The last few weeks have been turbulent for global equity and currency markets, with the mild liberalisation of the exchange regime for the Chinese yuan provoking knock-on effects in currencies of most other large emerging markets, including the rupee. These most recent developments follow upon longer-running downward adjustments in dollar-denominated prices of both fuels and metals and a disappointing start to the year for real global economic growth (measured at purchasing power parity). World trade growth remains sluggish, and indicators of headline inflation almost everywhere are well below the levels targeted by central banks.
Despite this rather sombre global picture, both the US Federal Reserve and the Bank of England are telegraphing their intention to raise interest rates in the not too distant future. The global economy seems to be at some kind of a point of inflection in the long, slow grind after the recession of 2008. Harder to discern is just what kind of point of inflection, and what that implies for India's policy response.
The difficulty arises in part from competing narratives on the policy responses that have shaped the world economy in the seven years since the crisis, particularly in the major advanced economies. These primarily comprise the US, the euro zone, Britain and Japan. In slow motion each central bank in turn has embraced policies of quantitative easing (QE), starting with the US relatively early in the recession, followed in turn by the UK, Japan and most recently the European Central Bank (ECB).
Supporters of such unorthodox policies (I am one) justify their actions by appealing to the so-called zero lower bound: the impossibility of reducing real interest rates to market-clearing levels in a deflationary environment. Critics of these policies (and I think RBI Governor Raghuram Rajan is among their number) point to the longer-term ineffectiveness of these measures, the longer-term collateral damage that they can cause, and the difficulties of exit.
In many ways these disagreements echo the different perspectives of Maynard Keynes and Friedrich Hayek on responses to the Great Depression 70 years ago, the one pointing to insufficient aggregate demand as the root cause, the other pointing to poor allocation of capital in the credit boom before the bust (what Hayek called "mal-investment"). Keynesianism has had its most fervent supporters in the Anglo-Saxon world, which is why the US led and the UK quickly followed. Its greatest sceptics have traditionally been the Germans, explaining the much slower and indeed reluctant actions by the ECB.
The relevance of these debates in the current context is well captured in a recent article by Martin Feldstein of Harvard University1. His opening paragraph is uncompromising, where he asserts, "The unfolding stock-market collapse [he is referring here to the US]... is the inevitable result of the Federal Reserve's policies, namely quantitative easing that produced abnormally low interest rates. The decline on Wall Street has spread to every stock market on the globe, many of which were also weakened by their policies of excessively easy money." In support of this view, he points out that the efficacy of QE was always predicated on driving investors to riskier assets in the search for yield. The rise in asset prices in turn raised household consumption through the so-called "wealth effect". The numbers cited in the article are impressive: the net worth of US households rose by $10 trillion in 2013, pushing valuations of US equities to historically high levels.
It is this apparent mispricing of financial assets that threatens to unravel further as the Fed seeks to move to more conventional policy settings. What is unknowable is whether the household sector is now strong enough to bear this unraveling, but Prof Feldstein at least believes that this uncertainty is no reason to postpone interest rate normalisation; for to do so would be to incur other risks, including the return of inflation.
This is of course only one view. Others, such as Alan Blinder of Princeton, a former vice-chairman of the Federal Reserve, also writing in the WSJ, have dismissed the frenzied speculation on when the Fed will begin tightening as largely inconsequential, given the very shallow glide path of policy interest rates increases that is likely to follow.
For his part, over the past year Governor Rajan has warned of the need for the Fed to be sensitive to the impact on emerging markets of its moves to normalise policy. While his warnings fell on deaf ears at the start, it is noteworthy that both the IMF and Professor Larry Summers of Harvard, an experienced and influential voice from the liberal end of the policy spectrum are both now urging the Fed to err on the side of caution.
I have focused thus far on the Fed rather than on China since the Fed sets the tone for global finance. For this reason much of the commentary linking the stock market correction in China to a deep-seated crisis in the Chinese economy could well be overdrawn, even if the reaction of the authorities has been somewhat ham-handed and counter-productive. The single most important development in global finance over the past year is arguably the appreciation of the US dollar, itself a reflection of the different stance of monetary policy across the major economies.
What does all this imply for India? First, we should see the recent move in the Chinese yuan for what it is: a belated imitation of the transition that India itself went through in the 1992-93 period, when we moved from a fixed to a managed float. Unpegging the yuan from the dollar will undoubtedly cause some difficulties for Hong Kong, but is surely justified given the scale of the Chinese economy and financial system.
Second, our own nominal exchange rate should continue to be determined as a byproduct of domestic monetary policy rather than being a policy target in its own right. This is what is implied by an inflation-targeting framework even if the implementation is less than pure in the attempt to boost the stock of reserves.
Third, as a net importer from China not linked closely in Chinese supply chains, India stands to benefit from terms of trade improvements from cheaper Chinese imports more than it loses through a slowing of Chinese-manufactured exports.
Finally, and less remarked, our immediate South Asian neighbours are doing rather well and constitute a natural market at our doorstep. So Governor Rajan is right: we are in a relatively good place, and need to concentrate on our own agenda, rather than being deterred or dismayed by noise from the equity markets.
The writer is chief economist, Royal Dutch Shell. Views are personal
1 The Fed's Stock-Price Correction. The Wall Street Journal, Aug 24,'15