Jaimini Bhagwati: Uncertain economic outcomes and humility
Jaimini Bhagwati / New Delhi May 16, 2008, 4:38 IST
Let us not overstate the importance of inflation targeting in ensuring high growth.
The Committee on Financial Sector Reforms (CFSR), set up by the Planning Commission, made its report available in April 2008, and earlier in February 2007 the Mumbai International Financial Centre (MIFC) report was submitted to the Ministry of Finance. Conventional wisdom is that financial sector reforms should follow or supplement real sector reforms. As we all know, many real sector reforms remain to be implemented, e.g. administered price anomalies in hydrocarbons, agriculture, labour, power and real estate. I guess there is no harm in reflecting yet again on those financial sector reforms which can be advanced even as higher priority real sector reforms remain stalled.
GOVERNMENT YIELD CURVES, EXCHANGE RATES, INFLATION
1991
1996
2001
2006
2008
India
3 month
-
-
-
5.57
7.25
5 year
-
-
9.01
7.05
7.93
10 year
-
-
10.14
7.48
7.92
Inflation
-
-
4.87
4.06
7.41
USA
3 month
5.62
-
3.89
4.81
1.51
5 year
7.57
6.57
4.87
4.97
3.08
10 year
7.44
6.86
5.29
5.11
3.77
Inflation
-
-
2.90
3.40
4.00
Japan
3 month
7.93
1.29
0.02
0.06
0.59
5 year
7.06
2.40
0.54
1.34
1.16
10 year
6.60
3.47
1.38
1.93
1.65
Inflation
-
-
-0.70
-0.20
1.20
Exchange
INR-US$
20.07
34.52
46.83
45.00
40.59
Rates
Yen-US$
137.4
104.8
123.53
114.16
104.14
Interest rates and Exchange rates: As of 2 May each year Inflation: As of March each year; WPI for India, CPI for Japan and the US Source: Bloomberg
To recapitulate, the MIFC report's recommendations which are of continuing relevance include: establishing a liquid, arbitrage-free sovereign Indian rupee (INR) yield curve; enabling exchange-traded currency and interest rate derivatives; and building up corporate bond markets. These suggestions are echoed in the CFSR report. The MIFC report also makes particularly useful recommendations on financial sector tax policies. In contrast to the MIFC report, the CFSR report is correctly circumspect about rushing towards capital account convertibility. In addition, the CFSR report's recommendations on financial inclusion, freedom to set up new branches, consolidated membership on stock exchanges, allowing FDI in asset reconstruction companies, warehouse receipts and the need to bring cooperative banks under the RBI's regulatory supervision are timely and important.
On the downside, the seriousness of the CFSR report's recommendations is diluted by gratuitous homilies, e.g. the wrong lesson for India to draw from current difficulties in the US financial sector is that competition does not work, because if that was true the "logical conclusion would be to adopt the economic system of North Korea". The ongoing US financial sector woes and related regulatory incompetence are dismissed too casually. The CFSR report remarks breezily that the "US equity markets have done better than Indian stock markets in recent months". Equity market performance is usually evaluated over a longer period of time. On May 8, 1998, the Dow Jones was at 9,055 and the Sensex at 4,022 and a decade later on May 9, 2008, these two equity indices were at 12,746 and 16,737, i.e. a gain of about 40% and 316% for listed stocks in the US and India, respectively.
The MIFC and CFSR reports focus almost exclusively on capital markets and the banking sector and do not adequately address the lack of development of the Indian insurance and pensions sectors. More broadly, the CFSR report does not discuss the implications of a tottering international financial power structure, set up post the Second World War, which is just not working for Asian countries.
In the last few months, sharp differences of opinion have emerged about measures that are needed to limit inflation in India. The MIFC and CFSR reports suggest that the RBI's only objective should be to contain inflation. On this count, a majority of OECD central banks have not formally adopted inflation targeting. In any case, perceptions of systemic risks result in coordinated action by central banks and governments, whether it is the Bank of England's rescue of Northern Rock or the US Federal Reserve guaranteeing mortgage securities it had not valued to help in the takeover of Bear Stearns.
Mark Tully observes in his book India: An Unending Journey that an important Indian philosophical insight is that there are no definitive answers to existential questions. In the same book Tully also mentions that India has taught him humility. It was amusing that in the context of the lack of anticipatory action by regulatory authorities to address the turmoil in international credit markets and global inflation, the RBI Governor remarked on April 29, 2008, that "central bankers will need a lot of humility to think of future challenges". More seriously, the excessive certainty with which some economists pronounce on macroeconomic drivers and corresponding outcomes is surely misplaced.
The MIFC and CFSR reports state that the Indian capital account is largely convertible and, consequently, the RBI's current rupee exchange rate policies are counterproductive. The suggestion that the rupee should be allowed to appreciate further is based on an understanding that negatives related to inflation outweigh positives such as maintenance of export growth and employment generation. Rupee, Japanese yen (JPY) and US$ nominal government interest rates, exchange rates and inflation numbers for select years between 1991 and 2008 are shown in the table. INR interest rates have been uniformly higher than US interest rates and if the Indian capital account is de facto convertible the rupee should have continued to depreciate against the dollar. However, it can be seen from the table that interest rate parity did not hold even for the two convertible currencies, namely JPY and the dollar. For instance, over the period 1996-2008, JPY should have appreciated consistently against the dollar but it ended at about the same level. These were the heyday of yen "carry" deals when hedge funds were confident that a Japan worried about deflation and low growth would not allow its currency to appreciate. Isn't it presumptuous to dismiss the exchange rate policies of Japan and China as completely misguided?
It is current orthodoxy that there is no trade-off in the medium to long term between low inflation and high growth. However, it is accepted that there could be a conflict between these two objectives in the short term. Consequently, if the RBI and the Ministry of Finance are responsible for restricting inflation and promoting growth, respectively, and act independently of each other they could be working at cross-purposes. Let us not overstate the importance of inflation targeting or central bank autonomy in ensuring high growth.
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