The pursuit of financial stability*
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, ...view middle of the document...
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.
* Speech by Smt. K. J. Udeshi, Deputy Governor, Reserve Bank of India at the 7th Money and Finance Conference organised by Indira Gandhi Institute of Development Research (IGIDR) on February 10, 2005
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.