‘Adaptations’ and ‘Mitigations’ in the Institutional Framework Governing Banking in India in Response to Disruptions in Nature *

* This is a slightly edited version of the proposal submitted to RBI for its Scholarship Scheme for Faculty Members from Academic Institutions — 2021. The proposal was selected. Work will start in February 2022 and output will be presented before RBI in May 2022.

As it is well known, some of the key objectives of Reserve Bank of India are:[1] (a) “securing monetary stability”, (b) “to operate the currency and credit system of the country to its advantage”, (c) “to have a modern monetary policy framework to meet the challenge of an increasingly complex economy”, (d) “maintain price stability while keeping in mind the objective of growth”, (e) “to expand the reach and sustain the efforts through a broad convergence of action involving all the stakeholders in the financial sector”. The fundamental ‘trilemma’ — involving economic growth, price stability and employment for the obvious and known trade-offs — that RBI faces is typical to every policymaker on the macroeconomic front. The ‘financial inclusion’ objective owes to the specific historical and social context in India. Disruptions in Nature — recognised by the authorities responsible for governing financial systems across geographical spaces including European Central Bank (link) and Reserve Bank of India (link) — have consequences not only for each of these objectives but also the trade-offs between them. This is the context for this proposal. It is in the ‘exploratory’ rather than ‘analytical’ or ‘predictive’ domain.

John, Singh and Kapur (2020: 1) from Monetary Policy Department of RBI found that the “inflation forecast combination approach based on the performance-based weighting scheme outperformed the individual models both for headline inflation as well as core inflation for the longer horizons relevant for monetary policy”. Among the three sources of “the absolute forecast errors of the combination models” that are ‘non-negligible’, they argued that “model misspecifications and breaks in structural relationships […] can be addressed, to some extent”. The other two, namely, “large recurrent fluctuations in the key conditioning variables […] greater role of global factors including volatility in crude oil prices and exchange rates and weather shocks continue to pose challenges to the forecasting process. […] Large shocks from the food side also contribute to the forecast errors.” (2020: 22–23). We focus on the last one here.

Arguably, the impact of ‘weather shocks’ may take a long time to be visible on the exchange sphere in agriculture even if they have affected the production sphere already and have been recognised (see Table 1 below). They involve slow moving variables and farmers have been adapting to these changes over hundreds of years — they have been adopting techniques and/or input combinations to address the ‘changed environment’ be it weather, soil fertility, water availability, land sizes, labour availability, and fluctuations in prices of inputs and outputs. Access to a larger stock of capital assets — physical, natural, human, institutional and circulating — provides more ‘handles’ to the decision-making farmer in making the adjustments. It follows that larger and diverse is the ‘capital set’ that such farmers who dominates the exchange sphere possess, the ‘lag’ will be longer. In fact the administered price mechanism through Minimum Support Price (MSP) of a large number of ‘principal crops’ may make this lag even longer. The recent move by the Ministry of Tribal Affairs, Government of India to declare MSP of minor forest products (87 such products till date; link) on the other hand may make the matters somewhat complex. Most of these products commanded quite a low price historically across the stages in a plethora of supply chains. Whether climatic disturbance induced supply shocks will impact the relevant markets (intermediate and final, both) and the resulting direction, rate and speed on the exchange sphere cannot be predicted immediately. Only one thing is certain: these supply shocks are real — may be tiny but widespread — affecting the scale of economic activities across sectors.

The resulting costs are borne both by the private entities (say, owner-cultivator of the inundated farming field) as well as the State (say, administrative bandobasts for shifting residents, issuing warnings, arranging food and shelter to those expected to be affected by a natural calamity, among others). All these impacts are different components of supply chains across real sectors from natural rubber (link) to electricity generation (inundated mines).

It is obvious that changes in the real (both production and exchange) affect the financial system per se; at times, with a lag of course. Such uncertainties — owing to disruptions in Nature — are getting recognised by the global economic leaders at the World Economic Forum over the years (Table 1) — though posed as ‘risks’:

By “uncertain” knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.

[John Maynard Keynes, 1973, ‘The General Theory of Employment,’ in The General Theory and After: Part II, London: Macmillan, 369 as cited in John Gowdy and Sabine O’Hara, 1995, Economic Theory for Environmentalists, Florida: St. Lucie Press.]

Conversion of this uncertainty into measurable risks is not an easy task. RBI (2021) and Nawn (2021) identified some of the challenges There are instances of assigning a (very low) probability to ‘catastrophes’ and arriving at the corresponding ‘premium’ that the risk takers is willing to accept. But there are events that are non-catastrophic yet non-trivial, affecting the entire supply chain. Experience of agricultural insurance in India is chequered to say the least (link). On the other hand, the industry is yet to be put under the umbrella of ‘weather related insurance’ at a mass scale at least. The quantum of risks a given producer shall be subjected to is a function of (a) extent of dependence on natural resources (in material and energy terms) per se and (b) geographical dispersions in the source of natural resources across the supply chain (same as logic of portfolio diversity).

In short, there are ample reasons for mainstreaming uncertainty owing to disruptions in Nature into the institutional framework governing Money and Banking in India. There are several such ‘adaptation’ and ‘mitigation’ options, with each having a distinct set of out-of-pocket and transaction costs. The overall costs will differ and so will be the ‘incidence’ of these costs. In fact, inaction will have costs too.

An alternative to these costs to adjust to the ‘new’ normal will be public and private investments to return to the ‘old’ normal through ecological restoration (see, Nawn 2021). Detailed Project Report and EFC memo of a “National Mission on Biodiversity and Human Well-being” [approved by PMSTIAC] is awaiting the final approval post inter-ministerial consultations at the level of Secretary (Expenditure) as on 20.10.21. Bawa et al. (2020) provides the general framework of this Mission. Bawa et al. (2021) elaborates further the contours of the Bioeconomy program within this Mission (this author is the lead author of this programme):

The broad aim of this Program is to identify and promote sustainable development pathways that are based on bio-resources, and are both economically viable and ecologically sustainable. In the process, the Program will estimate […] (b) cost of stabilising, augmenting and sustaining bio-resource flows in ecosystems faced with a rapid but recent decline in biodiversity and ecosystem services and © cost of restoring, stabilising, augmenting and sustaining ecosystems with a rich biodiversity history and/or potential. [Bawa et al. 2021]

But even there, financial norms towards making these investments have to be decided upon.

In any case, the parties to any financial transaction will have to agree on the allocation between ‘ex ante risks’ and ‘ex post losses’. Given the incompleteness of knowledge and uncertainties (see, Nawn 2021) it is not difficult to imagine contestations between the parties over assessment of risks and the corresponding collateral, insurance premium, and other such. No financial system can include every such uncertainly under force majure clause. Be it the managers at the local branch of a cooperative bank or the hedge fund manager at international financial institutions, there will be substantial costs, even to train everyone in these matters, leave alone the costs of ensuring sanctity of knowledge (observability, repeatability and verifiability tests). Even ascertaining these transactional costs can be the starting point of this exercise.

[1] As included in the RBI Act, 1934, several ‘policies’ including National Strategy for Financial Inclusion (NSFI) 2019–24 and the National Strategy for Financial Education (NSFE): 2020–25 with RBI as the ‘executive authority’ as well as RBI website (link).