to inadequate capital for public sector banks. Inadequate capital does not matter for public sector banks. Therefore, it is not a systemic crisis,” said Reddy.

He does, however, see a problem with a section of the banking sector being “numb”. A large segment of the banking system is not active and that could dull the effectiveness of any policy response that is intended to play through the banking system, the former governor said.

Watch the full interview with YV Reddy here: