Sagar Koparkar and Manas Paul

IGIDR, Mumbai, 400 065

As India becomes more and more of an open economy with a steady rise in the share of GDP originating in the traded good sector and her financial markets get more and more integrated with financial markets worldwide, it becomes necessary to understand the implications of such changes. There are implications both for traditional concerns such as the rates of inflation and growth, the distribution of income, the value of the rupee as well as for new areas of inquiry such as the state of the financial markets and links between financial and real sectors in an era of highly mobile capital.

IGIDR thought that it would be important to bring together researchers actively working on these ideas so that we could learn from each other. Such interactions would surely produce fresh insights into problems old and new as well as laying down some contours of a meaningful research agenda. With these objectives in mind we decided to host a Conference on Money and Finance in the Indian Economy.

The conference was inaugurated by Dr. C. Ranagarajan who also gave a keynote speech. The function was presided over by Dr. B. Jalan.

Dr. Rangarajan delivered a comprehensive talk on the controversial subject of monetary policy. Monetary targeting is controversial in the context of striking a balance between price stability and high growth rate. Empirical and theoretical literature says that in the long run, the objectives of price stability and growth do not necessarily conflict. In fact, price stability is a means to achieve sustained growth and avoid speculations in the investment decision. Price stability is also needed for exchange rate stability and for keeping nominal interest rates close to world levels.

Dr. Rangarajan warned that the effect of investment financing by money creation is significant only in the short run. In the long run, it can have adverse inflationary outcome. This could be worrisome as it would lead to deterioration in the current account deficit. Dr. Rangarajan stressed here the need to identify the level of inflation at which the adverse consequences really begin to set in.

In his view, money supply should be regulated keeping in view the expected increase in real output and the acceptable order of increase in prices. This is against narrow monetarism that money supply should grow at a certain fixed rate irrespective of the real rate of growth. Dr. Rangarajan made some remarks on targeting interest rate as practiced in most industrialized countries. Manipulation of interest rate in these countries does not have the objective of determining the level of interest rate but controlling prices. So interest rate could become an intermediate variable as inflation rate comes down and fluctuates in a narrow range. He also discussed the salient aspects of monetary policy during his tenure as RBI Governor.

Exchange Rates and Currency Crises

Sugata Marjit & Byasdeb Dasgupta in the paper "Exchange Rate and Exports from India- A Fresh look at the Official Statistics" tried to explain the phenomenon of immediate exports growth after liberalisation and its ultimate slowing down. They argued that the immediate increase in exports after the liberalisation process started more due to the increase in export declaration which was underinvoiced before, due to the presence of higher black market premium. In the paper "Towards a more rational IMF Quota Structure: A tentative partout in the direction of creating a new financial architecture" Raghbendra Jha and Mridul Saggar questioning the existing IMF quota formula, discussed the need to review it on the basis of giving due weights to the size of the economy along with the efficiency parameters. They suggest three alternative sets of formulas. The first was based on determinants of size variables and of the current account variables for international trade and payments; the second on formulas where macroeconomic stabilization parameters were introduced to capture member-country's relative positions in respect of lowering inflation and fiscal deficits; and the third set incorporated capital flow as an additional determinant. Their calculations show that India's rank can improve to 5^th from the present 13^th according to the 10^th and 11^th General Review of IMF Quotas. Partha Sen's paper " Non-uniqueness in the first generation balance of payments crisis models" showed that Krugman's (1979) model of a speculative attack is riddled with multiple equilibria i.e. the time of attack is not uniquely determined. A continuum of paths to a floating regime exist. The only difference across periods is the amount of foreign exchange reserves left with the Central Bank and hence the proportion of foreign exchange reserves that will back the money supply under a floating rate regime. How much reserves the Central Bank holds or is able to borrow is not germane to the issue of collapse (as long as the fixed exchange rate is expected to collapse eventually). The Central Bank may hold "large" stocks of reserves but not "enough" to maintain a fixed rate regime.

