The Hindu Business Line : Asset prices worry RBI

`A central bank has no means of knowing if asset prices are indeed inflated. Its primary responsibility is to be vigilant about the health of the financial system'.

Worries about asset prices have come to Indian shores. Of significant concern to central banks the world over in recent times has been the upsurge in stock markets and property values.

At least one major G-7 central bank, the Bank of England, started raising interest rates primarily in response to the UK's housing boom. And what it should do — if anything — about rising property prices has not been far from the mind of the US Federal Reserve, as is clear from the speeches of Mr Alan Greenspan, the previous Chairman; his successor, Mr Ben Bernanke and their colleagues on the Federal Open Market Committee (FOMC), which sets American interest rates.

First warning shot

If one's memory is correct, the first warning shot fired by a central banker on asset prices was Mr Greenspan's famous 1996 speech on the US stock market's `irrational exuberance'. Equally famously, the market just yawned and rose year after year for the next three years. This happened despite the Fed increasing interest rates — so strong was the market's momentum.

Following the (inevitable?) crash in 2000 and 9/11, Greenspan slashed rates to near zero. It didn't do anything for stock prices but sparked off a housing boom, as interest rates on mortgages fell to all-time lows.

More complicated

The current Indian situation is, if anything, more complicated. The economy is seeing a spree in new investments, be it infrastructure, industry or housing. Asset prices are hitting new highs by the day. Credit expansion is brisk. The economy is near 10 per cent growth — in fact, it may already be there.

Is it all too good to be true? As a responsible central bank, the RBI fears the boom could drive inflation beyond acceptable limits. Or (worse), the whole thing could collapse like a house of cards.

To add to its woes, the Prime Minister has asked it to move towards full rupee convertibility. For Dr Y.V. Reddy, the Prime Minister's advice could not have come at a more difficult time.

Key to issues

One feels the key to the issues involved is not so much whether interest rates should be increased sharply (there is a case for modest serial upward pushes) — for that would imply a definite view that current asset prices are unjustified and speculative — but systemic risk exposure.

To take the stock market, the pre-settlement margins, settlement and custodial systems have all but eliminated the possibility of a crash arising from gridlock.

Again, real estate lending, if backed by adequate and conservatively-valued collateral and suitably priced to reflect credit quality, will ensure banks are adequately protected if property prices fall.

Remember Greenspan

Thus, the damage from a crash and excessive corporate and household optimism will fall on equity. True, that could have significant repercussions on consumer and business spending and investments, but the central bank's job begins only then, starting with injecting sufficient liquidity and softening interest rates.

At this time, it is well to keep in mind what Greenspan has said several times: a central bank has no means of knowing if asset prices are indeed inflated and if monetary policy should be driven by asset prices. Its primary responsibility is to be vigilant about the health of the financial system.

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