With the Reserve Bank of India (RBI) recently receiving criticism from all sides for its management of inflation and exchange rates, it is interesting to examine India?s recent inflation-growth track record, and understand the causes behind its good performance.
India always seems to suffer in comparison to China, though it may well do relatively better in the longer run?witness China?s mounting problems with quality control in manufacturing, environmental degradation, and now even inflation. But put aside that popular pairing, and instead look at India relative to a few other large developing countries.
The table shows annual percentage rates for real growth and inflation. In the last seven years, India?s growth and inflation record is considerably better than any of these countries. If one includes the tough years around the Asian financial crisis, then the last dozen years make India?s relative performance look even better. One possible lesson from this comparison is that India has followed better policies during this period. Faster growth might be ascribed to catching up, or ongoing policy reforms, or even the late unleashing of entrepreneurial energies.
But the inflation record has nothing to do with these factors. If we accept that inflation is a monetary phenomenon, then the credit for good performance on this front must go to India?s chief money manager, the RBI. The ostensible puzzle here is that the RBI has not seemed to follow a monetary policy route that might fit with academic orthodoxy.
It is not particularly clear or transparent in its functioning, it employs quite a few quantitative and discretionary (perhaps bordering on ad hoc) policy levers, and it simultaneously tries to manage large external capital flows and the level of the exchange rate, along with domestic credit conditions. Yet, the Indian economy?s inflation performance is quite good, benchmarked against other large developing countries.
On this evidence, one could also credit the RBI with contributing to a strong growth performance, since it has avoided the double-digit inflation rates that have at times plagued the other countries in the table?and empirical evidence across many countries and over time suggests that double-digit inflation hurts growth. A related puzzle pertains specifically to capital account openness.
Cross-country evidence, recently marshaled in research by Abhijit Sen Gupta of Icrier, suggests a negative relationship between inflation and capital account openness, the latter being measured by the now-popular index constructed by Menzie Chinn and Hiro Ito. This correlation is particularly strong when inflation rates are high and domestic institutions are weak. According to the Chinn-Ito index, Brazil, Indonesia, Mexico and Russia (BIMR) all have greater capital account openness than India. Thus, the data in the table, based on this BIMR-India comparison, are in direct contradiction to the simple negative relationship observed by Sen Gupta.
One easy explanation (really a non-explanation) is to say that India is different. However, the real difference between India and the comparison countries may be in the quality of its institutions. All the other four nations in the table have weaker democratic institutions and feature prominent examples of governments effectively transferring resources to elites through various macroeconomic and regulatory policies. In this subset of the world?s nations, therefore, India?s RBI, and even its finance ministry, looks quite good.
Interestingly, Sen Gupta incorporates political economy conditions into a theoretical model, and suggests that capital account openness may work to check inflation by acting as a disciplining device on politicians. The evidence from the data in the table suggests that this may not be a strong justification for capital account openness.
Sen Gupta also looks at India?s record over time, and argues for the same possibility of a disciplining effect, based on a negative relationship between inflation and capital account openness for the period 1990-2006.
Since this latter evidence is for a single country, it mostly controls for variation in institutional quality. However, this observed relationship does not identify any causality?both variables might be affected by a third factor, or low inflation might be encouraging foreign investment. One is really left with some puzzles as to what has made India so successful in its macroeconomic management. In an earlier column (May 2005), I had cited work that suggested that, when properly measured, the RBI was following some version of a (modified) Taylor rule, and so it was effectively fighting inflation in an academically ?approved? way, without explicitly kowtowing to any simple formula.
Clearly, the answer to the puzzle lies somewhere in the detailed political economy of India?s institutions: we know that this creates strong inflation averseness. Understanding this political economy better, as well as the mechanisms that are determining both macroeconomic policy decisions and macroeconomic outcomes, will be helpful in recommending changes in the way that the RBI operates.
Despite India?s macroeconomic success in the last decade, it is entering rougher and uncharted seas, and sailing ahead may require a different approach than in the past, so changes will have to come.
?Nirvikar Singh is professor of Economics at the University of California, Santa Cruz