C.W.M. Naastepad, presented her paper "Trade-offs in Structural Adjustment: A CGE model with portfolio choice for India". This is a multi-period real-financial CGE model for India. The model goes beyond the extant literature by introducing credit for working capital as well as investment and allowing for credit rationing with real and financial market conditions being determined endogenously. The paper identifies two supply constraints: shortages of credit and of infrastructure affecting growth. In a theoretical set up, the paper " On Interest Rate Policies" by Romar Correa examined the relative merits of the stabilizing role of monetary policy in two cases. First, the monetary authority operates the discount window. Second, the central bank enters as a player with the interest rate on government paper as a strategy. The paper confirms evolutionary stability only in the second case. The paper entitled " An Econometric Model for India with emphasis on the Monetary Sector" by T. Palanivel and the Nobel laureate L.R. Klein had three objectives: first, to build a monetary sub-sector model for India; second, to estimate the model with pre and post reform data; and third to evaluate the impact of changes in trade, fiscal and monetary policies on output, inflation, trade flows, financial flows, structure of interest rates and exchange rate for the future period 1997-98 to 2001-2002.

FDI Flows and Exchange Rates

Manas Paul in his paper "Some findings on the issue of Real exchange Rate Targeting in India", studied the long run behavior of Indian real exchange rate in a cointigrating VAR framework over the period 1964 -94. The study showed the exogeneity of real exchange rate to any deviation from the long-run cointegrating relationship amongst real exchange rate and its fundamentals. This indicates the possibility of real exchange rate targeting. Endogeneity of government consumption to the cointegrating vector suggests that government consumption should not be used to attain internal and external balance concurrently. In the paper "Monetary Policy for Sustainable External Value of Rupee", B.M. Jani stressed the importance of RBI intervention in the foreign exchange market to maintain the real exchange rate at an appropriate level. C.S. Despande in his paper "The Role of Foreign Direct Investment in Indian Economy" discussed the relevance of Foreign Direct Investment for India.

E. Desouza in his paper "Financial Intermediation and Liberalisation under Asymmetric Information" discussed the importance of dealing with microeconomic problems associated with the institutional weakness of the financial system, prior to liberalisation of interest rates on government paper. Mahendra Pal in his paper " Financial Development in India: An empirical test of the Mckinnon-Shaw Model" utilising 2SLS and OLS techniques found statistically significant results in the support of McKinnon's complementarity hypothesis in India, using time series data for the period 1970-93. G.Darbha in his paper entitled "The Effects of Financial Constraints on Inventory Management", examined the sensitivity of inventory holding behavior of different type of firms to changes in internal finance over different phases of the business cycle. It shows that the cash flow effects are significant for smaller firms than for larger ones and the difference is more pronounced during the low growth phase.

The paper by K. Chaudhari, S. Chattoppadhyaya and S. Ashra entitled "Deficit, Money and Prices: The Indian Experience" found unidirectional causality from price to M3. Thus money is endogenous and prices are exogenous. The second paper was " On the Stability of Demand for Money in a Developing Economy: Some Empirical Issues" by B.K.Pradhan and A. Subramanian. The paper concludes that both narrow and broad measures of money exhibit long-run relationship with real income and rate of interest in India. Thus stabilization policy should aim at both broad and narrow money with a stable demand function, for bringing up price stability in the economy. The third paper" Does Money Supply in India follow a Mixed Portfolio-Loan Demand Model?" by D. Rath examined the endogeneity of money supply in India. The paper distinguishes amongst three competing models of the money supply process namely, pure portfolio approach, pure loan demand approach and mixed portfolio-loan demand approach for Indian economy. The author finds that in India the mixed portfolio-loan demand approach best describes the money supply process.

