REAL AND NOMINAL PRICES

Populous developing East Asian countries moderated food inflation and focused on raising agricultural productivity as long as food budget shares were high.

Prices were allowed to rise only after food budget shares fell; prices could now rise without pressure on wages and inflation. Governments could turn from taxing to subsidising agriculture as population in agriculture shrank.

India moved to subsidising agriculture, together with implicit taxes from restrictions, when food budget shares were still high.

But raising nominal farm prices does not guarantee favourable terms of trade, as nominal wages, industrial prices and input costs also rise with lags.

Since income elasticity of demand for food is still high, a more moderate nominal price increase gives better agricultural output and income growth, as in the eighties. Stable prices may actually provide better incentives for farmers.

SOLUTIONS

If the procurement price becomes a true support price, food stocks would reduce in a bad agricultural season when market prices rise, and rise as market prices fall in a good year. Farmers would get some assured income support, even as more genuine liberalisation and better infrastructure allowed them to diversify crops.

With lower average stocks held, the PDS should focus on remote areas. Food coupons or cash transfers to women can provide food security to the poor while allowing them to diversify their food basket.

Offtake is poor since they are doing this already. Foodgrains, for which the elaborate food policy structure is designed, now account for only 25 per cent of agricultural output. Thorough supply-side reform is required.

Political jostling focuses on the short-term, ignoring negative long-term effects. Poor coordination means multiple agencies do not factor in each other's costs, or consider the big picture. Since border prices act as a trigger for these multiple interest groups, a change in the nominal exchange rate can abort the whole process. It affects many agricultural prices, apart from foodgrains, making this a useful response to temporary external or internal price shocks in an open economy. 

As FX markets deepen, more than new instruments, incentives from two-way movement are most essential to induce hedging, or the laying off of currency exposure. Otherwise players try to gain from bets on one-way movement and therefore intensify it. But the moderate two-way movement within an implicit 5 percent band seen over 2004-06 was not sufficient to overcome strong expectations of medium term appreciation given India’s high growth rate. In 2007, market expectations of the Rupee-USD rate had even reached 32. Many corporates borrowed abroad based on such expectations, increasing currency risk. An occasional ten percent variation in the nominal exchange rate makes such speculation risky. But excessive volatility attracts more speculators, so limiting volatility within a ten percent range would discourage speculation and induce hedging. The impact of the exchange rate on profits and on financial volatility would be reduced.

The current depreciation has the advantage of moderating expectations of sustained medium-term appreciation, and is a useful reminder of the folly of building up positions based on such expectations. Since the September intensification of the financial crisis has contracted demand, depreciation is now a valid part of a policy demand boost that should include softening of interest rates. Appreciation is no longer required as world commodity prices have fallen. Too steep depreciation, however, has to be avoided since it can lead to a loss of confidence in the currency, and spark a currency crisis. India has the reserves to prevent such depreciation. Beyond the immediate crisis, maintaining decent growth is the best way to attract stable inflows.

Will the financial crisis derail India's real economy?

Curbing ECBs was the logical consequence of the policies followed over the past few months. The interest differential compared to international rates has widened, but no market guidance has been provided on the exchange rate. Despite sharp appreciation, high output growth and the weak dollar has led to expectations of continuing future appreciation, bringing in arbitraging inflows. Restrictions on banks restrain their arbitrage, but firms have naturally exploited the freedoms given to them. The first best policy response is to address the basic cause. Re-imposing controls is a second best response that has efficiency costs.

Gradual tightening started in 2003 itself, with the rise in growth. But the raising of repo rates to 7 percent and above in the latter half of 2006, given that the federal fund rate did not rise above 5.25, was too much and provoked large inflows and rapid reserve accumulation. The RBI then had to keep raising the CRR to check the liquidity its own policies had brought in. This disrupted the smooth functioning of money markets achieved earlier with the liquidity adjustment facility. The rise in interest rates was said to be required in response to inflation, but since this was driven by commodity prices—wheat, oil—interest rates were not of much help, apart from anchoring expectations. The exchange rate appreciation did help, but is only a temporary solution since higher domestic inflation itself appreciates the real exchange rate. The long-term solution requires a more efficient supply response, which higher interest rates impede.

An investment boom has driven manufacturing growth in the recent period. This was impervious to rising interest rates since firms were cash rich and able to raise low interest rate loans abroad. But such growth is susceptible to sentiment, to booms and to crashes. As capacity begins to come on stream industry requires consumer and export demand to sustain its growth. Consumer demand is more sensitive to interest rates. So far the slowdown in consumer durables and construction activity released resources for investment, without impacting the rate of growth. It also helped contain an incipient bubble in real estate. But bank credit growth has slowed and many indicators predict a slowdown. Financial markets are in turmoil worldwide. Even so, Indian growth is broad-based, coming from a number of sources, more immune to specific shocks. It is part of a structural catching-up process, not a cyclical phenomenon. Still policy must be forward-looking and support growth. Just as slow preemptive tightening was started with the beginning of higher growth, some relaxation and must begin now. Pre-emptive action reduces the output cost of adjustment, and smooth cycles.

Export firms have a choice, they can demonstrate hurt and lobby for rescue, or they can demonstrate strength, raise productivity and profits, then the rescue if it comes would be a bonus. Although large firms have restructured there is still a lot of slack in Indian systems. Tremendous productivity improvements are possible from systemic improvements—more experience and examples are available now on how to do this. Instead of copying Chinese cheap sweated labour policy, which has had tremendous costs in terms of environment degradation and inequality, we should aim for improvements in productivity.

But the rupee must remain competitive, so what happens to its nominal value depends on export outcomes. Aggregate export growth has not really slowed and our current account deficit is low since service exports and remittances, which are a return from manpower exports, are booming, so it is not clear that we have become uncompetitive. Even so, if inflation moderates, there will be some nominal depreciation, since two-way rupee movements help develop markets and reduce risk.

Yes, but cautiously and only if rates and other conditions are really good, and the funds productively used. Developing new markets and modalities of borrowing is part of the required deepening of government and corporate bond markets. It creates innovation that reduces spreads and lowers the cost of delivery of financial services.

The government is considering borrowing abroad in rupees. Emerging markets are said to suffer from original sin—no one is willing to lend to them in their own currency. The term was coined after many Latin American governments borrowed copiously in dollars, only to suffer an unbearable burden when their currencies depreciated. But those currencies and economies were fragile. Today the rupee is strong and sustained Indian growth is creating a class of borrowers willing to bet on its continuing strength, and absorb currency risk. If they offer lower interest rates, it is an opportunity to lower the cost of government borrowing. The interest rates should not, however, be factoring in an unacceptably high risk-premium.

But why does the government need to borrow at all and why does it need to borrow abroad? India requires huge infrastructure investment. Although domestic savings are high, government savings fall short of its investment targets. So it has to borrow, and as a borrower it should look for least cost-risk opportunities, even if they are abroad. India is now the World Bank’s largest borrower as State governments follow this strategy.

Since the rupee is not convertible, rupee sovereign loans will be only denominated in rupees, and there will be a net inflow of dollars. So why is the Government adding to inflows the RBI is struggling to sterilize? But this is the process of arbitrage that ensures domestic real interest rates cannot depart far from international rates. Monetary policy still has degrees of freedom to suit domestic needs, without relying on controls. Supply-side policies, including exchange rate appreciation, can help reduce inflation. Removing these arbitrage gaps is the best way to reduce losses such as the government borrowing abroad to add to reserves, which earn less than the original borrowing costs.  

The rupee is rising because of reduced intervention.  It has breached the implicit band within which markets had grown accustomed to see it. But there are advantages to allowing a temporary appreciation of the rupee, as long as a trend competitive rate is maintained. Random divergence from past behaviour helps inoculate markets against change, which is a constant now. Appreciation has occurred over the REER set15 yrs back, but there have been substantial improvements in productivity since then, which appreciation will further stimulate. Outcomes such as export growth are inputs in deciding current competitive rates. But in a phase where there are short-term capacity constraints, an appreciated rupee and lower interest rates will encourage the imports and investments required to release the capacity constraints. A temporary moderation in export growth to release capacity for domestic demand is justified.

Reducing inflation is another advantage of appreciation for the period that commodity prices and domestic inflation exceed comfort levels.  The lag with which the exchange rate affects domestic prices of imports such as foodgrain and petroleum are short. Shocks to these commodities account for a major share of current inflation.

ECBs are an example of capital inflows that occur if domestic interest rates exceed international rates plus expected appreciation. If our interest rates have to remain higher than international, an alternative to restricting ECBs is allowing temporary appreciation above trend. This is a third advantage. Since firms would then expect a future depreciation their incentive to borrow abroad is reduced despite the interest differential. As inflows fall pressures to raise interest rates further, as part of sterilization, also fall; interest differentials can narrow. Tighter ECBs restrictions have the disadvantage of reversing hard won freedoms for firms, and should be tried only if removing arbitrage gaps proves insufficient.

Developing markets to hedge currency risk is certainly desirable, but unpredictable two way movements in exchange rate are first necessary. These create inducements to eliminate exposure to future price movements. Otherwise markets and instruments also facilitate speculation or aiming to profit from a predicted one-way movement. Random exchange rate movements conditioned on external or monsoon related commodity shocks prevent such behaviour, while they moderate cost shocks. Moreover, they do not lead to opportunistic behaviour since the shocks cannot be influenced by internal actions. Agents are forced to acquire more complete insurance. This is the fourth advantage. When the demand is there markets begin to offer more hedging products.

Two-way positions in markets will allow regulatory restrictions, due to a fear of cumulative one-way movements, to be relaxed. In mature markets banks hedge currency risk and offer domestic currency loans to customers. But limited open positions and a protective regulatory stance may be preventing our banks from learning to swim with the waves. The inability of firms to borrow in domestic currency or unwillingness to hedge currency risk has been identified as a major cause of currency crises. Currently there are restrictions on hedging indirect currency exposure for non-banks, and on types of derivatives.

The strength of markets is the innovation in creating a variety of products that suit varied preferences. Customized forwards better suit the special features of the foreign exchange market where bilateral deals and private information dominate, compared to standardized futures. In theory hedging can be costless. An intermediary just has to bring together two parties with opposite currency exposures. Regulation should not restrict such innovation. The problem is the thin line between innovation and regulatory arbitrage. Independent consultants, who avoid conflicts of interest when the provider of the product is also the advisor on hedging strategies, can address regulatory concern about obscure or unnecessary products being sold. 

If the rupee does not appreciate above the competitive rate in the medium-term, the impact on Indian exports should be minimal, especially if they lay-off exposure to short-term fluctuations. The high profits of many exporting companies suggest they are doing well.

A number of issues need to be considered to decide on the policy stance. Let us consider these one by one. Wholesale price inflation is just below the RBI’s upper limit of 5.5, but shows signs of falling. The primary impetus has come from primary goods and fuel, which are regarded as volatile non-core components, not amenable to monetary tightening. Of course, prices of these two categories are not volatile in India, being subject to considerable administrative and political interference—domestic oil prices rise but rarely fall. But the interventions are outside the RBI’s purview. Since world oil prices have softened, pressures for a rise in domestic prices and inflationary expectations on this count are relieved.

The current account deficit has widened but remains manageable given bountiful reserves, and healthy export growth of 23 percent. Output and broad money growth have both exceeded the RBI’s projections. Growth in bank credit to the commercial sector has fallen below its earlier thirty plus rate of growth, but remains robust. A steep, sudden rise in credit makes the financial sector vulnerable, but our credit GDP ratio is low compared to other countries. It can be brought up, but in a sustainable way. Good corporate results have driven up stock price indices again. The rupee is showing two-way movement. Markets seem robust, having taken fluctuations in their stride.

Is the economy overheating? Does a nine percent plus rate of growth exceed the current potential, requiring a countercyclical tightening of interest rates? When there is uncertainty regarding potential output it is not helpful to follow quantitative targets on money or credit. It is better to infer the existence of excess demand from outcomes such as inflation. It is also not wise to make large changes—marginal adjustments affect market expectations and deliver results, while allowing learning to take place.

An emerging market has to be very careful about potential volatility in capital flows. Therefore a good rule of thumb is to respect arbitrage, keeping domestic interest rates aligned to international. The US Fed seems to have come to the end of its rate rising cycle having kept the Federal Fund Rate unchanged at 5.25 percent in the last three meetings. Our comparative call money rates are in the range of 5.7-6.75, while core inflation rates are similar. We are close but the appreciating rupee and falling risk premiums give us some leeway. The BIS points out that risk premiums on EMEs have fallen. BIS has even gone so far as to warn against a sharp rise in interest rates, which can be dangerous in highly leveraged financial systems. Debt-equity ratios tend to be higher in emerging markets, making the latter even more vulnerable. Indirect evidence that our interest differential is high enough to encourage arbitrage comes from the rise in NRI deposits and short-term external debt, over the past year, at 9 and 26 percent respectively. Firms are again finding it worthwhile to borrow abroad.

Moreover, monetary policy works with a lag. The past successive rise in reverse repo rates have led to a rise in some interest rates, and seem to have already slowed credit growth. Given the fall in world oil prices and stagnation in world interest rates, the lagged effects of the cumulative rise in reverse repo rates since 2005 would be a sufficient restraint on demand. Some risk of inflation, overheating, and asset bubbles remains so that a softening is not indicated, but neither is a tightening. Stagnating government security rates suggest markets do not expect a rise.    

It is sometimes argued that low interest rates do not reflect the high cost of capital for a capital scarce developing country. But capital mobility in an open economy means capital is not scarce anymore—perhaps enterprise still is; interest rates near world rates are one means of encouraging the latter. Monetary authorities would do well to wait and watch.

The economy has reached a critical mass; it is less vulnerable to shocks as reforms and openness have created diverse options. Feasibility is in doubt if 9% is an exceptional growth rate, but not if it approximates a new trend. Does nine percent reflect a transient boom or a trend? 

