Sustaining India’s growth

Font Size

Print

Feedback

Email

Discuss

Save & Share Article

What’s this?

Digg	My Yahoo	Fark
del.icio.us	Newsvine	Reddit

Rate This Article

Rating:  8.5

It is possible that with the correct set of policies we will not only be able to maintain this momentum of high growth into the near future but may be able to raise it to 10%.” This statement by Prime Minister Manmohan Singh, in the face of a world economy acknowledged to be slowing, is a welcome dose of optimism, and also a challenge. What is the correct set of policies? On the microeconomic front, there is probably considerable agreement about measures that can remove some of the constraints to growth, especially infrastructure improvements that increase operating efficiency. There is less appreciation of the efficiency enhancing impacts of competition, whether in financial markets, labour markets or product markets. Nevertheless, the most difficult issues with respect to microeconomic reform may be political and ideological—the battle of ideas I wrote about a fortnight ago.

In the case of macroeconomic policy, there is somewhat less unanimity among economists, whether it is about exchange rates, interest rates, or capital controls. Monetary policy may not impact long run growth in the normal course of things, but macroeconomic mistakes can have very severe, and possibly lasting, consequences when they disrupt the real economy. Indonesia, Argentina and other examples illustrate the costs of getting macroeconomic policies wrong. In that context, Indian monetary policy makers are perhaps right to be satisfied with their performance.

In a December 3 speech at Yale University, RBI Deputy Governor Rakesh Mohan said, “The overall macroeconomic record of the Indian economy since the early 1990s indicates an acceleration in growth and a significant reduction in inflation. Pre-emptive monetary and prudential measures have led to this welcome situation of a reduction in inflation and acceleration in growth while ensuring financial stability.”

The greatest disagreements with respect to macroeconomic policy seem to lie in the realm of exchange rate management. Deputy Governor Mohan stresses concerns about exchange rate volatility, in the context of a domestic financial sector that is insufficiently developed to insulate the real economy, particularly smaller producers, from the impacts of volatility. A different concern has been with the level of the exchange rate, with some arguing for a bias toward an undervalued rate, to promote export-led growth—the classic “East Asia model.”

Concerns about fluctuations and level have been somewhat intermingled in the recent Indian debate. While the appreciation of the rupee has hurt exporters, particularly small firms, its short-run impact may have been overstated. What was unfortunate, of course, was the suddenness with which the appreciation occurred, earlier this year. In this context, the problem was partly the lack of domestic institutions and instruments that would allow smaller firms to manage risks of exchange rate fluctuation. Thus, an approach to financial sector development that emphasises gradualism in order to contain risks may actually be contrary to what is needed. Recent experience may support the position that the risks are there, like it or not, and must be managed in a decentralised manner within a market framework, not through attempts to insulate enterprises from such fluctuations. Prudential regulation is not the same as prohibition.

With respect to the exchange rate level, the economics of the East Asia model rely on the existence of positive spillovers from exporting sectors to the rest of the economy, and even then, the exchange rate is an inferior policy tool to ones that directly optimise those spillovers. It may be that such policy alternatives are politically infeasible, but that argument needs to be made explicitly, and the spillovers need to be identified and quantified to the extent possible. To return to an old theme, neither the RBI nor key ministries seem to have a transparent, empirically tested model of the Indian economy that would provide good guidance on what the “correct set of policies” should be, if long run growth is to reach double digits.

Putting aside these long run issues, what is the right macroeconomic policy for the short run in India? The US Federal Reserve has been very proactive in cutting short term interest rates, even in the face of food and energy inflation that is uncomfortably high, and continued large fiscal and current account deficits. The rationale for these actions is the continued credit crunch, as more bad loans surface and large write-downs take place. If the world economy is going to slow as a result of the deflation of animal spirits, then the European Central Bank should also be moving in the direction of the US Fed, as the Bank of England has done. The RBI, as it struggles to sterilise capital inflows, may do well to be more proactive in this respect than the ECB, since Indian inflation seems in check, the consolidated fiscal position of the government has improved, and a US slowdown seems inevitable. The RBI was perhaps a bit slow to raise rates when there were signs of overheating—it should not repeat that tardiness in the opposite direction. An interest rate cut will not affect long-run growth, but it will help keep the economy humming for the short term, avoiding a severe slowdown.