by Arvind Subramanian, Peterson Institute for International Economics
Op-ed in Business Standard, New Delhi
January 27, 2010
© Business Standard
All eyes are focused on the Reserve Bank of India (RBI) as it makes key decisions on liquidity and interest rates. These decisions, which will aim to head off the very real threat of overheating while maintaining reasonable growth, will define more broadly the exit strategy from the substantial policy support provided in the aftermath of the global financial crisis. Very senior government policymakers have been generous in offering public (and unsolicited) advice to RBI to the extent that markets have lurched between Delhi and Mumbai to read the tea leaves on the future course of monetary policy.
Comparative advantage, let alone bureaucratic propriety, would dictate that cyclical monetary management be left to RBI. Coordination between Delhi and Mumbai should focus instead on other more strategic and long-term issues. One such issue is India's future globalization strategy and in particular the liberalization of the financial sector and the capital account. What lessons have policymakers drawn from the experience of the financial crisis? How much and what kind of globalization should India aim for?
The crisis served as a useful natural experiment to test two extreme models of globalization that countries had adopted going into the crisis. These models of globalization reflected choices about openness to foreign capital and to exports. The first can be described as the "foreign finance fetish" model, which relied on importing a lot of foreign capital, especially financial capital. This strategy was exemplified by many Eastern European emerging market economies that ran current account deficits well in excess of 10 percent of GDP.
The second model can be described as the "export fetish" or the mercantilist model, which entailed a reliance on exports as development strategy assisted by government intervention, for example through an undervalued exchange rate, and combined with a curtailment of some forms of foreign financial capital. China, of course, was the exemplar par excellence of the export fetish model.
India fell somewhere in the middle, pursuing—or rather lapsing into—what I have called the Goldilocks globalization model. India was neither overly reliant on exports for its growth nor, despite the surge in foreign capital, did it become overly reliant, in some absolute sense, on foreign finance. The Goldilocks model meant that India escaped the whiplash from the crisis that would have been felt either because of the sudden withdrawal of foreign capital or the precipitous collapse of export demand.
Going forward, the question is whether India should persist with this model. Policymakers will respond in the affirmative. Its appeal is not just its moderation. Its appeal is also that its preservation seems to require no new policy decisions. The thinking would run as follows: we followed the middle path, avoiding the extremes. It served us reasonably well. Let us continue with it, especially because inertia and inaction will guarantee continuation.
But here's the key point that policymakers must internalize: indecision will not preserve the Goldilocks globalization strategy. Indecision will instead lead India surely and steadily to the foreign finance fetish model, to a situation where inflows of foreign capital rise continuously over time. Two factors explain this prediction.
The first relates to the natural forces of economic convergence. As India grows more rapidly than the rest of the world, and with policy barriers already attenuated, India, for the foreseeable future, will be a haven for footloose foreign capital seeking the highest returns. That is inevitable.
The second factor is more subtle, and relates to domestic political economy, which will continue to favor further opening up to capital. The parallel with trade protection is instructive. Societies are predisposed toward protectionism because of the imbalance in its impact. The costs of import restrictions—higher prices—are diffused over many consumers while their benefits are concentrated in the hands of a few producers. Concentrated interests have more at stake and are, therefore, able to mobilize easily whereas collective action is more difficult for the consumers.
Something similar applies to foreign capital. The benefits of foreign capital often accrue to domestic firms and producers in the form of lower borrowing costs. And where domestic financial systems are inefficient, as they are in India, access to foreign capital is particularly valuable. So the benefits are concentrated. Moreover, these benefits are frontloaded: firms see immediately the lowering of the costs of borrowing. The potential costs, on the other hand, happen in some distant future because financial crises—one of the costs of excessive foreign borrowing—occur, if they do, only after a certain period of overreliance on foreign capital.
The other cost of foreign borrowing is its tendency to drive up the exchange rate and make a country's exports less competitive. In principle, therefore, if exporting interests are strong and a country follows a flexible exchange rate, this political economy imbalance in favor of opening up to foreign capital can be rectified. Flexibility leads foreign capital flows to put upward pressure on the currency, jeopardizing the profit margins of exporters, who can mobilize to complain about the outcome.
In practice, the mobilization of exporting interests will be impeded by the fact that RBI will not follow a pure float. By dampening and smoothing upward pressures on the currency, RBI will reduce the incentives for exporters to lobby against capital opening. The experience of the years leading up to the crisis, when capital flows surged, suggests that the finance lobby will tend to prevail over the export lobby.
It is possible that embracing foreign capital—and in copious amounts—is what policymakers really want or believe is in India's interest. If that is so, they should make that clear. However, they cannot claim that they are for the current middle path on globalization and believe that policy inertia will keep India on this path: they will have to resist the natural forces of economic convergence and battle against domestic political forces that will inevitably take India toward the foreign finance fetish strategy. Policy activism, especially in relation to the capital account, will be required to maintain the status quo of Goldilocks globalization.
What that policy activism must be—rather than whether RBI should tighten monetary policy—should be the object of coordination between the central bank and Delhi.
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Policy Brief 09-15: India-Pakistan Trade: A Roadmap for Enhancing Economic Relations July 2009
Working Paper 09-11: The Impact of the Financial Crisis on Emerging Asia November 2009
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Speech: Some Perspectives on the Indian Economy October 17, 2007