Growth in population or innovation limits growth in a mature economy. But labour surplus emerging markets have grown rapidly during catch-up. China is a recent example. The growth is not inevitable—there are preconditions. Potential bottlenecks have to be removed. Over the last ten years China has invested massively in infrastructure. Higher plan allocations required are possible despite the FRBM because savings available, both domestic and foreign, are rising. Investment is driving savings, bringing in resources. Household savings ratios rise in periods of rapid growth. Public savings have also risen after a long time; there is a healthy 40 percent growth in tax revenues. High growth-low interest rates are a painless way to reduce deficit ratios. Unlike the cycle of the mid-90s, which coincided with and drove the boom in a shallow economy, private investment is now taking place well into the boom. Yet since firms are cash rich, growth in borrowing has not reached the mid-nineties peak. Public-private partnerships and innovative financing is required to leverage the resources available within the FRBM Act.

Falling interest rates and rising infrastructure expenditure helped boost growth; the flattening of US interest rates, and moderation of world oil prices, will help restrain Indian interest rates. Inflation remains low despite recent spurts in oil prices, pointing to productivity and competitive gains that can only strengthen.

The required growth in agriculture has to come from higher productivity—the share of agriculture itself has to shrink as labour migrates to jobs expanding elsewhere. Therefore removal of rigidities that thwart mobility of resources, marketing reforms and improved infrastructure are required to allow the flowering, in agriculture also, of the individual initiative responsible for the boom in industry. There are signs that the latter is beginning to absorb labour. The economic census shows a steady rise in employment over the past few years. Design elements of the National Rural Employment Guarantee Scheme (NREGS) must be improved to ensure it creates durable assets. But governance and delivery has to improve in all government schemes. FRBM alone is insufficient to deliver this improvement. Better composition of expenditure, incentives, and more efficiency can stretch the resources available within the FRBM. Improvements in the water economy are crucial, to prevent agrarian distress.

Growth becomes inclusive after a lag. But we are benefiting from a new wave in technology. Once technology to employ distant labour is there, firms’ potential profits from such employment, drive technology development to use lower skill levels. A range of skills benefit, but high-end skills do benefit much more than those at the lower end. And time is required to acquire skills. But better opportunities have made the motivation to acquire skills strong, so one of the best ways to make growth more inclusive is to expand the opportunities for acquiring skills. All parts of education need attention; public provision here has to be drastically revamped. A simple reform is to give people what they want. For example, government schools must teach more English. Else the private sector is rushing in, even at fancy prices, where the government lags. More schemes such as the NREGS that create assets as well as provide insurance can also help the vulnerable. Growth makes resources available to compensate losers, but these must not be frittered away, as in the past, on short-term doles.

Human psychology is such that recent events have a disproportionate impact. Thus the time frame for convertibility in Tarapore I was indefinitely postponed after the East Asian currency and banking crisis. Let alone Indian policymakers, international institutions also toned down their rhetoric for freeing capital controls. The latter had helped India and China escape spillovers from the crisis. But human psychology is also such that the memory of events fades over time. Tarapore II was set up when the clarion call for convertibility sounded again. But the new report is a more hesitant and watered down version of Tarapore I. The timeframe is back, but it is conditional, with more opportunities to stop, check, reverse if necessary. Learning from crises is in evidence. Tarapore II can be characterized as embodying a concern for equality, safety, and progress.

Free convertibility is more a consequence of progress than a precondition for it. But a well-designed path to convertibility, which reduces the instability of markets but releases their strengths, can itself stimulate progress. As controls disappear incentive structures have to be in place to induce responsible behaviour, to ensure that both policy and individual responses are such as not to amplify shocks. Market design has to encourage a shift away from speculative to fundamentals based behaviour. Specific sectoral policy proposals should be assessed in terms of their contribution to these overall objectives, to encouraging innovation, and inducing more competition. Tarapore II has not clearly enunciated this vision, but has implemented it is parts.

Countercyclical macroeconomic policy that supports trend growth, two-way movement of exchange rates, and a transparent exchange rate policy can contribute to crises proofing. But the discussion of macroeconomic policy in Tarapore II is too focused on public sector borrowing requirements, sterilization, and reserve adequacy. It neglects the role of exchange rate policy in aligning interest rates to the domestic cycle. This is odd since periodic raising of interest rates, to contain exchange rate volatility, prolonged the last industrial slowdown. A collapse of growth also raises the risk of capital outflow.

The emphasis on equal treatment of domestic and foreign entities, harmonization of taxes and removal of opportunities for regulatory arbitrage is good, but “equality for what purpose” would have provided a sharper criterion for discrimination. Freedom for domestic residents to remit above the current $25,000 helps individuals diversify their asset portfolios but raises systemic risk and reserve requirements. Relaxing limits for productive purposes, such as exports, business acquisitions, expansions, development of debt and derivative markets improves resource allocation. Both have been given equal importance, when surely the second is more urgent.

The attempt to dissolve the control mindset through identifying and removing procedural impediments is a major strength of the report, as are the detailed list of recommendations for improving markets and their regulation and implementing international accounting standards. This reflects the learning India has gone through about how modern markets work, and the long path still ahead.

Given the stress on the regulator acquiring a richer more detailed information set; on regulation based on the instrument and activity rather than the institution, the recommendation to ban PNs is odd. Placing entry barriers also reduces competition, and is against the equality principle. Improving transparency and ensuring know your customer norms would be more consistent. It maybe is easier to collect information about institutions than about individuals, but given new technology, the latter is not impossible. Restricting individuals to access markets only through institutions lowers household participation in markets. Institutions neglect small accounts, but since those normally buy and hold, they make markets more stable.
 

It is development we have waited too long for; we cannot have full capital account convertibility without the latter. On the whole, Tarapore II contributes to fuller and well sequenced convertibility which will help us move faster to the goal.

The RBI had given a miss to its string of rate increases in April. This, combined with the statement that the neutral rate was expected to be achieved in 2006, implied the market need not factor in rising interest rates.

What has happened after that to justify reversal? There has been a hike in petrol and diesel prices, the rupee has depreciated to 46, a level last reached in 2004, the US Fed may continue is rate rising spree, other Central Banks are raising interest rates, the stock market has tanked, and there is an outflow of FIIs. Let us examine if any of these factors justifies the hike. That growth has exceeded and inflation fallen below RBI forecasts suggests the RBI is consistently underestimating potential output. If supply is elastic a demand squeeze is not the most effective way to counter supply-shock inflation. A rise in productivity and an exchange rate appreciation are better measures. Low interest rates benefit restructuring investment that lowers costs.

There is continuous RBI intervention in the foreign exchange market, and it has maintained two-way movement of exchange rates within an implicit band. Therefore exchange rates are due for an appreciation. To allow exchange rates to appreciate the RBI only has to stop buying dollars and may even sell some of its large stock, if necessary. Indian interest rates are near parity with US policy rates, but even if Bernanke raises rates this month, expected rupee appreciation allows Indian interest rates to fall somewhat below US rates, without leading to an arbitrage induced outflow of hot money.

Our monetary policy has, since the mid-nineties, been too reactive to external factors. This has prevented it from being fully adapted to domestic needs. There is also a misconception that money supply has little impact on output and largely affects inflation. The reality is the reverse, and this will continue as long as India has excess supplies of labour and rapid capacity expansion. Very recently lower interest rates, following the US rate cutting, have stimulated housing demand and the purchase and production of consumer durables. An excessive expansion of money supply would be inflationary, and the RBI does play a major role in anchoring inflationary expectations. Its commitment to contain inflation within 5-5.5 over the medium-term is sufficient to anchor the latter; there is no need to over-react while inflation remains below 5 percent.

A rate rise is certainly not required when stock markets are falling. Regulation has primary responsibility, but the best way the RBI can contribute to stock market heath today is to maintain sound growth; this will ultimately bring back the FIIs.  A rise in policy rates is not warranted at this juncture.

Controls raise transaction costs and create inefficiencies. Moreover, capital controls are difficult to implement in a more open and highly wired economy--the nuisance remains without the benefits. Global movement of capital to Emerging Market Economies (EMEs) has risen. It is feared controls may reduce India’s share of the pie (although China has had no problem attracting capital even with controls). India has the human capital to acquire a comparative advantage in the provision of financial services. Their development is handicapped without full rupee convertibility. The latter would also allow productive absorption of excess foreign exchange reserves as individuals optimally diversify their portfolio of assets.

But short-term capital flows can be excessively volatile, and self-fulfilling panics develop when fundamentals are not strong, and often uncertain in EMEs. Therefore strong fundamentals and crisis proofing are prerequisites for full rupee convertibility. EMEs that opened the capital account without the necessary institutional maturity suffered a series of crises in the nineties. Acquiring external signs of development without the internal strengths is dangerous.

Even so, steady progress is possible on the road to full convertibility. Well sequenced partial convertibility has lowered transaction costs and stimulated financial development in India. The next step is allowing our banks more freedom to compete in providing offshore services in SEZs.

Absent the required changes in the international financial architecture, participating in a closer association of Asian nations will help pool risks. Strong macroeconomic fundamentals required include robust sustainable growth, low inflation, sustainable debt and deficits. Foreign exchange reserves have to be larger to cover a potential outflow not just of foreign short-term debt but also of domestic savings. The financial sector has to be healthy and well-regulated. We have made progress on all these fronts. Although reform of legal systems and implementation takes time, regulatory convergence is occurring faster. Debt markets still need to be deepened and international accounting standards adopted. 

But even if fundamental weaknesses are removed any system will face future shocks. Policy and individual responses at present tend to amplify shocks.  Macroeconomic policy is not sufficiently countercyclical. Crisis proofing requires building fiscal surpluses in good times that are available to spend in bad, capping government expenditure at an expected trend growth rate, changing its composition and making it more effective. Monetary policy must tighten only if there is excess demand. Pre-emptive tightening, to focus expectations and lower output costs of disinflation, requires better forecasting.  Foreign capital comes in because of growth expectations and can go both if growth collapses and if overheating occurs. Policy has to maintain a fine balance.

A fiscal deficit does not automatically imply excess demand if private savings are high and foreign savings are available, based on a higher expected trend growth rate during the catch up phase. In an economy amply endowed with labour, the easier availability of capital should allow faster absorption of labour without running into a tight labour market, so aggregate supply remains elastic. In the past monetary policy has tightened to restrain exchange rate volatility even during an industrial slowdown. A flexible exchange rate can encourage hedging and free monetary policy to attend to the domestic cycle.

Currently monetary policy is tightening for fear of asset bubbles. But making prudential norms pro-cyclical and increasing margin requirements is the better way to contain bubbles. Higher interest rates tend to squeeze productive activity more than speculative. A liquidity squeeze also cannot be effective if domestic interest rates exceed international. Overborrowing abroad results and makes the financial system more fragile. Controls can go fully when correct incentive structures are in place to induce responsible behaviour.

Legal systems, institutions, regulation, and policy have to be appropriate before capital account openness makes a useful and safe contribution to development. Proper sequencing is necessary. Without that the probability of a financial crash rises. There is a long path between zero and one or full capital account convertibility. While we should continue to make progress towards the one, more complementary changes are required before we reach what is a valid eventual destination.  

In industrialised countries an index gives current account openness as 0.76 in the 1970s and capital account openness as 0.22, both rose to 0.96 in the 1990s. Capital account openness followed full maturity of markets. Many emerging market economies (EMEs) thought they could benefit from faster adoption of capital account convertibility. In the 1990s the index for both current and capital account openness was 0.5 for EMEs.  The IMF was advocating it and the then Indian government also set up a road map for it in 1997. But the Asian financial crises that followed aborted both the enthusiasm and the map.

Early capital account convertibility without necessary prerequisites in place led to large unhedged short term debt that multiplied minor demand shocks into full fledged currency and banking crises in four East Asian countries.  Short term debt was high because domestic interest rates exceeded international, under fixed or appreciating exchange rates, as the foreign money flowed in and was sterilized to restrict domestic money growth. The absence of capital controls gave banks and firms the ability and the monetary policy gave them the incentive to borrow abroad. As the currency started depreciating, debtors with foreign liabilities rushed to obtain cover. This further lowered demand for domestic currency. Poor financial regulation was blamed for the lack of hedging of currency risk, along with the implicit government guarantee from fixed exchange rates.

Capital account convertibility is desirable because of the inefficiencies and leakages associated with controls. Moreover, India has the human capital to acquire a comparative advantage in financial services, and is handicapped in developing these without capital account convertibility. Therefore our path from zero to one has followed the logic first of allowing global capital to come in and go out more easily. Convertibility is almost full for this category. Restrictions have been relaxed for businesses and banks, for the tourist and the student. Transaction costs have been lowered but the irritation of permissions remains. Therefore the next step is to allow full freedom in the SEZs, and letting our banks compete with offshore financial centres. Domestic residents have the least freedoms.

Strong macroeconomic fundamentals are preconditions for full convertibility. The fiscal and the current account deficit and government debt must be sustainable. We have made progress here, with deficits falling, excessive foreign exchange reserves, and low inflation and robust growth. Financial sector reforms have also progressed steadily. Although financial laws and their implementation are still flawed, financial regulation is converging to international standards. As controls disappear incentive structures have to be in place to induce responsible behaviour. Counter-cyclical prudential regulation gives banks those incentives. NPAs have come down to respectable levels.

But even if fundamental weaknesses are removed, any system will always face future shocks. Both policy and individual responses must be such as not to amplify those shocks. Here major lacunae remain. Macroeconomic policy is not sufficiently countercyclical. Rigidities in our interest rate structure keep our interest rates above international. Hedging is incomplete, partly because of habit and partly because of continuing restrictions on hedging imposed for fear of speculative activity. Although some two-way movement of exchange rates has started it is largely because of changes in the dollar. Firms are already borrowing large amounts abroad. Short term unhedged debt can boom in the absence of restrictions. Then, a slowdown in growth, without the appropriate macroeconomic response, can leave us vulnerable to a massive capital outflow such as occurred in East Asia.

