Subir Gokarn: Questions of interest

A number of factors can contribute to mitigating the inflationary pressure as well as balance of payments concerns.

My last column (Macro Manoeuvrings, June 5) recommended that the Reserve Bank of India (RBI) not raise interest rates in response to the stock market and exchange rate turbulence. Of course, three days later, rates were raised, in step with the actions of central banks around the world. The US Federal Reserve is expected to raise rates in end-June and the RBI is expected to raise its benchmark rates again in its quarterly announcement in end-July.

Going beyond the immediate to a somewhat longer-term view, it is clear that the global economy is rapidly entering an environment that has not been seen for over two decades. Whether the lessons learnt during that period are entirely relevant or not is, of course, a debatable proposition. Some things never change, of course, but the world economy is a very different animal from what it was at the time of the second oil shock in the late 1970s and early 1980s.

The most fundamental difference is the huge increase in the level of integration, both across sectors and across countries. Barriers to merchandise trade have dropped dramatically. Services have become significantly more tradable. And, capital mobility has unified most of the world's capital markets. These processes have collectively strengthened the global economy's capacity to absorb shocks, such as the one we are experiencing these days. This is obviously reflected in the persistence of growth over the last couple of years, despite historically high oil prices.

But, as we have seen over these last few weeks, integration has also changed the nature of risk. The more closely linked countries are, the faster is the transmission of shocks across them. In the current situation, accelerating inflation is clearly the most visible global threat. So far, the efficiencies inherent in expanding global supply chains have apparently moderated the inflationary consequences of rising oil prices. But, once those have been exhausted, higher integration will inevitably reinforce inflationary tendencies across the globe.

Textbook monetary economics suggests that if the inflationary shock is global, the best response is a global contraction of liquidity. If the US Federal Reserve is going to increase rates, then the optimal response for all other central banks, particularly those in economies which receive large capital flows from the US, is to do the same. Failure to do this, the textbook indicates, would lead to surging capital outflows and a resultant depreciation of the local currency.

The Mexican and East Asian currency crises in 1994 and 1997, respectively, though not really the outcomes of global developments, demonstrated the impossibility of maintaining monetary control in an environment of integrated capital markets. These have made central bankers naturally wary of following an independent course, driven by domestic priorities.

In a somewhat ironic turn of the wheel, the conduct of monetary policy around the world today has come to resemble the Bretton Woods system of fixed exchange rates and full co-ordination that prevailed between 1944 and 1971, when it was abandoned. But, as the Europeans have demonstrated, greater economic integration makes the case for co-ordinated monetary policy (of which a common currency is the extreme case) stronger. Since Asia as a whole is highly integrated with the US economy, this argument would justify the convergence and alignment of interest rate movements between Asian economies and the US.

However, as significant as the integration process has been for the world as a whole, and for India specifically, it is far from complete. As I argued in my column before last ("Global Threats, Domestic Buffers," May 22), the unique strength of economies like India and China is that they are able to offset the risks of increasing global integration with the scale and power of domestic factors, which are relatively independent of the global environment. It is for the central bank to find a balance between the compulsion of global monetary alignment and the objective of finding the most favourable growth-inflation scenario in the domestic economy. It is from this perspective that I have some reservations about raising domestic interest rates.

What impact will this have beyond the immediate time frame? A primary objective of the move is to contain the damage to the balance of payments that sudden and large capital outflows can cause. Substantial rupee depreciation will immediately cause an increase in the rupee costs of oil imports, aggravating the inflationary problem (or the other macroeconomic consequences of failure to pass the higher prices on to consumers). Indian companies which have borrowed abroad will see the rupee values of their debt increase along with the costs of servicing it.

Higher interest rates, by slowing down growth down a bit, will ease the demand for imports (including oil) and, through this, the domestic demand for foreign exchange. In other words, if recent levels of capital inflow cannot be relied on to sustain, balance of payments problems can be avoided by reducing the current account deficit. This may well work, but at the cost of growth.

The alternative is to bank on sustaining current rates of growth to increase capital inflow, which, after the turbulence has settled, will go back to their routine search for the highest returns worldwide. The faster our growth rate, the more inflow we will attract; balance of payments concerns will be addressed as the inflow increases. The risk, of course, is that inflation will accelerate beyond the 5-6 per cent range, which currently appears to be the limit of the RBI's tolerance. How serious is this risk?

Obviously, not negligible, but, a number of factors can contribute to mitigating the inflationary pressure as well as balance of payments concerns. One, stabilising (high, but not increasing much more) energy prices combined with continuing increases in efficiency will ease pressure on producers to reduce prices. Two, the cumulative impact of previous interest rate increases, combined with an expected moderation in world growth, will in any case cause some deceleration in the domestic economy. Three, remittances into India are likely to benefit from the oil-driven boom as Indian workers rush to take advantage of increased opportunities in oil-exporting countries.

All these arguments are, of course, subject to hard scrutiny and validation. The simple point is that it is incumbent upon policymakers to aim for the best possible growth-inflation outcome even under the current circumstances. It is not obvious, at least to me, that this will be attained with persistent increases in the interest rate, as consistent with the global pattern as this might be.

The author is chief economist, Crisil. The views here are personal