Sustaining India’s growth

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Wednesday, December 19, 2007 at 2347 hrs 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.