The CSO’s latest estimate suggests growth is to continue, unlike the spurt that petered in the mid-90s. Widespread under-prediction indicates the inability of experts to comprehend times-are-a-changing. The economy has reached a critical mass, with sufficiently diverse activities to be able to sustain a higher growth trend. It is less susceptible to shocks than in the 90s. Robustness has improved, with more options from reforms and openness. But, much of the boost has come from a straight macroeconomic stimulus. Falling interest rates, which stimulated consumer durables and housing, rising government spending on infrastructure, and a broad-based boom in exports, have all helped growth rates reach the new peak.

Unlike the capex expenditure cycle of the mid-90s, which coincided with and drove the boom in a shallow economy, private investment is now taking place well into the boom. And it is accompanied by a promised expansion in government spending on infrastructure that should ease bottlenecks. Investment will expand capacity and demand; it should be more economical and effective in a more competitive economy. The domestic market is expanding and our exports have crossed a quality barrier. There are large new export opportunities from growth in Asia and from the relaxation of textile quotas.

Although monetary policy is tightening interest rates, the rise will be measured and our rates cannot far exceed real international ones. The US has already reached the end of its tightening cycle. The RBI only has to stop sterilising its foreign exchange reserves’ accumulation for available liquidity to expand. A current account deficit of about 3% after three years when it was in surplus is sustainable and implies domestic investment exceeds savings. Savings themselves have risen to record levels with growth and will rise further.

The fear of overheating follows if 8% is an exceptional growth rate, but not if it establishes a new trend. Inflation is surprisingly low, given the cost-push from record world oil prices. It points to productivity and competitive gains that can only strengthen. There is a fear of unsustainable asset booms. This can happen, but regulation has improved and built in useful counter-cyclical features. Growth and productivity in agriculture have to improve, but agriculture has to shrink to allow labour to flow to jobs expanding elsewhere. So, the Bharat Nirman and National Rural Employment Guarantee Scheme will help if they are successful in creating durable assets. Better governance and delivery and the promised infrastructure are indeed necessary. Growth may itself facilitate other reforms by making it easier to compensate losers.

Quarterly adjustment in interest rates is a good recognition of the impact of interest rates and the possibilities of preemptive adjustment. Moving away from monetary targets will allow more flexible response to rapidly changing needs.

A larger weight on price stability motivates the rise in the reverse repo rate. But Indian core inflation is only at 2.7 percent, while the WPI and CPI hover around 4 percent, much below the inflation target of 5-5.5 percent. Even the permanent oil price shock has not raised inflation because of compensating productivity increase. True, staggered adjustment will continue to impart an upward push to prices even if international oil prices stabilize. In India domestic oil prices rise more slowly than international but they never come down when international prices fall. But productivity increase should be sufficient to absorb this adjustment. As long as investment intentions materialize our potential output will grow faster than actual so that reducing demand is not necessary for stabilizing inflation expectations.

A sequence of small steps in one direction is meant partly to allow markets to internalize expected future movements in the same direction. But the policy statement states that it is aiming for a neutral rate that should be achieved sometime in 2006. Therefore it is possible interest rates stop rising or even reverse in 2006, depending on macroeconomic outcomes. The Bank rate remaining at 6 also signals that the rise is short-term. But the sequenced rise in short policy rates has raised the median bank-lending rate for term loans that impact investment intentions. The sharp rise in ECBs and other short-term debt suggests that many firms are finding it cheaper to borrow abroad.

We are at a critical phase for building infrastructure. Our labour endowments are similar to China’s and we lag them ten years in reform. They have made major improvements in infrastructure over the past ten years. It is possible for us to grow like they did if we emulate their past ten years of intensive infrastructure investment, so that labour can be absorbed in higher productivity employment.

Apart from anchoring inflationary expectations, the main reason for the RBI pushing rates upwards is the fear of asset price bubbles. But these are best handled by countercyclical prudential requirements, along with more effective investigation and punishment of wrongdoing. SEBI is becoming better at this. The RBI has already tightened prudential requirements from banks.  A sharp rise in credit is dangerous but our credit GDP ratio is very low compared to world levels and has to rise. The BIS and the IMF have been pressuring us to raise interest rates to moderate the asset price boom even without evidence of excess demand. China’s relative lack of transparency allowed it to escape similar international pressure and fund the required investment. We should point to its success, and the similarities in our economic structure, in order to convince the international watchdogs.

International parity must also restrain our interest rates now. As liquidity is tight currently banks are borrowing from the RBI at the Repo rate, which has been raised to 6.5. It follows that the call money rate will rise above 7. The Federal Funds Rate, has reached 4.25, and is not expected to rise much above this level. This is the daily rate at which US banks borrow from each other and can be compared to the Indian call money rate. Since our inflation only exceeds US inflation by about 0.75 percent, the interest differential of 2.75, more than covers for country and exchange risk. Changes in NRI deposits, which are a good indicator of approximate interest parity, have changed from the net outflow that developed in 2004 as the Fed raised interest rates to a net inflow in 2005 as the RBI also began to follow. Surely the RBI does not again want the flood of 2003? Monetary possible has to be forward looking, but suited to our structure, to help sustain higher growth yet control risk.

Since the title of Professor Sen’s new book captures how we think about ourselves it has become a buzz word. He reminds us of long Indian roots of reason; secularism; democracy, and invites us to rediscover these roots. Western interest in exotic India salvaged our dented pride, and co-opted us in the perception of poor Indian reasoning ability. But while he tells us that we value reason and logic too little, he has called the West “rational fools” because of the narrow identification of rationality with the pursuit of self-interest.

He blasts the blind following of tradition, but the reason he advocates is a broad “reasoned scrutiny” that starts with a conscious choice of values. Reason helps to develop a “moral imagination” from a position of respect and sympathy for others. Then “the clear stream of reason” would not lose its way “in the dreary desert sands of dead habit” and could promote both ethical humanism and freedom—although the values chosen may well be the traditional ones.

For Sen, public voice and reasoned scrutiny from a variety of perspectives is necessary for democracy--change requires constant re-thinking. Good reasoning is possible without training in logic; substantive arguments challenging the existing order have come from the underclass—the bhakti saints are an example.

The book demonstrates the power of sharp, skillful reasoning applied to a range of relevant topics. So the best way to respect Sen’s arguments is to engage with them.

Dialogue: Sen quotes the norms established for dialogue, in ancient Buddhist Councils—such as do not unduly praise your own sect or disparage others. It is not clear why Ashoka’s dialogue has ended in the argumentative and often rude Indian, whose aim is to prove the opponent wrong, not to advance understanding. Perhaps fighting over a small cake was responsible for bitter ideological battles; more constructive dialogue may be possible as the cake expands. Sen’s own deep study of social choice theory suggests it is not possible to aggregate individual preferences to get a social choice rule when the focus is only on redistribution.

Many of the articles collected here were written during the period the BJP was in power. This may explain the over-emphasis on Hindu fundamentalism, as the source of many ills, although it never really had broad support in the accommodative Hindu tradition.

Poverty: Since Sen gives a critical role to voice, identifying it is the reason democracies have been able to avoid famine, he has to explain the persistence of chronic hunger. He blames the multiple disadvantages of caste and class the poorest suffer from--other groups were able to capture policies designed for the poor. For example, teacher unions made it difficult to discipline teacher absenteeism in village schools. Legislating rights, ensuring education, better nutrition targeting, NGOs activism, will all help free their voice.

But Sen neglects the perverse incentives built into the system. For example, if a ration shop owner can sell elsewhere at a higher price leakages are bound to follow; if a bureaucrat has the power to allocate a subsidy, he will take a cut. The system encouraged public servants to subvert the provision of public services for private gain. Better delivery requires not only more democratic voice but also better institutions and incentives, that stimulate competition to innovate, reduce costs and improve quality. Voice only creates anarchy if it is at the expense of work.

Women: Sen argues that Indian women, particularly among the poor, have been denied freedom and facilities to develop their full capabilities. Sen’s rational man can choose to sacrifice for others, but when a woman does so she is blindly following social custom. In other contexts he underlines the importance of “other-regarding” behaviour as necessary for societies and even for markets to function. Maybe lack of awareness is not so much the problem as is the absence of opportunities consistent with women’s choices. Such opportunities are arising with the new technologies and the flexi-time and location work they make possible, with self-help groups, and political reservation for women. They have allowed women to make major contributions to society; their quick success suggests women are aware.

Only if men respect women’s caring values can deep social problems such as son preference be ameliorated. It is necessary to give women more choice, but it is also necessary to share their other–regarding choices more widely. 

India offers startling contrasts—35 per cent of its populace cannot read or write but it is rapidly acquiring a worldwide reputation for technical skills. Have India’s failures in education been due to a poor supply of education—the absence of push, or did a paucity of jobs lead to low demand-pull for education? There are factors making for improvements in both areas. But the delivery and quality of education, where push meets pull, requires sustained attention.  

The large size and youthful structure of its population can be India’s comparative advantage. It has 20 percent of the world’s population of under 24 year olds; 31 percent are below 14 years of age. Almost 50 percent of the population is of working age. Countries with a higher share of working age population have done well, if people are equipped with skills and jobs. The latter two are the crux of the matter.

Higher growth is creating more jobs—there is already a shortage of technical skills. In one quarter of 2005 alone Infosys and TCS have recruited more than five times the annual output of the IITs. The British neglected primary education, and the Indian Government has been unable to remedy the lacunae in all the years that followed. So expansion of education facilities is required at all levels. More complete availability of primary education will improve equity in Indian society and enable a multiplication of the IITs. 

Internet and communication technology (ICT) allows the world’s populous but underdeveloped areas to access global labour markets. Although technical change sometimes compensates for a scarce resource, abundance of a resource can also stimulate technology to utilize it. Greater labour availability will induce more labour-using technical change. Further developments in ICT will continue to create more jobs in India because of huge cost savings for the world’s firms from global sourcing.

India’s history of more pronounced illiteracy for some castes and classes implies they will not immediately be able to access the best jobs, but ICT itself creates a range of jobs. It has a multiplier effect in supporting jobs, with one job in ICT creating four jobs elsewhere. High growth in manufacturing is now bolstering the boom in ICT related jobs, creating more broad based labour demand. So there will be more opportunities for all skill types, and an inducement for the young to reach and expand their skill frontier. The rise in the returns to education means a rise in the demand for education all down the education chain.

Enhanced wages from acquiring varying degrees of skills will make illiterate parents insist on education for their children. Since they will also get jobs it may not be necessary for them to force their children to work. First generation literates may not be able to make it to IITs, but they will get better jobs than their parents.  New research suggests that reservation is more effective when it is supplemented by clear selection criteria that give opportunities to those able to make use of them.

Female literacy in India is only 53 percent compared to male literacy of 75 percent. Muslim women have even lower education levels; those in the South of India are relatively better educated. Illiteracy among Northern Muslim women is as high as 85 per cent. But today the top work aspiration of Muslim mothers in Mumbai is for computer related jobs for their daughters. ICT makes flexi- time and location jobs feasible. These allow women to maintain their human capital and pace their work according to the needs of their lifecycle. The rise in lifetime returns to female literacy will contribute to its spread.

So much for demand. What about expansion in the supply of education? Here there have been massive government failures, but now the private sector is becoming involved in a big way. For example, large ICT firms are interested in primary education because their future depends on trained manpower. But private education may not be affordable for the poor. Government will have to remain active but major improvements are required in governance through setting the right incentives for teachers and their students.

Village schools have functioned poorly, one reason 60 percent of the population is still employed in agriculture. Absenteeism of teachers is higher (at 25%) than in most countries of the world. Research shows better infrastructure and activism of parent teacher associations are most effective in reducing absenteeism. Teacher unions have harmed teacher discipline. Stronger local accountability and parent activism would be an effective counter. Mother’s education makes more of a difference to school attendance than father’s education does. As the pull factors make women more willing to send their daughters to school, over time, it would strengthen beneficial dynamic tendencies.

Schemes such as a mid-day meals and free education for one girl child put in place good corrective incentives. Since the eldest girl child is often kept at home as a child minder and help, crèches should be made widely available.

More resources and variety in inputs will help to free Indian schools from their focus on the book knowledge required to produce Macaulay’s babus in colonial times. Quality must accompany quantity. If curricula emphasize relevant learning and the development of innovative abilities required to seize future opportunities, it will require less push from parents as children are pulled into school.   

Is the current rupee depreciation reversing the trend appreciation of the past three years? Is it any clause for alarm? We have been proud of our ballooning reserves, appreciating rupee, respectable growth. But our confidence is not deeply rooted. Slight depreciation, a slowdown in reserve accumulation and a widening trade deficit are sufficient to make us fear a return to foreign exchange shortages and a weak rupee. But reserves should be used to fund higher growth. A widening of the deficit makes it possible to absorb foreign savings in higher domestic investment.

Relative productivity determines the long-run value of the rupee that can deliver a sustainable balance of payment. A surplus is necessary tomorrow to finance a deficit today, and the real exchange rate must be such as to encourage the required growth in exports. Indian productivity and the demand for our goods are both rising, so the rupee can safely appreciate without harming exports. But since China is a major trade partner and competitor, with productivity growth even higher than India’s, the rupee cannot afford to move too far from the Yuan, even as it appreciates against the dollar. The tight tie of the Yuan to the USD has recently been loosened, but future Yuan appreciation depends on more deepening of Chinese financial markets. The dollar has to depreciate in the long-term given the large US fiscal and balance of payment deficits. Even in real terms the rupee has appreciated recently, although the appreciation is not much on the 5-country trade weighted basket that the RBI has been informally targeting. It is now coming out with a new 6-country trade weighted basket, which captures the rising importance of Asian trade.

