Arvind Subramanian: Reassuring politics,
reasonable economics
Business Standard
Arvind Subramanian / New Delhi July 27, 2007
The Indian system has shown capacity for learning by doing and learning from
over-doing.
Exchange rate management and capital account opening may seem an
unlikely prism to view the workings of the Indian political system. So, before
assessing the economics of the recent policy changes, stop and focus on the
politics, and you will find cause to celebrate the spectacle: different actors
pushing their interests; vigorous and open debate amongst them and others;
and decision-making that reflects and reconciles competing claims and shows
capacity for learning based on experience. To Oscar Wilde’s prudish
governess, who famously counselled her ward to omit the chapter on the
rupee, the response would have to be: do so and your understanding of
political economy will be poorer for it.
Economic outcomes in pluralist societies arise from the interaction of different
interest groups and institutions. Take the actors in this saga of the rupee each
with distinct but legitimate objectives: the RBI, which is concerned with
preserving monetary autonomy; the Commerce Ministry, which has to be
mindful of the interests of exporters; the Finance Ministry, which is keen to
promote financial efficiency and integration but is also acutely sensitive to
safeguarding the public finances; and finally, the Economic Advisory Council to
the Prime Minister, which presumably takes a broader view, aggregating and
weighting the interests of each of these actors.
How did the process play itself out? The saga unfolds in three acts.
In act one, we had the RBI that, partly out of policy decisions to liberalise the
capital account, especially for external commercial borrowings (ECBs), found
itself in the unenviable situation of struggling to preserve monetary autonomy;
the autonomy it needed to combat what seemed then (around April) like
incipient but potentially damaging inflationary pressures. It responded by letting
the exchange rate go, and the rupee quickly appreciated by about 10 per cent.
The consequences were predictable and predicted. The resulting appreciation
led to a clamour for help from exporters. A spate of studies also started to
suggest that the Indian growth machine would slow down because of the
appreciation. So, in act two, the Commerce Ministry, announced a package of
financial assistance—comprising duty drawbacks and cheap credit—amounting
to Rs 1,400 crore.
While the budgetary consequences of this package are not immediately large
or fiscally fatal (less than 0.1 per cent of GDP), it must nevertheless have been
discomforting to the finance ministry—especially if the package were to set a
precedent for future episodes of appreciation—which is justifiably keen to
reassure a sceptical world that its stated fiscal targets will be met. The finance
ministry has probably also come to recognise the tension between its
objectives of furthering financial integration and maintaining fiscal prudence:
increased capital inflows inevitably entail additional fiscal costs either in the
form of sterilisation (to prevent appreciation) or explicit assistance to exporters
(to address appreciation). Thus, in act three, the EAC recommended that the
government should clamp down on ECBs, thereby trying to head off some of
the future pressures for rupee appreciation.
The EAC’s intervention has been especially noteworthy as a contrast to the
recent Mistry Report, which made a strong ideological case, with little empirical
substantiation, for faster capital account convertibility. The EAC’s advice, on
the other hand, seems to have been sensitive to the experience of the last few
months, demonstrating the system’s capacity for learning by doing and, indeed,
learning from over-doing.
Consider next the economics of the different policy changes. Under current
conditions of dwindling ability to influence the exchange rate, the EAC’s
recommendation of limiting ECBs, without damaging market confidence, is the
most appropriate policy response. I argued in a recent paper in the Economic
and Political Weekly that inflows of foreign capital are a double-edged sword
(http://www.epw.org.in/epw/uploads/articles/10751.pdf). India can, at this stage
of its development and given the considerable tightness in skilled labour
markets, forgo the efficiency gains from capital inflows for averting costly real
exchange rate appreciation. For this reason, the other vestige of policy
influence over capital flows—limiting foreign flows into domestic bond
markets—should also be preserved for the time being.
Assistance to exporters in the form of duty drawbacks is an inferior response to
declining competitiveness: drawbacks provide relief only to some (mainly
manufacturing) exporters; the magnitude of relief is arbitrary and perverse (the
more a sector buys imported intermediate inputs, the more relief it gets);
import-competing industries get no assistance; and drawbacks give rise to
administrative costs and opportunities for rent-seeking and evasion. One hopes
the assistance will be implemented consistent with India’s WTO obligations. If
that is the case, and given the relatively modest magnitude of the relief, it can
be viewed as a small cost, perhaps even a necessary political concession to
forestall demands for more damaging policy actions.
Monetary and exchange rate policy, however, deserves special mention. This
policy has mutated three times in three months. First, we had exchange market
intervention combined with large-scale sterilisation; this was followed by a brief
period of a free float; and now in the third phase, the RBI has reverted to
exchange intervention but without sterilisation. The consequence has been an
explosion in liquidity, with the call rate at nearly zero per cent, which is likely to
stoke goods and asset price inflation down the road. Moreover, for an economy
growing at close to 10 per cent, a near zero per cent reference interest rate
seems unusually low and unsustainable; indeed, some recent inflows are
clearly speculative, anticipating that current rupee fixity and monetary laxity will
give way again to future appreciation.
It is imperative now for monetary policy to acquire greater predictability. The
difficulties should not be underestimated because the RBI is juggling multiple
objectives with limited policy levers—all the more reason not to further deplete
the RBI’s arsenal by pushing capital account convertibility. Even so, moving
between three monetary policy regimes within such a short period, with call
rates oscillating between 60 per cent and zero per cent, cannot be good for
engendering market confidence.
On the whole, though, policy making in this recent episode of capital flows and
rupee appreciation has been reassuring, even impressive, to watch. But one
price of economic success, of being an attractive destination for capital, is the
near certainty that more rupee-related turbulence lies ahead.
The author is Senior Fellow, Peterson Institute for International Economics, and
Center for Global Development, Washington D.C., and Senior Research
Professor Johns Hopkins University