Wednesday, November 10, 2010

Analysing trends in India's macroeconomic policy

The Great Recession has accelerated several changes already underway in the world economy for the past few years. Arguably the most significant development has been the emergence of developing countries as engines of global economic growth. It has also exposed several deficiencies in the dominant Washington Consensus model of economic growth. So much so that, faced with its deepest economic downturn since the Great Depression, the US itself is reassessing many of the sacred tenets of the Washington Consensus.

The spectacular rise of China and the increasing certainty of India emulating China have meant that Beijing Consensus and now, the "Mumbai Consensus", are slowly gaining wider acceptance. In a recent speech in Mumbai, Lawrence Summers coined the phrase "Mumbai Consensus" to describe the nature of India's economic growth model which has seen the country's chart the troubled sub-prime waters relatively trouble-free.

The Indian model is characterized by "a reliance on domestic consumption rather than exports, services rather than manufacturing, and private enterprise rather than state-led companies and investments". It bears striking similarities with America's own growth history and trajectory, and unlike the Chinese model, revolves around private-sector driven growth and democratic pattern of development. Further, India's response to several important global macroeconomic issues has generated the impression that the Mumbai Consensus is closer to an open-market economy driven approach. This feeling gets amplified when seen against diametrically opposite reactions among other developing economies and even developed economies.

India's willingness to allow both capital unfettered access into equity and debt markets and the exchange rate to strengthen stands against reluctance among others, both developed and developing, to do the same. These have been part of a remarkable trend where Indian economy charts a path at variance from the rest of the world, one which appears to put India to the right of the economic spectrum. Here are a few examples.

1. The aftermath of the sub-prime meltdown has engendered deep financial market uncertainty. However, despite the Great Recession in the developed economies, the global financial markets have recovered smartly since March 2010. This has been characterized by sharp spurt in capital flows into the emerging economies, whose equity markets are clearly showing signs of froth.

It is in this context that, early this year, the IMF broke with its long-held ideological position, and said that capital controls are a "legitimate" tool in some cases for governments facing surges in external investments that threaten to destabilize their economies. There have been an increasing chorus of voices calling for capital controls for developing economies. The World Bank is the latest to advice Asian economies of temporary and targeted controls to contain asset bubbles in the region’s stock, currency and property markets.

Before and after the IMF's change in stance, countries like Brazil and Thailand have announced policy measures to limit capital flows. Brazil imposed a 2% tax on foreign portfolio inflows last October. Thailand has imposed a 15% withholding tax last month on interest and capital gains earned by foreign investors on Thai bonds issued by the government, central bank and state enterprises, and is contemplating more controls. Earlier in June, Indonesia introduced "quasi-capital control measure" by making short-term investment less attractive to foreign funds. A few days back, the South Korean government moved to stabilize the won by limiting assets accessible to foreign capital, while Taiwanese officials made some bank deposits off limits to foreign investors.

However, despite itself experiencing a steep rise in foreign capital inflows into its equity markets which recently breached its highest ever mark and shows signs of a bubble getting inflated, India has so far refrained from any talk of capital controls. The FIIs have pumped in a massive $26.7 bn into Indian equities till October end. In fact, just a few days back, even as some other economies were contemplating introduction of capital controls, the Indian government again reiterated its resolve to not impose capital controls. Instead it has preferred sector-specific selective credit controls to prevent the build-up of asset bubbles.

India's tolerance for higher capital inflows stem partly from the realization that it requires foreign capital to bridge the widening current account deficit (CAD) and to fund its huge infrastructure investment needs.

The strong economic growth and its import-intensity, coupled with a not-so-strong export growth and relatively stagnant domestic savings rate, makes foreign capital critical to sustaining high growth rates.

In view of all the aforementioned, the RBI and the Government appear to have informally agreed to raise the tolerable level of net capital inflows to $150 billion, up from the earlier figure of around $110 billion.

2. China's policy of keeping its currency pegged to a steadily declining dollar confers significant advantages on Chinese exporters. This has raised concerns among its trade competitors, especially those from other emerging economies. Atleast some of them have already started open-market operations to buy up dollars, and more look likely to follow.

Recently, after many years, the Bank of Japan carried out foreign exchange market interventions to keep the yen from appreciating any further. The central banks of Brazil, Thailand and South Korea have also been active in the foreign exchange markets to limit the appreciation of their respective currencies.

The Rupee has appreciated strongly against the dollar. Led by the export-dependent software industry, Indian exporters have been mounting pressure on the government to take action to stem the appreciation. However, the RBI has been remarkably reluctant to buy this line and has steadfastly refused to intervene. The exporters have been advised to become more competitive to respond to such market pressures, instead of relying on government crutches.

In fact, the RBI appears to have taken a measured and long-term view of the rupee appreciation. In a recent speech, the RBI Governor even said that "currency interventions should be resorted to not as an instrument of trade policy but only to manage disruptions to macroeconomic stability" and cautioned about the costs of such interventions.

3. The recent second round of quantitative easing announced by the US Federal Reserve has been met with strong criticism across the world. The German finance minister denounced it as "undermining the credibility of US financial policy". Many emerging economies too have criticized the move, describing it as postponing structural adjustments in the US economy and exacerbating the global macroeconomic imbalances.