While the real value of the rupee affects exports, arbitraging cross border flows affect the short-run value of the rupee. Relative returns to holding rupees must equal those to holding foreign currency to prevent such arbitrage. The RBI has the clout and the reserves to intervene and affect the value of the rupee but it does not do so unless there is excess volatility, or there is too large a departure from a competitive real value. After the successive rise in US short-term interest rates, Indian short-term real interest rates are marginally lower than US, even adjusting for inflation. An indication that the arbitrage gap has disappeared is the shrinking of NRI deposits. Foreign institutional investors are also booking profits in equity markets. But is it necessary to raise our short-term interest rates further to prevent outflows? The answer is no, to the extent reserves continue to be in excess, capital mobility is less than fully perfect and the current depreciation implies an expected appreciation in the near future. These factors allow our interest rates to continue lower as is required to maintain current high growth, which in turn is the best attractor of stable foreign inflows. Monetary policy gets a wedge of freedom from rising international interest rates. Although Indian long-term interest rates are among the highest in the world, short-term interest rates are becoming more closely linked with the international cycle and they do have some lagged effect on long-term rates. A rise in short-term interest rates itself raises business costs and the cost of home loans thus depressing activity.

Thus some two-way movement in exchange rates, as has occurred over the past year, gives more freedom in adjusting interest rates to suit domestic requirements. Its other beneficial effect is that it should, over time, by encourage more hedging of exchange risk, make markets more robust. With hedging small currency fluctuations have less effect on balance sheets, so losses are not passed on to banks or suppliers thus reducing the chances of a cumulative East Asia-type financial crash.

But our corporates are still not hedging, hoping rather to make money from predictable currency movements. Thus the unexpected appreciation after a long depreciation meant losses for net exporters, while now importers and debtors are in trouble. Many dollar liabilities had been created to benefit from appreciation, and the unhedged corporate exposure is said to be 30 billion USD. Unclear accounting procedures for currency gains and losses compound the problem. While making available more instruments and permissions for hedging, the RBI is also pushing for improved accounting. The lesson should begin to sink home that short-term changes in the rupee can be sudden, unexpected, and in a direction opposite to the long-term trend. Therefore the wise businessman will cover his currency exposure and become immune to rupee surprises.     

Interest rates need to be raised if there is excess demand in goods markets or if higher rates are required for financial stability. But there is no generalized excess capacity, to the extent investment is adding to capacity, robust export growth and reserves permit a wider trade deficit, and structural bottlenecks are being reduced. Turning to financial markets, the stock market is falling, so a rise in interest rates is no longer required to prick an incipient bubble.

In foreign exchange markets, the relative returns to holding rupees must equal those to holding foreign currency to prevent large arbitraging flows. Adjusting for inflation, Indian short-term real interest rates are marginally lower than US, but probable appreciation of the real exchange rate is compensating for the shortfall. An indication that the arbitrage gap has disappeared is the shrinking of NRI deposits. But reserves are still too high to need to acquire high cost deposits and then park them in low interest foreign security holdings.  Some two-way movement has started in the exchange rate over the last two years, with trend appreciation. Since the rupee has recently depreciated, it should appreciate in the near future. Trend appreciation is also possible because of productivity increase, if the Chinese currency appreciates. The trade deficit, widening with growth, is not sufficient reason for depreciation since export growth remains high. Some widening of the deficit is required to absorb foreign savings.

In an open economy, the nominal interest rate becomes tied to the international interest rate, and monetary policy cannot affect output. But there are a number of degrees of freedom. Obvious ones are those that come from managed floating and less than perfect capital mobility. But others come from reduction in the risk premium; from output being at less than full employment; and from changing equilibrium exchange rates.  These give monetary policy sufficient freedom from international arbitrage to attend to the needs of domestic policy.

Indian experience of the past few years suggests that it would be folly to neglect the power and the possibilities of monetary policy. Since political barriers created a threshold below which Indian nominal interest rates could not fall, the steady reduction in the US federal fund rate under falling Indian inflation and an appreciating rupee had created an arbitrage gap. This was partly responsible for the huge accumulation of forex reserves after January 2002. Although a stance towards softening interest rates had been announced as industry slowed, reversals often occurred to smooth the exchange rate. The last such episode took place over mid-May to early August 2000. From 2001, the absence of pressure on the rupee and the implementation of the liquidity adjustment facility allowed the domestic short-term interest rates to drift downward steadily. This showed the leeway that existed to reduce interest rates despite high government deficits. But inflation fell even faster so that real interest rates remained high, and growth still did not recover. Poor absorption also contributed to the over-accumulation of forex reserves. By 2003 the softening and smoothing of nominal interest rates had spread to long-term rates and growth finally revived. The interest elasticity of expenditure was considered to be low but the fall in interest rates encouraged housing construction and consumer expenditure, which, along with road building, helped industry. Policy effectiveness facilitated by, and lessons learnt when international interest rates fell, must not be lost even if international rates start to rise.

The RBI will probably raise interest rates because being risk averse they impute a large risk premium that interest rates need to cover, but risk is adversely affected by too high interest rates as well as too low. A sharp rise in interest rates triggered the 1997 slowdown. RBI is aware of the knife-edge. They tried to gently nudge interest rates upwards through the repo rates, so even if a rise comes it will be marginal.

Ashima Goyal

The committee on capital account convertibility (CAC) is to be congratulated for a focused yet comprehensive report. It is refreshing to find a committee appointed by the RBI reducing the discretionary powers of the RBI, lowering costs in foreign transactions, and embracing change. There is a clear vision of what CAC will mean for India in the near future -- a carefully phased and limited freedom for domestic residents to send capital out and hold foreign assets and currencies, and preconditions required.

The ultimate objective of capital account convertibility, however, should be to deepen and integrate financial markets, raise access to global savings, discipline domestic policy makers, and allow greater freedom for individual decision making. In order to understand why CAC is necessary, it is helpful to take a historical perspective. Relative to world output, global capital flows were much larger before the first world war, and they, along with the gold standard limited the independence of domestic macropolicy, but facilitated trade. But during the wars, and the great depression, as destabilizing movements in capital occurred, more and more countries put controls on capital movements in order to gain freedom to stimulate domestic economies. Unfortunately, in many countries, the stimulus turned inflationary as income groups fought to raise or maintain their shares, and governments accommodated these demands. Moreover, as world trade and capital movements expanded again, these controls became porous and sometimes counterproductive. But the problem with capital flows is that they can be destabilising -- especially short-term capital movements. If a country is not doing well, a cumulative flight of capital can confirm the fears that provoked it. Still, there has been experimentation with different international mechanisms to minimize fluctuations and the consensus is that nations with sound fundamentals have been able to benefit from capital flows. It is possible that the tiger can be tamed. But the trouble is that the committee on CAC defines fundamentals very narrowly.

The theoretical framework underlying the report is not spelt out. It seems to be a monetarist one in which it is presumed that restraining the fiscal deficit and the money supply, will be sufficient to keep inflation low, and absorb foreign inflows at a real effective exchange rate that stays within a narrow band. The report carries a very useful summary of the experience of ten countries that are in various stages of implementing CAC. The statistics show unambiguously that the countries that have absorbed foreign inflows with the greatest success have been those with high investment and growth. Such countries have also prevented their real exchange rates from appreciating, in order to stimulate exports. Yet these aspects are nowhere emphasised. The presumption seems to be that deeper markets and the allocative efficiency they induce will automatically stimulate growth.

A major lacunae in the country statistics is that China is missing. Although its currency is not convertible, this is the country that has been able to attract and absorb the highest volume of foreign inflows at the fastest rate of growth. Since it is a labour surplus country and 42% of its growth post 1978, has come from a rise in labour productivity, it has a lot to teach India. Our brief historical analysis suggests that populous countries have the most to gain from the new mobility of global capital; they can use it to raise labour productivity. The World Economic Forum reported recently, on the basis of a survey of global executives, that India is the third most preferred destination for capital, after the United States and China.

The strongest fundamental to attract and safely absorb capital flows is high growth, not low inflation or a low fiscal deficit. The irony is that high growth does lower inflation, and improve other parameters; but targeting low inflation and cutting public capital expenditure to lower a fiscal deficit can harm growth, and eventually worsen the fiscal balance. Public debt would become unsustainable only if the real rate of interest on old debt is higher than the rate of growth of the economy and new debt is raised at a cost higher than the returns from its investment. The experience of England and America after World War II bears this out. Britain followed conservative macro policies and had to struggle with its public debt for nearly a decade. In America high rates of growth made for a relatively painless lowering of the debt/GDP ratio. In the Indian context, a better way to contain inflationary expectations is to institute supply side policies that result in a 3-5% rise in agricultural prices. Rather than target the fiscal deficit which is the budget deficit plus government borrowings, the revenue deficit should be targeted to raise government savings. There is no harm in the Government borrowing for productive purposes. It is necessary for large countries to retain some independence in domestic policy making.

The very high real interest rates and slowdown in growth in 1996 were partly caused by a tight money policy. In 1997, although money supply has been easy, inflation has remained low falsifying monetarist fears. Empirical research has established that there is no very close relationship between money supply and inflation in India. We have never had to suffer Latin American rates of inflation. The international literature on stabilisation focuses on Latin America, therefore it emphasises the control of inflation. India's current rate of inflation compares well with South-East Asian rates; Chinese rates are even higher.

Low interest rates and easy credit availability are necessary to stimulate investment. Low interest rates will also ease the public debt burden. Fluctuations in real interest rates cause financial volatility and may be partly responsible for the failure of CRB capital markets. The perceptive, and widely welcomed, new credit policy of the RBI recognises the need to pay attention to real interest rates; it is strange that the committee neglects this aspect in its preconditions. It is a major way in which the Indian entrepreneur will gain from CAC since our interest rates are higher than world rates. But in transition, it is a major responsibility of the monetary authority to keep Indian interest rates linked to global ones. Low interest rates are also essential to prevent high short-term debt creating inflows. The committee suggests that allowing outflows is one way to absorb high inflows without an appreciation of the exchange rate. This seems wasteful when India needs capital. Holding excess reserves is a similar waste. Moreover, as long as risk adjusted returns in India remain higher than international, allowing outflows will only stimulate more inflows. But if growth falls then the outflows will take place. Foreign inflows can be used, in a transition period, to prevent crowding out of domestic by government borrowing. As long as exports are growing, and excess imports financed predominantly by remittances, foreign direct investment and long-term debt, a widening current account deficit is not a problem. Indeed, if net imports allow a rise in investment over saving, the real exchange rate determined by equating the current to the capital account of the balance of payments will be relatively constant.

The committee seems to be revelling in a techno-nirvana, where derivatives, futures, capital adequacy and hedging smooth all obstacles. There is no alternative to globalisation, the adoption of new techniques, and the development of markets, but it is necessary to be aware of potential problems. It is known that program trading strategies of portfolio fund managers, that use index futures, can enhance volatility of financial variables. Developing cheap avenues for risk diversification offers the greatest benefits. If risks are well diversified cumulative infections in financial markets can be minimized. Imposing higher capital adequacy on weak banks can force them to take even greater risks to maintain profits. If they are to be restricted to government securities--a good suggestion--there is no need to impose higher capital adequacy as well.

It makes sense to excuse the large Indian corporate, exporter and banker from capital controls; such flexibility is desirable for efficient operation; anyway it is now difficult to police them; most of them already enjoy de facto convertibility. But it needs much learning and greater deepening of the retail mechanisms before the Laxman's common Indian will be able to securely play in dollars. Let us indulge our national proclivity for mathematical games: undoubtedly we will quickly become skilled at diversifying risk. But the pragmatic Chinese realise that the priority is attracting foreign inflows by high growth, not capital account convertibility. It is dangerous to neglect non-financial fundamentals.

Ashima Goyal

The continuing slow growth of industry, even after a stimulatory budget and successive rounds of interest rates reduction is exciting concern. But unfortunately prescriptions and their evaluation come from ideological positions, rather than a reasoned response to the situation. Rightists say that sufficient liberalising reform measures have not been undertaken. Leftists indite neglect of the poor and the cutback in public investments. The worst of it is when policy makers are stuck in such positions: certain actions become taboo just because they are favorites of the opposite ideology. Partly, to sell a new regime it is necessary to depict it as totally opposed to the old; but when an idea is accepted, contrasts can afford to be less stark. Over the past year both fiscal and monetary authorities have shown the pragmatism and maturity to adapt in response to information thrown up by events. Manmohan Singh admitted that his government's neglect of public investment in infrastructure was a mistake, and Jyoti Basu is welcoming Foreign Direct Investment to Bengal.

The economy is not a mechanical object whose working is perfectly understood. Policy mistakes, in most cases, arise due to imperfect understanding of the economy, and not due to expediency. Biological analogies are more apt; we know that an organism and its parts thrive in a stimulatory environment adapted to their requirements. Although it is impossible to agree over ideology or theory, it may be possible to arrive at a consensus on stimulatory pre-requisites. To initiate discussion we list some general pragmatic principles for policy making.

First, policy must empower people by replacing hurdles they face by aid-posts. Transaction costs are reduced wherever infrastructure is improved; discretionary regulations are replaced by self-enforcing ones; and markets become more efficient. Second, policy must be feasible: matched to global trends, current institutions and attainable rates of change. Third it must seek for balance-- between the short-and the long-run, between demand and supply, free markets and government action. No extreme position has a chance of being correct; truth always lies somewhere in between. Fourth, in an economy such as India's, the potential impact of policies on development and growth must be kept paramount. Wherever there is a conflict between any two of the principles, the impact on growth should be the deciding factor.

In its deepest meaning reform should be understood as moving from telling people what to do to helping them do what they want, but motivating them to want the right things--encouraging individual initiative, but raising motivations for socially productive actions. These principles can clarify many policy dilemmas and suggest new directions for current debates.

It was necessary to liberalize interest rates, but real rates were allowed to rise too high. A smoother management of money supply is possible, although it requires a fine balance between foreign inflows and private and public credit demands. Interest rates are more free now and convey information faster; this must be used in designing monetary policy. As the share of private investment is rising in the economy, it is becoming more sensitive to shocks to the real interest rate.

