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Rajan’s Call for International Monetary Cooperation Won’t Work


In a speech, Rajan calls for international monetary cooperation, whatever that means.

He talks about how the exit from massive monetary and quantitative easing will play out. The language is complicated, so here’s the gist:

  • When you have too much “liquidity” because of central bank buying, people buy “low yield” bonds even if they don’t really believe they will get paid back – because if the shit hits the fan, central banks will come in and buy no?
  • So you prefer to make loans or buy bonds thinking you can sell them at a higher price, rather than because you are confident this bond will pay you back.
  • Then, banks keep holding “illiquid” stuff because when push comes to shove, central banks will buy it from you (or give you liquidity with that as collateral).
  • Finally, when crappy stuff is showing good returns, then all fund managers want to buy them because not holding them amounts to “underperformance”.
  • In this situation when liquidity is tightened or the central bank says it will stop buying, everyone gets hot and bothered.
  • You have illiquid stuff, can’t sell. You bought crappy bonds on the “guarantee” there would be an idiot buyer to sell to, suddenly the idiots vanished. Basically, you’re back in deep doo-doo.
  • Basically, you turn off the tap, asset prices fall again, and guess what, the banks are even more heavily loaded up on risky, illiquid assets at fire sale prices, which prompted the need for QE in the first place.
  • And this causes no end of problems to other countries.

That’s his second point, that it hurts other, unrelated countries which see both a massive surge of inflows and a surge of outflows. This “distorts” their economies – when you see a lot of money flowing into real estate, for instance, everything seems good. Registration and property taxes go up, making states look financially healthier (but when real estate crashes that game is over).

The distortions make “adjustment” for other countries more difficult. When money flows out fast, smaller countries get screwed – the exchange rate goes berserk, inflation heats up, people exit risky positions really fast, causing “fire sales”.

He calls for central banks to co-operate with each other.

I do not mean that central bankers sit around a table and make policy collectively, nor do I mean that they call each other regularly and coordinate actions. In its strong form, I propose that large country central banks, both in advanced countries and emerging markets, internalize more of the spillovers from their policies in their mandate, and are forced by new conventions on the “rules of the game” to avoid unconventional policies with large adverse spillovers and questionable domestic benefits.

Given the difficulties of operationalizing the strong form, I suggest that, at the very least, central banks reinterpret their domestic mandate to take into account other country reactions over time (and not just the immediate feedback effects), and thus become more sensitive to spillovers. This weak “coordination” could be supplemented with a re-examination of global safety nets.

How feasible is this? Do we want monetary management by international committee?

Capital Mind View: We think this is a noble thing to ask for, but it is very undesirable to a capitalist economy. Central banks have become more important than we should allow them. It’s not apparent why it would become acceptable that my deposit rate went down even though I have high inflation, just because Sri Lanka wet its pants. We shouldn’t try and create a model where we need to ask Bangladesh if we should put Tripura into the priority sector because it distorts their economy.

International cooperation will instantly mean that foreign countries demand that India free up the rupee completely, which there is no reason not to do anymore (and can easily insulate us from these volatility issues partially). They will demand we remove our stupid restrictions from foreigners buying bonds (which are ill-advised and based on some historical fear of short term “hot” flows). They will demand we stop our distortions when we buy dollars to add to “reserves”.

Not. Listening.

India should however act independently and do these things anyhow. It should give up the concept of “exchange rate stability” – and in the face of big inflows, let the rupee appreciate, as we let it depreciate. And let everyone hedge their exchange rate risks (right now foreigners aren’t allowed to). And make the rupee convertible. And let foreigners buy any bonds they want.

And let Indians create investment companies without having to register them as NBFCs. And make it easier for investors to buy bonds and currencies and all that. You let us be free, and the world will come to us.


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