India has been the only major economy to support US QE. It has acknowledged the importance of monetary accommodation for economic recovery in the US and the importance of a healthy US economy to global economic prospects.

4. In a classic inversion of roles, India today appears on the free-market side of the globalization debate more than even many developed economies. Apart from certain controls on food-grain exports, it has been continuously liberalizing its economy, albeit at a slow pace. This trend has been in contrast to protectionist sentiment on the rise elsewhere, including the US.

In response to the outsourcing bogey, the US has tinkered with various measures like limits on visas for IT personnel from abroad and restrictions on firms receiving stimulus assistance outsourcing work abroad (discriminatory tax treatment based on whether the firms create jobs at home or abroad). It recently imposed fee hikes of $2,000 or more on H1-B and L-1 visas for highly-skilled foreign workers at firms employing more than 50 workers, with half or more of their workers on H1-B visas.

Realizing the benefits of an open economy and expanding international trade, India has been steadily opening up its economy. This stands in contrast to the continuing reluctance of the East Asian countries to open their economies to trade. India has gone far ahead of even OECD economies like South Korea in liberalizing both its real economy and financial markets to international competition.

5. The contrasting fortunes of the developed economies and India to the sub-prime mortgage crisis has drawn attention to the role of regulators on all sides. How did India and its financial institutions, despite its relatively open financial markets and conventional regulatory architecture, escape the fate of counterparts elsewhere?

The RBI has used multiple instruments and a menu of options to manage the external sector and the monetary policy both before and in response to the sub-prime crisis. It has followed a carefully sequenced movement (which is also dependent on the developments in both the real economy and financial markets) towards capital account convertibility and controls on debt flows - both private and inflows into risk-free sovereign debt instruments to take advantage of interest differentials (carry trade). And all this has been backed up with strict enforcement of regulations.

6. India has contributed its fair share to addressing the global macroeconomic imbalances - skewed trade, savings, consumption, and investment preferences. In stark contrast to countries like China which implicitly suppresses local consumption, India has one of the largest shares of domestic consumption. Its domestic savings rate at around 35%, which while not adequate, has grown significantly over the past decade.

At a time when the developed economies are attempting to export their way out of recession and emerging economies want to continue with their export-dependent growth model, India is one of the handful of major economies willing to provide aggregate demand. Unlike, the closed and export-oriented East Asian economies, India has steadily liberalized its economy and is an increasingly significant market for global exporters.

A recent speech by the RBI Governor conveyed a great sense of maturity about the way India conducts its macroeconomic policy. He described the dilemma facing the Central Bank
"The biggest problem thrown up by capital flows is currency appreciation which erodes export competitiveness. Intervention in the forex market to prevent appreciation entails costs... If the resultant liquidity is left unsterilized, it fuels inflationary pressures. If resultant liquidity is sterilized, it puts upward pressure on interest rates which, apart from hurting competitiveness, also encourages further flows."

He had more wise words for Central Banks and governments across the world,

"In as much as lumpy and volatile flows are a spillover from policy choices of advanced economies, the burden of adjustment has to be shared. It’s unrealistic to expect emerging market economies to carry the full burden of lifting global growth... Managing currency tension will need shared understanding on keeping exchange rates aligned to economic fundamentals and an agreement that currency interventions should be resorted to not as an instrument of trade policy but only to manage disruptions to macroeconomic stability."

And about what the world needs now, he said

"The surplus economies will need to mirror these efforts — save less and spend more, and shift from external to domestic demand. They need to let their currencies appreciate."

Are US, China, and Germany listening?

Update 1 (13/11/2010)
Among the major economies, India has the lowest exports to imports ratio.


sai prasad said...

Do V really have an Indian model ?

""The Indian model is characterized by "a reliance on domestic consumption rather than exports, services rather than manufacturing, and private enterprise rather than state-led companies and investments""

Whatever happens in its natural course is treated to be the Indian model. Dont u agree? If u dont, let us see evidence. Where is the above stated in a policy document---an implementation startegy for each of its sub-components -- intermediate measurements and mid-course corrections etc. The trails..?

sai prasad said...

""Recently, after many years, the Bank of Japan carried out foreign exchange market interventions to keep the yen from appreciating any further."""

What does a country do when they have too much money. Let us say when they reach threshold X. Do they raise the bar for themselves ?
What happens then ?
A Japan like stagnation ? Is theis not brought on by self limiting factors ?

Why raise the bar beyond reasonable limits ? Why grow forever ?

gulzar said...

thanks sir.

first, by model, I did not mean any consciously created or artificial approach. i only mean the way in which India has pursued its macroeconomic policy, or the natural course.

in other words, we rationalize the current policy as a model. but the natural course is not so natural as it appears. we only need to look at the counterfactual of China or any East Asian tiger to get an idea of how the opposite could have been true.

but, whether it is laid out in a document or not (and there are documents on atleast some of them, one only needs to read the annual pre-budget economic review carefully to glean them out) in one place, it cannot be denied that all these trends are reflected or are underlying in our broad macroeconomic policies.

second, i guess in Japan's case, it is not about growing more, but merely retaining their current living standards. for over two decades now they have been struggling to just stay on.

i am not sure about the self-limiting factors. there cannot be an "end-of-growth" stage for any country. growth will take place along different dimensions. in its most simplest terms, the quality of lives will continue to improve. different industries and jobs will emerge and so on.