The experience with financial reforms illustrates the need for coordinating policy over a variety of dimensions. Ideally reform while allowing greater market determination of nominal interest rates, must ensure macro stability and low rates of inflation so that there is a small positive real rate of interest that encourages both investment and savings. Second, use new technology to move to non-discretionary regulation, while expanding the range of assets available, the ease of movement across assets, and adapting institutions and norms to increase the depth of the markets. Third, raise the share of credit going for long-term and other productive investment. The market should be used to increase the return to productive physical investment, and lower that to short-term speculation. But just increasing the availability of credit may not work in a industrial recession. It is possible to pull on a string but not to push on it. In a recession policy should concentrate on measures for raising physical investment.

Focusing exclusively on one of these items may lead to problems. Consistent policies that target all three will be able to minimize bubbles in asset prices and failures, such as the CRB scam, the listless stock market indices, the steep rise in real interest rates, and fall in physical capital accumulation. Early discussion of financial reforms concentrated on making the case for raising interest rates, removing public sector pre-emptions, and freeing markets. This is too narrow. A broader definition of the objective of reform is required: namely, to hasten the process of financial deepening.

Policies tailored to the requirements of only one sector, are sometimes inconsistent with those imposed in another. They are far less effective than they would be with supporting or consistent policies elsewhere. Allowing the cost of credit to rise so steeply and neglecting export infrastructure while devaluing the currency meant that policy was working at cross purposes. A stimulatory environment requires all factors impinging on a desirable target to act in the same direction and to enhance each other's effect.

At present the present juncture, massive government projects to build roads need to be initiated, with transparent and competitive bidding for the contracts. Toll charges will be possible in some cases but the roads can be financed by borrowing, and future expected tax receipts as growth revives. This is the well accepted tax smoothing argument, but overall reform to improve fiscal finances should continue. The roads will generate demand in the short-run, mop up excess liquidity, raise labour intensive employment, lower costs and improve supply in the long-run. Such projects are among the easiest to flag off quickly and have a short gestation lag. Agriculture has been vibrant in the past year. Most industries are in the doldrums yet output of tractors has grown by 27%. Improved roads will give a further impetus to this growth.

My research has shown that, in the past, high growth periods in India have always been those with high induced investment. The reason is the demand stimulus that can be sustained by a future expansion in supply. Reform to raise efficiency can complement, but not totally substitute this. Indeed, such reform, if successful, boosts the inducement to invest. Private investment is faltering, public must take up the slack, and the former will revive. Institutional experimentation to reduce corruption and encourage private sector participation in infrastructure must continue. Partly, corruption is a disease of a stagnant economy--where opportunities abound to make money in legal ways, and discretionary powers are lowered, the illegal will whither away. Governmental infrastructure projects got a bad name in Latin America where huge roads were built in the Amazon, that no one uses. In India population pressures are such that it would be difficult to build such roads.

Indians are more like Asians in their savings habits. The common man is frugal and hardworking, but the right environment is yet to be created for these attributes to fructify. Foreign firms, have to adapt to Indian tastes and charge prices that target the middle classes, to succeed. Brand driven high price consumerism has a limited scope here. The higher growth of the past three years has raised household savings more than consumption, but these savings have only been used to finance government consumption. Although the share of public investment has fallen the share of the government in borrowing remains unchanged. Paper profits have accrued as the Government paid high interest rates to banks and generated huge profits part of which will go back to the government. In 1997 although corporate profits fell steeply, banks made high profits.

Leftists and Keynesians should agree to demand injunctions that are designed to improve supply in the long-run and raise employment opportunities, rather than just stimuli for consumption. They should not object to restructuring that raises efficiency and lowers transaction costs. Rightists should be able to accept governmental intervention that facilitates the working of markets. Even the World bank, under the influence of the East Asian miracle and Prof. Stiglitz, has accepted the need for greater government intervention. It is natural to discover the lacunae in a policy regime when things are going badly, but it is necessary not to throw the baby out with the bath water, in swinging from one extreme to the other. The answer to malfunctioning reform is not no reform or more reform, but intelligent reform. Only then can we stop wasting our time battling over who is right and instead do the right thing at the right time.

Ashima Goyal

There has been much comment on the fall in inflation, but little analysis. Most articles attribute it to monetary policy, but while some congratulate the RBI, others point to the industrial slowdown as the unfortunate but inevitable by product. We explore the conditions under which higher growth and lower inflation can occur together. Our conclusion is that the fall in inflation would have been possible without the industrial slowdown, with a differing policy mix.

The main contending theories of inflation are cost-push or demand-pull. In the former, costs components are factor payments, productivity and expectations of nominal wage growth. In the latter, excess demand causes pressure on resources and leads to inflation. Monetary or fiscal expansion stimulates such demand. The two theories can be reconciled if the influence of demand pressures on expected nominal wages is taken into account. The forces of demand, supply and inertia then determine inflation. It can mechanically be calculated as the weighted sum of the components of price indices, but at a deeper level, core inflation is determined by profit shares, expected nominal wages and shifts in productivity.

The common perception is that periods of rapid growth lead to excess demand and therefore generate more inflation: there is a tradeoff between growth and inflation. But this is inevitable only if demand falls on resources in fixed supply. If the composition of demand is such that it utilizes resources in excess supply, or stimulates the supply of goods subject to increasing returns, technological upgradation, economies of scale, or lowers transaction costs as institutional efficiency rises, growth may well be accompanied by falling costs and prices. But to accept this, macroeconomists have to make an imaginative leap, whereby they analyse two periods in succession; demand in the first expands supply in the second.

In India, the two major supply constraints are wage goods and infrastructure. After the shock associated with devaluation, good monsoons have meant stable food prices. But measures to maintain a high rate of growth of agriculture, and a careful sequencing of the process by which foodgrain prices reach border prices are necessary. Much of infrastructure has administered prices, even if these are low, poor infrastructure adds steeply to transaction costs. A switch in the composition of demand towards investment in infrastructure can stimulate demand and relieve supply bottlenecks.

Macro policies tailored to growth and the institutions of a developing country can be quite different from traditional ones. Institutional features of the labour market give leeway in the design of policies. In America, where nominal wages are rigid with contracts reset every three years, monetary policy can be more stimulatory than in Germany where real wages are rigid. In India, real wages measured in food prices are rigid. An agricultural price shock eventually sets off a rise in wages and prices, because of widespread poverty and the large share of food in the consumption basket. Democracy will not allow rapid erosion of the purchasing power of the masses. A recent example of this is the spurt in inflation that followed devaluation and rise in food support prices. The latter became essential to narrow the gap between the domestic and international prices of foodgrains, in an era of greater liberalization. Yet even if real food wages are rigid monetary policy does not have to be tight—it is possible to raise the efficiency and level of utilisation of resources. Besides, there is some relaxation in the resource constraint due to international capital inflows. Macro policy, in India, can be stimulatory as long as steps are taken to ensure low prices of food and an adequate infrastructure. Moreover, there is excess capacity in manufacturing currently because of the reorganization of the early nineties followed by capacity build up over 1994-96.

So much for the theory and institutions that make an inverse relationship between growth and inflation possible; there is also real evidence.

First, the conservative view is that lax money supply stimulates output but also inflation. But there is no very exact relationship between money supply and inflation. Take the past ten years: in the mid-eighties the rate of growth of money supply ranged between 17-22%, but inflation was relatively low. Monetary growth was considerably tightened in the early nineties to 15-16%, but inflation rose. In 1996 money supply growth fell to about 13%; it has exceeded 16% in 1997 but inflation in the latter year is lower.

Industrial prices are firming in the current year, even as the annual rate of growth of industry has fallen to about 2%. Haseeb Drabu reports (Business Standard, Nov. 12, 1997), that manufacturing price inflation was falling until June 1996, coinciding with the period of rapid growth. After that manufacturing prices stabilised and began to rise in this year. The contribution of manufacturing to the overall rise in the wholesale price index rose from 28% in March to almost 50% in September 1997. Inflation has continued to decline because primary product price-inflation has fallen. It was approximately 11% in January but only 3.7% in August 1997. In a recent Business India poll of CEO’s 58.6% said no when asked, "would you consider cutting prices to reduce your inventories?"

In a simulation macromodel (IGIDR) trend rise in labour productivity raised real wages but trend counter-cyclical variations in the mark-up (which is the same as the profit share) clearly affected the rate of inflation over 1960-1995. The reason may be that productivity impacts on the nominal wage bargaining process, while medium-run prices are set as a mark-up on unit costs. The reduction in mark-ups as growth revived, then accounts for the fall in the rate of inflation from 10.85% in 1994-95 to 7.68% in 1995-96, and 6% in 1996-97. As these tendencies work out through lags in expectation and inertia, the rate of inflation will continue to fall by shrinking amounts until it reaches a new equilibrium level. But this is conditional on reasonable growth, the absence of major shocks to costs, and the maintenance of competitive pressures. If capital-productivity, which has stayed constant, rises in the future, there would be greater leeway in making required adjustment in relative prices, and inflation would be low inspite of inertia and rigidities in nominal prices. Large gains in productivity may, in the future, allow inflation to decrease independently of changes in the mark-up. So far changes in the latter due to cyclical adjustments, competitive changes and organisational restructuring have influenced the trend reduction in inflation. The model can explain the absorption of the petroleum price hike: it was widely expected to lead to a rise in inflation of 0.77%, instead inflation has fallen by 1%.

International experience with inflation and growth gives a mixed picture. Hyper inflationary episodes are always accompanied by low growth; African countries show low growth and average rates of inflation; but the majority of very high growth countries in South-East Asia have very low inflation. China has had bouts of high inflation, probably explained by transition from a fiscal system dependent on public enterprises for revenue, combined with poorly developed monetary institutions. The low inflation rates of the fast growing economies of South East Asia support our thesis.

Even so, the emerging consensus in favour of monetary stimuli, in India, is dangerous. Monetary laxity without supporting supply side policies will raise inflationary expectations and impinge on core inflation. Monetary policy must ensure low real interest rates, but given the structure of India’s financial sector, more than just a rise in high powered money will be required for this. Public expenditure on infrastructure must rise. It is harmless for this to be financed by a rise in fiscal deficit as long as the revenue deficit falls and interest rates remain low. The latter can be ensured, even with high government borrowing, by the use of foreign inflows and synchronization of exchange and interest rate policy.

One reason the 1997 budget has not lived up to the expectations it raised is that the promised investment in infrastructure has not materialized. In reply to "what policy measures are essential to a revival?", 31.4% said lower interest rates; but 60.0% wanted increased infrastructure spending. But because of the rise in the share of private investment, aggregate investment in India has become more sensitive to interest rates, than it used to be.

Policy makers fear a rise in the fiscal deficit, because it is regarded as a signal of future problems by foreign capital. But South East Asian governments generally had a budget surplus and this did not prevent global capital from departing. High growth dominates the fiscal deficit as a signal and is a more powerful lure for foreign capital. In the last few paragraphs we have outlined the policy mix hinted at in the first. It is to be hoped that our policy makers have enough freedom, flexibility and understanding of the economy to respond to its needs and to events.

Ashima Goyal

The overall reaction to the budget has been negative. But extreme reactions are often motivated. As an example consider that the same attribute has invited both criticism and praise. Continuity implies the absence of a new "big idea". One party has dismissed the budget as having no big idea or vision; another has praised the continuity in direct tax rates. The swelling chorus of attack compels an attempt at a balanced assessment.

The theoretical vision underlying the budget can be understood as optimizing the transition to a low internal public debt under severe political constraints. Interest payments on internal public debt swallow about 47 per cent of revenue receipts at present, severely limiting degrees of freedom. An internal debt trap can follow if either the interest rate is high or the growth rate is low and government borrowing for consumption is high. Therefore the best strategy to lower debt is have a regime of high growth and low interest rates. High growth in America after the world war, made for a relatively painless lowering of the debt/GDP ratio. England, which followed conservative deflationary macroeconomic policies with high interest rates, suffered low growth and a continued high debt/GDP ratio for more than a decade.

The government has chosen to keep the interest rate low by encouraging foreign direct investment (barring a panic exit when it will have to be raised), and to stimulate growth by steeply raising investment expenditure on infrastructure. This stimulates demand, but unlike Keynesian pump priming, also expands supply in the medium-run and would therefore moderate inflationary pressures over time. The argument that the government should have let the budget deficit rise, rather than give a push to costs by raising duties, is also flawed. It is imperative to lower the revenue deficit (RD) to prevent a debt trap. The last government failed in this; revised estimates of the RD as a percentage of GDP (3.1) have exceeded the budget estimates (2.1) primarily due to a 22 per cent fall in estimated collections from customs duties. Taxes had to be raised. The strategy of improving collections from direct taxes by keeping rates low and expanding the base is the best for the long-term. But it will take time to fructify and until then indirect taxes will have to make up the shortfall. The new import duty that is decried as "swadeshi", will also provide protection to successful foreign entrants and therefore attract FDI. Inspite of these tax-raising efforts the budgeted RD remains high at 3 per cent of GDP, reflecting perhaps political constraints and the current slowdown in growth.

Much of the infrastructure expansion is aimed at agriculture. If productivity in agriculture is successfully enhanced, this will have very beneficial effects in terms of lowering inflation, and may overcome the effects of the previous year’s slowdown in agricultural growth. Manufacturing products have a weight of about 57 per cent in the wholesale price index, but over the last two years they have accounted for only about 40 per cent of the rise in wholesale prices, reflecting the rise in manufacturing productivity. Manufacturing prices relative to agricultural have fallen from about 90 in the mid-eighties to about 85 per cent currently. Therefore the direct impact of the rise in import duties on wholesale price inflation would be only about half per cent. And if some prices fall as others rise, even this may not be observed. The weight of food products is even higher in the consumer price index, since more than 50 per cent of the average budget is still spent on food. If agricultural prices rise this effects all prices through a rise in nominal wages. The depreciation of the exchange rate has widened the gap between domestic and border prices. But since export controls still exist the gap is transmitted, to domestic food prices, mainly through a rise in procurement price or fall in food subsidy—the budget does neither of these.

