It gives me great pleasure to address this gathering
at the 7th Annual Conference on Money and Finance in the Indian economy
organised by the Indira Gandhi Institute of Development Research (IGIDR). Issues
related to monetary policy and financial sector continue to attract a lot of
research interest all over the world and this is all the more true for emerging
economies like India which are gradually integrating with the rest of the world.
Accordingly, the initiatives taken by the IGIDR to hold annual conferences on
the topic of Money and Finance to bring together researchers and policymakers
are indeed welcome.
2. With growing financial openness, globalisation
and liberalisation, financial stability issues have come to the forefront. These
issues have ranged from discussions on basic issues of the definition of financial
stability itself to issues of measurement, issues of choice of instruments to
achieve the objective of financial stability and even issues on the degree of
activism that central banks should adopt in pursuing this objective.
3. Traditionally, it has been believed that
monetary stability leads to financial stability. However, as the events of the
1990s show, it need not necessarily be the case. While there are complementarities
between these two objectives, especially in the long run, the same need not
hold in the short-run. A stable macroeconomic environment - low and stable inflation,
sustained growth and low interest rates - can generate excessive optimism about
the future economic prospects and often the risks are downplayed. Accordingly,
episodes of financial instability often have their origins in environment of
macroeconomic stability. Thus, macro economic stability need not necessarily
always place an economy in financial stability in the medium/long term and central
banks, therefore, now bestow a more focussed attention to the objective of maintaining
financial stability. Historically, central banks have been concerned with both
price stability and financial stability, albeit not at the same time (Crockett,
2004). What is rather unique since the 1990s has been a simultaneous pursuit
of price and financial stability by central banks.
Forces affecting financial stability
4. The basic forces affecting financial stability
are the quickening pace of technological innovation and the growing acceptance
of market processes as basic determinant of resource allocation. Due to sectoral
distinctions getting blurred, financial intermediaries have the ability to effectively
compete in sectors beyond their domain by deconstructing and recombining risks.
Further, the source of financial disturbances has become more unpredictable
mainly due to integration of financial markets. Financial liberalisation has
led to the emergence of financial conglomerates, cutting across not only various
financial sectors such as banking and insurance, but also a number of countries.
Therefore, a contagion means the problems of distant economies can become problems
of our own. The progressive opening up of the economies to external flows since
1990s has led to massive cross-border capital flows and volatile exchange rates.
Sharp movements in exchange rates can have an adverse impact upon the balance
sheets of both financial and non-financial entities. This is especially true
for emerging economies as they usually need to resort to borrowing in foreign
currencies.
5. If we recall the banking crisis and the
resultant financial crisis of Latin America (IMF 2004), we can broadly categorise
the trigger points as:
- A boom in credit to the private sector, for both investment
and consumption (Mexico, 1994; and Colombia, 1999). A particular form of boom
and bust cycle is generated by the end of hyperinflationary episodes (Bolivia,
1986);
- Wholesale liberalization in the absence of an appropriate
and effective prudential regulatory framework (Mexico, 1994; and Chile, 1984).
It is worth stressing, however, that highly regulated systems have also suffered
crises (Peru, 1987);
- Direct effects of fiscal difficulties on the domestic banking
system, a factor that seems to have become an increasingly important source
of strain on Latin American banks (Argentina, 2001);
- Contagion and spillovers, where a crisis in one country induces
economic agents to reassess their expectations and thus reduce investment
in other countries (Argentina, 1995), or where a crisis in one country has
a direct effect on economic conditions in another country (Uruguay, 2001);
- Terms of trade shocks and movements in real exchange rates
(Venezuela, 1994; and Ecuador, 1998); and
- Political instability, unrest, and, in some cases, civil
conflict.
6. Deficiencies in the following areas have
detracted from good banking practices and increased vulnerability to crisis
in some Latin American countries:
- Inappropriate and ineffective prudential regulation and supervision;
- Inefficacy of bank intervention and resolution;
- Policy-induced distortions, and, in particular, government
influence over public sector banks;
- Poor structure and composition of government finances;
- Inadequate accounting practices, property rights, and corporate
governance; and
- Inefficiency of the judicial system and poor observance and
enforcement of laws.
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