Inflation Is Not A Uni-Dimensional Phenomenon

Q: What is the purpose of your visit to India, especially since the World Economic Outlook was released a fortnight ago?

A: It is to enhance peoples understanding of the Funds broader work on the international monetary system. There is considerable understanding in India about the Funds role in advising individual countries that are undertaking fundamental economic reforms. There was a particular purpose to come on this occasion because this report is devoted to a thorough assessment of the forces of globalisation. What we have done in this report is to assess the consequences for developing countries and advanced economies. We are also using the visit to tell people how the IMF is adapting to this phenomenon of rapidly increasing global integration of capital markets in particular.

 

Q: In your presentation, you said inflation no longer necessarily manifests itself in the consumer price index. Could you elaborate?

A: It is a new concept and something we have been observing in the late eighties in some of the advanced economies following the liberalisation of financial markets. It is also probably a result of an increase in competition in trade and goods markets. This makes it more difficult for producers and retailers to bid up prices when demand begins to rise during the up phase in business cycles.

Instead, what we have seen in several countries is that a substantial increase in asset prices as much as liquidity in the economy has been directed to the stock market and real estate sector. These price booms were eventually followed by significant price adjustments which had severe implications for the financial system in these countries. Because when the banks have been engaged in financing a build-up of pressure in real estate sectors and if prices fall, then the worth of the collateral would be less than the outstanding loans. These have been major factors contributing to the severe recession in Japan and the Scandinavian countries. This is something we need to be looking out for in the future.

Q: What does this trend mean for policy? Also, has this trend replicated itself in developing countries?

A: We are certainly observing this phenomenon in developing countries, not least in Asia, where in several countries there has been a rapid build up in the property market. Without mentioning specific countries we believe there may have been overbuilding in some countries. And we are beginning to see price corrections that are raising questions about the effect this is going to have on the financial sectors.

Hence, monetary policy will need to look not only at CPI or whatever is the usual inflation measure but also take a broad look at what is happening in the economy, and there may well be circumstances in which rapid expansions in the property market or very rapid increase in stock prices may be an indication of overheating pressures and may warrant pre-emptive adjustments in policy, even though the CPI may not have begun to pick up.

Traditional policy responses to inflation management, therefore, need to be more sophisticated and pragmatic because we never know where precisely the inflation problem is going to pop up.

Q: Are there any academic origins to this school of thought?

A: Oh yes. This goes back a long way. The first economist who had talked about the problem based on a very concrete episode of the late depression of the 1930s was Irving Fischer. For a long time it was not discussed as it was not a major problem. But developments in the 1980s and early 1990s in many countries have forced us to go back and study these early experiences. In fact, that is the experience of today and we need to take it seriously. We have to accept that inflation is not a uni-dimensional phenomenon.

Q: Have you observed the Indian economy in this context, because we have had subdued trends in inflation in the past one year and at the same time there has been a tremendous build-up of liquidity prompted by large foreign capital inflows?

A: I dont wish to comment on the Indian economy in particular. This is a general issue that is relevant to many countries and needs to be taken into account in setting out policies.

Q: Is the IMF advising developing countries like India, which are facing a deluge of foreign capital inflows?

A: We have done a number of studies including one in the context of the World Economic Outlook. We have sought to emphasise the context in which the capital inflows are taking place and the context may have a bearing on the policy approach. We are particularly concerned about the possibility that capital inflows may become a substitute for domestic saving. And here, I am not talking particularly about India, but in general, as it applies to many countries. If it becomes a substitute for domestic savings and results in a large deficit on the current account of balance of payments, one should not necessarily assume that because a capital inflow may appear sustainable today that it is also going to be sustainable in the future. So we are cautioning countries against complacency in the face of large capital inflows that are apparently financing with ease the large current account deficit. Sooner or later, market sentiments will undergo a change and there would be a quick turnaround, like we saw in the case of

Mexico. We are generally concerned about the large capital inflows.

Many of these countries are facing a situation with a policy mix biased in favour of a large fiscal deficit, which therefore necessitates a tight monetary policy. Here, the prescription is fairly straightforward because capital inflows provide an excellent opportunity to do something about the fiscal imbalances without being concerned about the fiscal tightening causing a slowdown in growth.

Q: How do you define large capital inflows?

A: When you are beginning to see capital inflows of such a magnitude that they are pushing a current account deficit to 3-4 per cent of GDP, then it is a matter of concern. It is difficult to specify a level, but a current account deficit of over 4 per cent of GDP necessitates caution.

Q: Is sterilisation of these foreign inflows sustainable?

A: Sterilisation needs to be part of the overall set of instruments that a country would choose. But it is clear that this is difficult in many developing countries since the financial system is not as developed as industrial countries. This puts a limit on the ability to sterilise effectively. If the capital inflows do take place in the context of a policy mix that has this bias towards large fiscal deficits and therefore high interest rates, it would not be enough to sterilise. There one has to tackle the root of the problem, which is the policy mix.

Q: What does the pick-up in global trade posited in the World Economic Outlook augur for developing countries?

A: Just as the outlook for trade is strong, we have to be prepared for a tightening of world financial conditions. You have already seen appropriate necessary steps to preempt inflationary pressures in the early stages in the United States and United Kingdom. And as recoveries are gaining momentum, we expect and hope there would be more demand in Japan and continental Europe. It would require lots of resources to finance investment and consumption requirements in these countries. And hence it would be prudent to assume that both the terms and overall levels of capital flows from the developed countries to the emerging markets will become a bit less generous in 1997 and 1998. That is, capital flows would be smaller and interest spreads would be a bit more. Some countries may feel this development more than others. It would depend to some extent on their policies and attractiveness to foreign investors.

It would be prudent to assume that both the terms and overall levels of capital flows from the developed countries to the emerging markets will become a bit less generous in 1997-98.