Commentators, who are worried about growthflation, need to more carefully think out what is the highest rate of growth India can sustain without inflation. Definitely it is much higher than the current growth rate. It is also not true that the government has succumbed to a temptation to boost revenues by printing money. The presence of the large public debt works against such an incentive. Interest rates rise with expected inflation and interest payments on public debt become heavier. Moreover, inflation negatively impacts electoral prospects in a country without widespread income indexation of many poor. Money supply growth at 13.2 per cent in 1995-96 helped to provoke the recession, and the current rate of growth of 17 per cent is still below the 20 per cent associated with the growth spurt of 1994. People think that excess money supply is the major cause of inflation, but in today’s world productivity has the major impact on prices. The current very low rates of inflation associated with America’s high growth rates are due to productivity rises carried by the boom in software. India has the potential for a similar boom, if food prices are taken care of. Monetary policy has to follow a tightrope because too rapid a rate of growth can provoke inflationary expectations, but too low a rate can choke growth. Real interest rate targeting is the best way to respond rapidly and flexibly to market needs, while restraining inflationary expectations.

One call pull on a thread but one cannot push on it. The lowering of interest rates has been insufficient to revive growth, by itself. Since 1996 the budget had talked of raising public investment in infrastructure. But this was not substantial enough to overcome the trend fall in public investment in the nineties. The 35-40 per cent increase in core sector spending is very welcome. But in order to work it will have to be implemented. Budgetary support for this has increased only by 11.7 per cent and more than 80 per cent has to be provided by internal and extra budgetary borrowing. Therefore the key to implementation lies in the new institutions floated and organizational changes mooted to make such borrowing and spending possible. One big idea the budget does have is the road map provided for privatization – this will help in improving the efficiency of utilization of public capital and in making funds available. The 3 S policy is another attempt to increase the organizational efficiency of the government. But this brings us to the major lacunae. The budget can only be credible if the government machinery is seen to be making some sacrifices in terms of effort and re-structuring. An improvement in quality of public services will make a rise in user costs more acceptable, reduce hidden subsidies, and the revenue deficit. The government must commit to transparent and simplified procedures that will reduce the scope for political handouts in the budget and therefore interest in it.

Like Christian bride, the budget has something old and something new. There is evidence of an intelligent attempt to fit the circumstances; and correct policies that have not delivered but continue those that still have the promise to deliver.

Ashima Goyal

The general malaise gripping the economic scene has focused in the widespread expectation that interest rates will rise, at least in the short-term, and damage any possible industrial recovery. Let us carefully examine the arguments for and against this position.

First, defense of the exchange rate may require a rise in interest rates. The latter would induce short-term capital to stay and make credit for speculative purchases of the dollar more expensive. Second, if foreign inflows reverse it will be more difficult to fulfil domestic credit needs, and the latter will put pressure on interest rates. Third, higher inflation will raise nominal interest rates. Fourth, since India is a capital scarce country its steady-state interest rate is higher than world interest rates.

Fortunately there are counter-arguments against each of these positions. The classic interest rate defense is required if a financial panic leads to expectations of escalating depreciation that need to be broken. Interest rates will also have to rise if the equilibrium exchange rate rises above a fixed nominal exchange rate. But the rupee has depreciated, closer to its equilibrium value, and it has done so in a controlled manner. Our short-term foreign debt is low in relation to our reserves, so even if all the creditors decided to exit the rupee will not collapse. Being rational, our creditors realize this and will not exit. The ratio of short-term debt to reserves was 0.23 for India compared to 1.7 for South Korea in end 1997. Second, the interest rate defense is of doubtful value. Of the stricken Southeast Asian countries Malaysia, actually cut bank-lending rates by 1 per cent in end 1997, but has managed the fallout of the crisis well. Even when financial markets are sophisticated, there are problems with the interest rate defense. Institutional investors, who place an absolute ceiling on losses from currency fluctuations, try to replicate a put option dynamically. This dynamic hedging mechanizes stop-loss trading, and, during a speculative attack on a currency, can lead to such large sales of the currency, that it nullifies the squeeze on short traders by the classic interest rate defense. Rising interest rates make debtors worse off, harm the real sector and make recovery more difficult, while protecting the interests of international creditors. It is better to let the latter go and take the required depreciation. Movements in foreign portfolio investment are self-correcting; the fall in stock indices that occurs with an exit of capital will make it worthwhile to stay.

Second, much of the foreign inflows that came into India in the nineties were not utilized, and because of this they added to resource constraints rather than loosening them. This is a subtle point that has escaped notice. The FII inflows led to an accumulation of reserves. Money supply rises as the Reserve Bank sells rupees to buy foreign exchange and accumulates reserves. To maintain a money growth target sterilization is required. That is, as reserves rise, the Reserve Bank sells bonds so as to reverse the rise in money supply; domestic bonds are swapped for foreign exchange reserves. The only way to accomplish this in a narrow debt market is by a fall in the government share of the monetary base: the RBI's credit to the government has to fall. Foreign exchange reserves as a ratio of outstanding RBI credit to the government were already 0.79 in April 1998, giving little room for traditional sterilization. While the growth in RBI credit to the government was 20.58 in 1990-91 it varied between only 0.86 and 5.82 over 1991-1995. These were the years when foreign exchange reserves were built up. RBI credit to the government fell steadily from about 15-16 per cent of the GDP over 1988-1992 to 10 per cent in 1996-97. The influx of foreign capital started in 1993. The government has therefore had to resort more to borrowing from banks to fulfil its credit needs and this has put pressure on interest rates. If foreign inflows shrink this source of pressure on interest rates will disappear.

For foreign inflows to be fully utilized they must raise investment, rather than reserves. But private investment fluctuated steeply in the nineties. Sharp declines occurred in 1993-94 and 1996-97. And the trend decline in public investment meant that it was not compensated. Growth rises if buoyant investment is attracting foreign inflows. We have not been able to convert our foreign inflows into investment. FPI has just contributed to volatility in stock prices. But there was a trend decline in stock indices because high interest rates and the uncertainties of re-structuring have kept domestic investors away from stock markets. FDI directly boosts investment, but only about 20 per cent of the FDI that was sanctioned have actually been utilized. Reduction in procedural delays can significantly improve this percentage, in addition to attracting fresh FDI.

Third, demand, supply and inertia determine inflation. Both monetary and real factors influence these. A mechanical calculation gives it as the weighted sum of the components of price indices, but at a deeper level, core inflation is determined by profit shares, expected nominal wages and shifts in productivity. Infrastructure investment is a component of demand that expands supply with a lag. Therefore, inflation will not rise if, along with a stimulus to demand the productivity of resource utilization is improved, superior technologies adopted, and food prices are stable. Current growth with low inflation in America is driven by the productivity gains accruing from the spread of information technology--India is well positioned to harvest these gains. For example, cheapening of communication due to new fiber-technology has major externalities in every sphere. Our industries have restructured, lowered costs and now have excess capacity that can satisfy rising demand without raising prices. When some prices are falling, even if others rise, it does not translate into an overall cost-push. For example the cost-push of the petroleum price hike in 1997 should have lead to a rise in inflation of 0.77%, instead inflation fell by 1%. If inflation does not rise that push on nominal interest rates will not materialize.

Factors making for a rise in inflation are the depreciation and the current rise in food prices due to a bad agricultural year. But the latter makes productivity raising expenditure on agriculture all the more important. We cannot forever rely on good monsoons. It is true that monetary laxity without supporting supply side policies can raise inflationary expectations and impinge on core inflation. But targeting low interest rates is compatible with low aggregate money supply growth; it will only show more variation point to point as it responds flexibly to market needs. It is a well known result in the targeting literature that interest rate targeting is better than nominal money supply targeting when financial shocks are more frequent compared to demand shocks.

Fourth, there is insufficient understanding of the implications for interest rates, of being in an open economy, with highly mobile short-term global capital. In older macromodels imperfect substitutability between domestic and foreign assets, allowed domestic interest rates to differ from foreign. But today, even if assets are imperfect substitutes, or there is no capital account convertibility, there is enough mobile capital, at the margin, to force domestic interest rates for a small economy, to approach foreign. The gap between the interest rates reflects country risk, and raising domestic interest rates can serve as a self-fulfilling prophecy of rising risk. The rise in international credit risk with the adverse rating after the sanctions can be absorbed in the current gap between domestic and foreign interest rates. But in a capital poor economy should the steady-state domestic interest rate be higher to reflect the capital scarcity? The answer is that we are never in a steady state. Indeed, if properly utilized, the rising global mobility of FDI can be a boon and prompt more rapid convergence of per capita productivity and income across nations.

The fifth argument is a bonus: the government is now committed to a low interest rate regime. Government domestic borrowing is high and needs to be brought down but the optimal strategy to reduce public debt is one of low interest and high growth rates. The RBI has announced movement to interest rate targeting. In 1996 the mistaken belief that a high interest rate regime was necessary to keep inflation low killed industrial growth; the lesson of history has been learnt. Latest reports are of banks flush with funds, turning once more to government securities. Where is the credit squeeze?

Ashima Goyal

A low fiscal deficit has become a norm that is demanded by mobile global capital. In an interlinked world it is difficult for any country to defy a global norm. India has been trying to comply in the nineties, but without much success. It has become necessary to ask why. Strong medicine can suppress a symptom, but a lasting cure is possible only if the root cause is understood. The political economy of India's revenue deficit lies at this root.

The popular explanation is in terms of powerful vested interests each getting concessions such as employment, subsidies, free loans, cheap public goods and bureaucrats pampering themselves. But examining disaggregated figures of the government deficit and exploring the structure of causality gives a few surprises. Budget data, starting from the seventies, is divided by GDP at market prices, in order to reveal trends. The diagnostic table 1 allows us to clearly identify pathology, which is confirmed using more detailed data and time series analysis.

Since the seventies the government has not been able to fund its current expenditures from current revenues, and this has had a cumulative effect on interest payments and therefore the revenue deficit. Although investment has been cut the most, government consumption has also suffered. Consumption expenditures as a ratio of the GDP were the same in the mid-nineties as they were in the mid-eighties. The ratio of purchase of commodities and services in 1995-96 was about the same as in 1970-71. The component of current expenditure that has risen is interest payments. The share of compensation of employees has never been excessive, given the expansion in government activities. It has been falling in the nineties. These facts support an alternative view of the political forces that have impinged on budget making. It was the supply shocks (such as oil price rise and agricultural output declines) of the seventies, combined with the objective of lowering poverty, that initiated the decay in government finances.

The political imperatives in a poor democracy made it difficult to raise user charges for public goods. The result was increasing cross-subsidization, where industry and the well off were to pay for provision of services to the poor. This in itself is a laudable social objective (apart from catering to dominant vote banks). But it had built in incentives leading to a fall in quality and in investment. Since capacity constraints soon appeared, poor quality, such as time delays, were used as a rationing device. It became increasingly optimal for the rich to opt out of the system. Private alternatives appeared to service them. The government lost the geese that laid the golden eggs, and the poor suffered non-monetary costs. A humane society is not possible without cross-subsidization, but it only works if the budget is balanced and other economic criteria are met. The cross-subsidization chosen became unsustainable as interest payments on borrowing made to preserve consumption began adding on to revenue deficits. The irony is that alternative policies were available to protect the poor.

The famous Ramsey-Boiteux rule derives optimal cross-subsidization by maximizing social welfare subject to a budget constraint. It implies that prices differ from marginal cost but the gap should be inversely proportional to elasticities of demand. The rule can take account of other objectives in social welfare, such as redistribution, and the provision of incentives, and has been generalized into the theory of optimal non-linear tariffs. But since the government budget deficit has been steadily deepening, and the quality of services deteriorating any kind of optimality has been neglected. Moreover, if price in any sub-market exceeds cost, or if new technology lowers cost or breaks a natural monopoly, competitive entry occurs. Government revenues fall further.

There are two natural extremes in pricing rules that have opposite effects on incentives. A price cap offers high-powered incentives since the residual profit share lies with the firm. Rate of return regulation provides the cost of the service so there is no motivation to decrease costs. Moreover as profits from improvements do not stay with the firm incentives are low-powered. In designing an incentive scheme there is always a trade-off between rent-extraction and providing incentives for additional effort. A price cap if low enough extracts all rent, but can still motivate a decrease in costs. But it reduces incentives to invest and improve quality. Costs rise with quality so that low-powered incentives are required for the provision of quality. Similarly there is a disincentive to invest in the presence of price caps because sunk costs made for investment may be expropriated.

The government functioned with price caps for much of the products and services it provided. But where it had monopoly power and was servicing the rich, prices were raised much above costs of production. As the rich found alternatives, the cross subsidization was not sufficient to cover costs. Quality and quantity of government services deteriorated with the price caps.

A detailed examination of electricity, telephones, railways, education, irrigation,

Roads, State Transport Units and tax collection shows the same picture of prices held constant in the face of cost shocks; coercive but ultimately unsuccessful attempts at cross subsidization; budgetary losses combined with falling investment and quality. If the consequences of holding prices constant in the face of adverse cost shocks are understood, clear implications follow for policy. Moreover, the acceptability of these changes rises, if alternatives are adopted to protect the poor, and a gradual rise in user costs is directly linked to the provision of better quality.

This analysis of political economy is more hopeful than that based on implacable vested interests. There is no reason why the latter should moderate their demands. User charges required to improve the revenue deficit will be more acceptable if the adverse role of pricing distortions in the face of cost shocks is recognized. Poor quality is as much a cost to the poor as high prices. There is evidence that Indians are willing to pay higher prices for better quality. Politicians and bureaucrats are as much a victim of adverse circumstances and policy choices as the rest of us; they suffer from emptying coffers and poor reputations. Re-organization can quickly deliver a better quality of public service if the reasons for the decline in quality are recognized and steps taken to reverse them. The latter will bring the well off back into the revenue net, and make feasible the public investment that can sustain a virtuous cycle of improvement. Some results can come even without investment, which requires finance and time. Just as cost shocks initiated the rot, improved technology available today can be harnessed to lower costs over a wide spectrum.