The paper " Monetary Transmission Mechanism: The Credit Channel Hypothesis Revisited" by H. Mukhopadhyaya, argued against conventional method of testing "credit channel" hypothesis. This paper diverges from the earlier work by considering only the credit-supply constrained firms. His study of Indian industry documented three major findings. First, bank credit does indeed influence inventory accumulations. Second, the size of external finance premium depends on the financial conditions of firms and third, bank dependent small industries suffer most during the period of quantitative credit control. The paper "Money, Credit and Exogeneity: A Multivariate Cointegration Approach" by S. Koparkar introduced credit for the first time in a money demand equation for India and examined the long run relationship between bank credit, money supply, foreign exchange reserves and industrial output over 1952-1996. Causality tests suggested that money is endogenous and thus monetary policy may be accommodative. The third paper entitled "Dynamics of Money, Output and Price Interaction: Some Indian Evidence" by S. Dutta Roy and G. Darbha modeled the dynamic interaction between money, output and prices in a structural vector auto regression framework. The study has two major findings. An increase in money/credit supply leads to increase in output and prices in the short run and only prices in the long run. A non-accommodative monetary policy is ineffective in controlling inflation even at the cost of substantial output losses.

The paper "The East Asian Crisis of 1997: The Role of Structural and Proximate Factors" by S. Gokarn tries to unify extant explanations of the East Asian crisis. The paper argues that the crisis can indeed be interpreted as a consequence of the growth strategy. The paper has linked up the proximate (or how) factors and structural (or why) factors associated with the crisis. The main lesson for India is the requirement of rapid development of asset markets with new financial instruments allowing the banks to hedge their portfolios. The second paper " East Asian Crisis: Lessons for Indian Banking" by P. Mitra discussed the East Asian Crisis more as banking crisis and less as currency crisis.

The paper " Real and Financial Sector Interaction under Liberalization in an Open Developing Economy " by A. Goyal and S. Dash showed that a passive monetary stance would lead to a monetary tightening and rise in interest rates. The rate of inflation may fall, but there could be large fluctuation in interest rates and equity returns, which can harm the output in medium term. The paper " The Status of NBFCs in India" by B. Gayathri argued that healthy and growing Non-Banking Financial (NBF) sector is necessary for promoting the growth of an efficient and competitive economy provided NBFCs improve degree of financial intermediation. The paper " Integration and Price Discovery in Indian Stock Markets" by R. Jha, C. Krishnamurthy and H. Nagarajan examined price discovery and integration of the various stock markets in India. Their results indicate that markets are integrated in the long run, thus regional stock exchanges should be promoted in a national interest of wide spread trading. The authors have recommended better information dissemination between markets to avoid arbitrage, strengthening competition in securities to reduce fears of price rigging, trading of medium size stocks on regional stock exchange with centralized order booking. Also strengthening of interaction between stock exchanges with sharing of order flow might have the benefit of widening and deepening the market.

M. Thiripalraju & T.P. Madhusoodanan in their paper "Commodity Futures prices in India: Evidence on Forecast Power, Price Formation and Inter-Market Feedback" found the efficiency of price formation in the Indian commodity futures markets of Pepper and Castorseeds. T. Waghmare in his paper " Volatility in Indian Stock Markets: A Study of Badla and Short Sales Restrictions" discussed the effectiveness of banning short sales and badla transactions by the Indian regulatory authorities, on destabilizing volatility on the Bombay Stock Exchange. He found that though the ban on short sales did prove effective in reducing volatility due to "noise", the same was not true in the case of Badla transactions. Ajay Shah in his paper "Improved methods for obtaining information from distributed dealer markets" offered a market microstructure interpretation of the information obtained by polling dealers and proposed improvements for many elements of the polling process. The paper offers empirical evidence based on polling in India's call money market, about this tradeoff. The paper "Natural experiments with price limits, Ajay Shah, Susan Thomas and G. Darbha studied a set of natural experiments where price limits were changed on India's National Stock Exchange (NSE). Their result suggested that a combination of liquidity and volatility influence the impact of price limits upon prices.

Each paper was the subject of intense discussions, both by a formal discussant and from the floor. The participants and audience came away with the conviction that considerable and exciting work on money and finance is being done in Indian universities/institutes. A conference such as this by bringing together some of these people have surely led to considerable cross fertilization of ideas. During the valedictory session, it was felt that money and finance conference should become a regular feature at IGIDR and that IGIDR has established itself at the forefront of research in monetary economics in India.