Only sustainable cross subsidization should be undertaken and the tax base widened; attention must be paid to relative demand elasticities as well as re-distribution objectives. A fixed price/price cap mechanism with quality of service and performance norms and specific provisions for evaluation and adjustment over time is the most effective. Fixed prices need to be adjusted to ensure quality and investment, but maintain pressures to decrease costs. Another way to lower costs is to invite competition from private parties under strict regulation to ensure that they maintain safety standards and service some uneconomic sectors as well.

Non-discretionary and non-distorting methods of protecting the poor are first, increasing the productivity of agriculture and maintaining the price of basic foods in line with average purchasing power. Second public investment in infrastructure and human capital. As this raises human capability, incomes and taxes in the future, a short to medium term rise in the fiscal deficit to finance it is feasible. Food prices serve as a standard for all other prices in a poor country. In India poverty has risen in the short-run and inflation in the medium-run with food prices.

The perception that the pervasive decline in quality and corrosion in public life had a cause, and is not inevitable, will make its reversal possible. Political parties and state governments can then come together and act on this platform.

No other single economic event generates as much debate as the budget. It demonstrates the process of the hammering out a democratic consensus. People are interested not only because the budget directly impinges on wallets, but also because of the joy of ideas. With so much critical focus there is little chance of errors persisting. It is difficult for one group to be favoured in a way that is unacceptable to other groups. But for the debate to truly become a progressive dialectic, it must be issue based and rise above party lines. Statesmen such as ex-finance ministers should give the lead in this. Mr. Chidambaram first reversed the declining trend in public investment and turned the focus on infrastructure. Manmohan Singh acknowledged his government’s mistake in neglecting the latter. Where Yashwant Sinha builds upon the lessons his predecessors taught and learnt they should be gracious enough to acknowledge this; where there are lacunae constructive criticism should be welcome.

The budget has been widely praised for pragmatism, and giving a further boost to reforms, but a frequently aired criticism is that there is no underlying framework. This is unfair. The parts cohere very well together and are entirely consistent with the objectives of promoting growth with efficiency. The economy is too complex to be captured in any mechanical model. A biological metaphor is more apt. According to this, it is necessary to discover the set of conditions that create a favourable climate for growth. The emphasis in the budget on empowering the individual through tax policies and public spending that promote efficiency and stimulate agriculture, industry, construction, capital markets and encourage foreign investment, create such a climate. Moreover, it does so by paying necessary attention to uniquely Indian features such as the low average level of human development, the importance of agriculture, and the preference for holding gold. The reason why the mis-perception of ad-hocism has arisen is that the budget creatively departs from the reform ideology in two aspects: consumption –led growth and minimalist government.

Reformist budgets of the nineties have lowered taxes in a bid to improve compliance and stimulate consumption. The former has increased marginally, but consumption has not risen sufficiently to sustain manufacturing growth. The development of vibrant markets requires more than just tax cuts. It needs a creative restructuring to suit the price-quality-product requirements of different classes of Indian consumers. This budget shifts the focus from consumption to stimulation of savings and investment. In the face of the limited success with the former, this is a justifiable strategy. The Economic Survey points out that the awards of the Fifth Pay Commission have gone into increased household financial savings. When the large increment in income he had put in their hands did not raise consumption, Mr. Chidambaram tried reminding consumers about their Dharma, which was to consume. The budget does have features to boost overall efficiency and quality; these will eventually provide consumers with incentives to fulfil their Dharma.

Improving tax/GDP ratios and compliance does not require raising tax rates but expanding the tax base. The budget has not done enough for the latter; but the marginal and temporary surcharge on income tax will not adversely affect compliance. It is regarded as too costly to tax agricultural incomes, but if panchayats that are being vitalised in many ways, are given the responsibility of collecting agricultural taxes, costs will not be so high.

The finance minister has committed himself to downsizing the government administration; but expenditure on health, education and infrastructure is slated to rise. The latter displeases those who think that governments can do nothing right. But it is consistent with the policy of strengthening human and physical capital for growth. It is true that more features could have been built in to improve the efficiency of government, help to reduce the revenue deficit and release more funds for investment. The US government converted a persistent deficit, running for 29 years, into a surplus by systematically removing all incentives for waste in government activities. Wider use should have been made of incentive payments such as that of releasing 20 per cent of funds to panchayats only if they are elected and functioning. Not enough has been done to raise user charges.

In this context it might be useful to report the figures on a new concept—the Primary Revenue Deficit. The fiscal deficit is the center of attention because it measures the government borrowing requirements, which are regarded as crowding out private borrowing. But in a developmental state, where some types of government expenditures complement private activity, the focus should be on reducing unproductive government expenditures and widening the tax base. And since 49 per cent of revenue receipts are pre-empted by interest payments on past debt, current efforts in such fiscal reform are best measured by the revenue deficit net of interest payments. This is the Primary Revenue Deficit. Focusing on this will force the government to go beyond easy and harmful options such as cutting productive capital expenditures.

How has the government performed in this respect? It has not done well in the last budget, but future intentions are better. Non-plan expenditure on revenue account, net of interest payments was slated to rise 15 per cent in the 1998-99 budget estimates (BE) but actually rose 25 per cent. Still, the rise built in for the current BE is only three per cent.

This government is often blamed for making empty promises. What is its record with respect to the last budget? There was overshooting in last year’s consumption expenditures, plan outlays fell, and there was a severe shortfall in tax collections compared to budget estimates. The much trumpeted 40 per cent rise in public investment on energy was cut to 20 per cent. Although plan expenditure on capital account was below budget estimates, it did grow by a steady 12.6 per cent over the actual expenditures of 1997-98. And the same rate of increase is projected for the future. Remembering that industry did not perform well in the past year, there is every chance that these more modest promises will be fulfilled in the next year. But the growth rate of infrastructure output (2 per cent) fell to half its previous value in 1998. The economic survey blames the slowdown on the demand recession. Mr. Chidambaram’s budget of 1996-97 reversed the stagnation in public investment—it grew by 16 per cent in 1997-98 compared to only 4.5 per cent in 1996-97. But this was sufficient to raise the public investment /GDP ratio only to 7 from 6.7. As private investment continues to flag, much higher rates of increase in public investment are required to have a discernable impact. The funds for this can only come from a restructuring that improves the fiscal position. The reduction of the Primary Revenue Deficit is all the more important.

An innovative feature that has attracted much discussion is the new treatment of small savings. Many regard it as an artful dodge to window dress the fiscal deficit. But it is welcome for two reasons. First, small savings depend on individual decisions and the government cannot directly influence it. For example, last year it increased 34 per cent above the estimated value. This plays havoc with tight deficit targets. Second, if the expenditure is also removed from government control and managed by professionals, it may improve returns to the small savers. And also help in the realisation that government borrowing or guarantees for specific purposes may be productive enough not be included in measures of the current fiscal deficit.

The government does seem to be on a learning curve and should be given credit for it. This budget was based on extensive discussion with different groups. Perhaps that has helped them to improve presentation. The import duty structure that received so much criticism last time has gone down smoothly this time as a temporary surcharge that is part of efficient restructuring. Second, unlike widespread expectation last year’s budget and rise in money supply has not been inflationary. Features in the current budget will help prevent the recurrence of last year’s sharp spike in select agricultural commodity prices. And the welcome cut in interest rates will help the budget to boost growth. Many welcoming moves have still not made the Government popular with foreign investors. There is scope for further improvement in presentation. But perhaps high growth will help foreigners change their perceptions.

Ashima Goyal

The nuclear blasts and the sanctions that have followed them offer a useful opportunity to examine the role of foreign inflows in the Indian growth process. To do this it is unnecessary to go into the issue of whether the blasts were right or wrong. All thinking and sensitive people are committed to nuclear non-proliferation – the debate is about the best way to go about this. As Kautilya said the powerful speak only to the powerful, and two pieces of iron will solder only if they are both red hot. It is a case of eastern strategy pitted against western. Now that the blasts are history which is the best way forward? India must negotiate no first use agreements with its neighbours and push for overall nuclear disarmament. The sanctions will eventually crumble, as they will harm the commercial interests of the nations that impose them. Moreover, they lack moral force: they are a mask for a self-serving, hypocritical policy of apartheid and inequality. The only long-run solution is for countries known to possess nuclear capability to be included in the group of nuclear haves while tightening non-proliferation and beginning systematic disarmament. The US believes in the sanctity of the individual; it cannot for long commit itself to massive intervention that seeks to harm one billion individuals for an act of their government.

The other reason the sanctions will fail is that they will not work. The penalty they inflict will be minor compared to the effort of organizing them. Some facts: In 1995-96 India received a total of $3648.8 million of official assistance, which constituted only 1.2 per cent of its GDP. International organizations such as the IBRD and IDA had a major share of about 40 per cent, Japan was a close second, but the share of the major individual country donors varied from 1 to 2.4 per cent. Now that the G-8 group of countries have not supported the sanctions it is unlikely that the aid from international organizations will be stopped. Therefore India immediately stands to loose only half of a relatively small amount.

Moreover foreign inflows on private account have been rapidly supplanting official assistance in the nineties. Even in 1993-94, a year when they were not very high, foreign inflows accounted for 43 per cent of the capital account of the balance of payment, while external assistance lagged at 9 per cent. If foreign inflows on private account are encouraged they can easily make up the shortfall in external assistance; there will not be even a dent in the balance of payment. In addition foreign firms will be a powerful lobby against the sanctions. Easing and expediting entry of such firms is a good strategic response of the Indian government. US banks are not going to enjoy loosing out to British and French banks. The US is proud of the decade of worldwide liberalization; but as the power of governments around the world has been emasculated, that of the US government has also fallen.

The other fear, although that is rapidly receding as time passes, is that of the sanctions triggering off a cumulative exit of short-term global capital. But India’s short-term debt comprised only 5.46 per cent of its total debt in 1996. More than half of this was made up of NRI deposits of less than one year’s maturity. As NRI’s around the world rediscover fellow feeling and gear up to support their country of origin at a time of unfair global ostracism, it is unlikely that these deposits will depart. Moreover the Reserve Bank has a good knowledge of the interest and exchange rate policies required to suppress speculation, after having used them successfully in 1995-96 and 1997. Short-term interest rates may have to be raised, but only if signs of a panic develop.

The most immediate sufferer will be the Government of India, as foreign sources of funds dry up at a time when it is struggling with a tight budget. But if the closing of soft options forces it to undertake structural reforms it has been avoiding, it will be a long-term benefit. In a time of nationalistic fervor it may be able to push through privatization programs, reduction in subsidies and broadening of the tax base that will improve the revenue deficit. At the same time it must not be afraid to borrow and use innovative new financial instruments to steeply raise investment in infrastructure. Industry has recorded a very low growth of only 4.2 per cent. And the worst performer has been the capital goods sector. This needs a boost from public investment. A rise in growth will improve revenues. If enough private foreign inflows are stimulated interest rates need not rise either. In this way the government can absorb the consequences of its action without passing it on to the people.

The mistake Mr. Chidambaram made was to resist raising public investment because of a fear of the fiscal deficit, and the mantra of consumption driven growth. A rise in consumption offers only an indirect and lagged stimulus to capital goods industries; that from infrastructure spending is more direct. Moreover, the ratio of savings has been rising; to prevent demand deficiency from setting in the ratio of investment must also rise. As private investment is recession struck public investment needs to take the lead. In India growth cannot be fully consumer driven as yet because of the deep dualism in consumer markets. But a trend rise in savings ratios does not preclude a rise in consumption levels as incomes also rise.

This leads us to the question with which we started this article: how do foreign inflows stimulate growth? Growth theory offers one of those conundrums that make economics so difficult to understand: resources available, such as savings and foreign inflows, affect the level of per capita income but not the rate of growth. The latter is determined by the rate of growth of resources. In a country such as India where human resources availability is not a constraint, the rate of growth of resources is determined by investment as the active principle. If we are able to raise investment foreign inflows will follow, and if the investment is productive it will not lead to unsustainable foreign debt.

Finally those who have responded to the blasts by wondering how such a poor country has dared to alienate the powerful, need to be reminded that a precondition to stop being poor is to envisage the possibility of being rich. Actions will be motivated by principles and not by fear as the dependence paradigm gives way to one of mutual cooperation and well being.

Ashima Goyal

Commentators on the Indian economy are divided into two camps: those that would like to see the rupee depreciate and those who want it to appreciate. The first want to stimulate export competitiveness, the second fear a cumulative descent the South East Asian way. The recent measures the Reserve Bank has taken to defend the rupee puts it in the second camp. The debate continues because it is not easy to determine the equilibrium real exchange rate of the rupee. Ideally this is defined as the value that equates the current and the capital account of the balance of payment, over time. That is current account deficits must be financed by sustainable capital account deficits. Since future periods are involved market expectations enter the fray. Before the eighties the determination of the exchange rate was simpler. It was dominated largely by trade flows. But now capital transactions dominate. The exchange rate behaves more like an asset price; expectations of market traders and bandwagon effects, as they learn from each other, can lead to large price movements. If markets were perfectly efficient trading should discover the equilibrium exchange rate. But the experience in Europe, Mexico and now South East Asia demonstrates that the foreign exchange market is subject to bubbles. Therefore there is scope for welfare improving policy intervention. But what should this be?

Sustaining the nominal exchange rate above the value expected by the market requires high interest rates to prevent capital from flowing out of the country. Over time this harms domestic investment, output and productivity and therefore causes a depreciation in the equilibrium real exchange rate. To maintain the level of the nominal exchange rate will then require even higher interest rates; it is not a sustainable strategy. South East Asian countries made this mistake: nominal exchange rates were fixed in the nineties or did not vary sufficiently while their interest rates exceeded world interest rates. Data from the International Financial Statistics (IMF) for Thailand show that while the nominal exchange rate remained fixed in the nineties, domestic nominal interest rates exceeded international by an average of 2.5 per cent and a peak of 5 per cent. Such a policy regime provoked excessive foreign borrowing, which was not wisely used. If foreign inflows are freed, and nominal exchange rates are stable, the inflows must be allowed to reduce domestic interest rates to international rates. Otherwise the regime is susceptible to a crash in exchange rates and cumulative departure of short-term capital.

If domestic inflation exceeds world inflation it causes real appreciation in the face of a fixed nominal exchange rate. As approximately 40 per cent of our population remain under the poverty line, and food still comprises a large share of the budget for the majority, inflation in India is very sensitive to food prices. After the steep devaluation of 1992, a rise in food procurement prices became necessary to lower the large gap that had opened between the domestic and border prices of foodgrain. The high inflation of the early nineties was partly caused by these events. Domestic food prices rose and so did wages and the general price level. Domestic inflation exceeded world and the real exchange rate appreciated nullifying part of the earlier devaluation.

This sequence of events suggests an interesting transitional rule for managing the nominal exchange rate: it should be varied to equate the domestic and world prices of an average food consumption basket. The scheme has several advantages. It reflects the current structure of the Indian economy; the resulting nominal exchange rate would not generate inflation that would lead to a real appreciation-it would therefore be sustainable. The variations in the nominal exchange rate would force the purchase of hedging devices. Such devices aid in preventing bubbles by moderating losses in exchange transactions. But they only work if interest rate variation is low. One of the factors determining domestic interest rates is the gap between equilibrium and actual exchange rates. If the rule were able to lower this gap it would also moderate pressures on the interest rate. The rule would only address the real appreciation that occurs due to excessive domestic inflation; other policies would be required to allow the equilibrium real exchange rate to appreciate to sustainable levels, and close the gap between it and the actual real exchange rate. A low real domestic interest rate is among such policies. The rule artificially imposes purchasing power parity on staple food products, and is well suited to the objective of agricultural liberalization.

Since the weights and constituents of the food basket would not be known speculators would not be able to outguess monetary authorities. India’s comparative productivity in agriculture at present is much lower than that of the major food exporting countries. Therefore the resulting exchange rate would be depreciated enough to stimulate exports. Over time it could safely appreciate as productivity rose in Indian agriculture. Because inflation would be lower monetary authorities could afford to allow a regime of lower interest rates that would stimulate the real sector.

We illustrate the working of such a rule with Indian and US (c.i.f.) wheat prices. Moderate quality wheat enters the average consumption basket; therefore this is the one used. The commodity exchange rate is determined by the ratio of domestic to foreign wheat prices. Over 1992-94 this would have been at about rupees 25 per dollar, when the rupee was devalued in two stages from 17 to 25 to 31.25. Therefore the second stage overdid the devaluation. In consequence, the rate of inflation rose leading to a real appreciation. As US wheat prices fell and domestic rose the commodity exchange rate had reached 31 by 1994. But in 1995 US wheat prices fell requiring an appreciation of the rupee to 25 to maintain parity. Instead the rupee fell and had reached 35 by 1996. Therefore domestic wheat prices rose steeply and peaked by early 1997. The commodity exchange rate now reached the forties as US wheat prices began to fall steeply once more. Because the rupee was not depreciated, and remained at around 35, domestic wheat prices began to fall, contributing to the all time low in the inflation rate, which stood at 4 per cent in July 1997. By the end of the year there was equivalence once more between the commodity and the actual exchange rate.

Even this rough data supports the working of the suggested rule. Therefore the analysis does offer new useful inputs to the difficult task of exchange rate management. It answers the two camps: the current level of exchange rates is about right from the point of view of minimizing inflation. Second, to minimize inflation in the future the monetary authorities should allow the rupee to appreciate if international foodgrain prices fall, but depreciate it less than fully if they rise. The coefficient of variation in domestic wheat prices over 1994-96 was 0.23, higher than that of US wheat prices that stood at 0.16. Therefore another benefit would be a reduction in the volatility of domestic prices. Mild volatility would instead be imparted to the nominal exchange rate; this would fulfil the purpose of getting agents used to hedging instruments, and prevent the onset of high volatility. Participants in the exchange rate market would be insured against small losses, therefore these would not trigger off a panic withdrawal of foreign capital. Since international commodity prices would be only one of the factors influencing exchange rate policy, speculators would not be able to outguess the Reserve Bank. And lower domestic interest rates would help to stimulate the productivity increases that would allow an eventual appreciation in the equilibrium and actual exchange rate without harming exports.

Ashima Goyal

In a country with a low per capita income, the price of food is a nominal standard, in the sense that a rise in the price of food will raise all other prices. The average level of nominal wages will rise with food prices over the medium-term, both because of the debilitating effects of a long-term fall in nutrition on labour productivity, and because of political pressures in a democracy. An illustration of the latter comes from the impact of onion prices on the electoral fortunes of the BJP. There is evidence that the effect of food prices on real agricultural wages disappears in the medium-run as wages adjust to food prices, after leading to political unrest in the short-run. Ill effects of the wage-price cycle continue from the inflation and induced aggregate output contraction resulting from an agricultural shock.

Conscious policies to stabilize the price of basic food were widely adopted in Asia in the sixties. These arose in the context of widespread poverty, and the disastrous political consequences of food shortages. Therefore the objectives were wider than just price stabilization. There was a desire to achieve self-sufficiency in the production of basic food and to break the nexus between food prices-wages-inflation, of which there was an implicit understanding. Low and stable price of the basic foodgrain was thought desirable to keep down inflation, reduce upward pressure on wages, and improve the profitability of the industrial sector. Policies followed were different for food importing and exporting countries.

A floor price was required to maintain incentives for producers and a ceiling price to protect consumers. The floor price was considered necessary to induce the adoption and wide diffusion of new agricultural technology including high yielding and pest- and disease resistant crop varieties. In pure price stabilization a sustainable target price must be the mean between the high and low prices, and is not necessarily linked to any such floor or ceiling.

The types of interventions commonly followed were procurement, buffer stocks and distribution by the government, imports, taxes and subsidies. If prices are not to respond fully to production variations, they have to be offset by variations in trade or stocks rather than in consumption. A price band has to be fixed around an average price, taking into account the supply response to the new price regime. The major thrust of domestic stock operations was toward seasonal price stabilization, whereas imports have been the major instrument for inter-year price stabilization. Carrying buffer stocks for long periods is costly.

Although public stabilization programs were not efficient, still they did lead to lower variability of domestic prices compared to international prices. But changes in the nominal protection rate occurred more due to changes in the real exchange rate, than due to the policies to stabilise domestic prices. In the period, nominal exchange rates were largely fixed. As markets get better integrated, and transaction costs in trade fall, trade policies become cheaper compared to buffer stocks. Costs of trade contacts and negotiations fall. Even so, poor populous country can afford to let imports form a large percentage of domestic consumption needs. But as the country approaches self-sufficiency, trade at the margin can become freer. With growth in per capita incomes, food price fluctuations become less important. But the impact of a price rise on the poorest consumers, and collapse in producers’ prices due to an unusually large harvest remains a concern; some kind of food price stabilisation is still required. The nominal exchange rate can play a role in this.

These changes coincide with a major re-thinking on exchange rate regimes. As agricultural prices approach border prices, the exchange rate influences the inflationary process. The level of productivity in the basic food crop determines the nominal exchange rate that is sustainable without inflation. Since food is the largest constituent of the consumption basket in a low per capita income country, the inflationary impact of devaluation, will be higher, as agricultural products become traded goods. The level of real wages must be such as to make possible the purchase of the basic consumption basket.

To attain food price stabilisation, in a regime of freer trade, the nominal exchange rate will have to be managed. There is a level of the real exchange rate that delivers the desired wage rate. If the actual exchange rate is above that, inflation and real appreciation results. Therefore a nominal exchange rate rule should be followed, whereby the nominal exchange rate is set to equal the ratio of domestic to world prices of a basic foodgrain. Domestic prices would then be constant, while the nominal exchange rate would be subject to small random fluctuations, moderated by trade margins. In India wheat is the natural commodity to implement the rule with. At current exchange rates, domestic wheat prices are close to border prices. Restrictions on agricultural imports and exports that remain follow the logic that exports are restricted in products that are important for food security, and imports are restricted in products where India wants to develop dynamic comparative advantage. In the first category, exports are restricted for coarse grains, while imports are canalised. Rice and wheat belonged to this category at the beginning of reforms, but now exports have been freed for rice and for some varieties of wheat. Oil seeds belong to both categories and there has been no change in their trade policy status. They are the only agricultural products that enjohigh rates of protection—in most others foreign prices are higher than domestic and there is great export potential which will be increased as GATT is implemented. In products where India has a clear comparative advantage such as fruits, vegetables, tea, spices, exports have been freed while imports continue to be restricted.

If imports of wheat are privatised, but exports remain canalised, prices cannot fall below the border price since government would buy and cannot rise above it since private parties would import. Both the very poor and farmers would be protected from extreme price fluctuations. In wheat production, farmers would get the highest incentive commensurate with low inflation and they will have other profitable opportunities as export is freed in horticulture etc. The farm lobby which has been arguing against the restrictions on free trade in agricultural products and the disprotection evident in agricultural prices that are lower than border prices while manufacturing prices are, in general, higher, should then be satisfied.

Because nominal domestic prices of basic food will now be fixed, demand will be equated to supply by variation in quantities. Imports-exports or variation in government buffer stocks will do the adjusting post-harvest, but because domestic prices vary less hoarding and buffer stock requirements will be lower. Private traders, in both foreign trade and domestic markets, respond to market signals faster. But sufficient competition and ease of entry is required to prevent collusion. Further stimulus to private trade can come from investment in transport and communication infrastructure and the development of institutions to finance trade. As speculation is discouraged, public stocks can be smaller. By buying when domestic production is very high the government can prevent foodgrain prices crashing, thus protecting farmers; by importing quickly when domestic production falls below trend; traders will protect the poor consumer. Traders will expect future prices to move in line with the government’s projections as its purchase and sales policy will be credible.

Because productivity in Indian agriculture is much lower than world levels, the exchange rate will be depreciated enough, at this level, to stimulate exports. Indeed, it can appreciate only if productivity rises in agriculture or infrastructure improvements let c.i.f. import prices fall. Real wages can rise if agricultural productivity rises.

The basic reason for the impact of the nominal exchange rate on wages and prices is that investment, exports, and labour productivity are too low to give the required real wage, and equate the current to the capital account of the balance of payments. The latter determines the equilibrium real exchange rate.

The nominal exchange rate would vary with fluctuations in world agricultural prices. Hedging devices such as futures are easier to use in foreign exchange markets compared to agricultural markets. With the random fluctuation in the nominal exchange rate, the habit of using them would be encouraged. If such devices are properly used to spread risk, and are combined with a low real interest rate regime, the chances of financial crashes would be reduced. If inflationary expectations are stable, determined by the supply side, monetary policy can target a low real interest rate that would also prevent a depreciation of the equilibrium real exchange rate, and stimulate improvements in productivity.

As India becomes an open economy agriculture and the price of food will remain important, as it must in a country with a large population below the poverty line. But the analysis changes in interesting ways; in many aspects agriculture becomes like industry.

In an Harvard Business Review article Krugman made the point that the Economist's world view differs from that of the Businessman. The first saw the whole and the latter the part, and therefore the Businessman was somewhat off the mark. To substantiate his point, Krugman asserted that a businessman does not easily recognize limits--his perception is that if he does not grow it is by choice. The Economist, working from a resource constrained equilibrium concept, recognises that while some will grow others will fail--external limits impinge on an individual business. Another principle of equilibrium economic analysis is that only prices of inputs and outputs should influence the firm's decision; aggregate macro quantities will not convey additional information.

A recent seminar on the "Economic Foundations of Management Strategy" at IGIDR provided an opportunity to test these impressions. Practitioners and management economists gathered there did have the strong belief that "if the businessman wants to he can". But there was a clear recognition of the importance of macrovariables and policies for business decisions: most businesses expand with aggregate activity, and vice versa, although each businessman would like to believe that he would be immune from the contraction.

In an interesting relatively recent development modern economic theorists are moving around to the businessman's point of view. There are three related sets of ideas that have caused the shift. First, growth can be endogenous, driven by constant returns to the produced means of production; second growth can therefore respond to individual actions; and third, the natural consequence, coordinating these actions can improve growth. Business cycles have long been recognized, but they were regarded as a purely short-term phenomena, with ups and downs canceling over the cycle. The new departure is the realisation that there are long-term consequences of these cycles; indeed, development can be understood as sustaining a positive cycle.

The idea of gainers and losers came from a static optimum point. When the cake is fixed, a larger piece for me must put you on a diet. If resources are fixed, or growing at an externally determined rate, the size of the cake is independent of the actions of individual agents. All agents need not be undertaking similar actions. It is not necessary or likely that the majority of businesses will be expanding together. If most businesses are growing, prospects for others will not improve.

New theories build in endogenous growth based on positive spillovers, constant returns to scale or multiple equilibria. A positive spillover arises when an action by one agent benefits another. If the first does not receive any compensation for these benefits, he would, therefore, undertake less of the action than is socially desirable. It is then an externality. But if the second agent has an incentive to undertake some reciprocal action, swelling mutual benefits ensure that the activity is undertaken. The result depends on individual actions. This brings in the necessity of coordination. The idea has long been around in the development literature, but has recently been formalized and clarified. A coordination of efforts can push an economy out of a trap where everything operates at a low level, allow it to grow more rapidly and utilize its resources more fully. If such outcomes are possible then the businessman's instinctive view is the correct one.

In such circumstances, since policies can trigger the movement of the economy towards a higher growth equilibrium they have a major impact and greatly aid the coordination effort. The policies need to be specific to the structure of an economy. Macrodynamic theories are available that have worked out the details. In such theories a very simple dynamic model turns out to be capable of reproducing complex observed behaviour. The response of demand to supply shocks can stimulate the shift from low to high growth equilibria. For example, the large remittances from non-resident Indian's in the seventies, helped to raise both public and private investment and rates of growth in the Indian economy. There was an accumulation of internal and external debt, however, and the productivity of investment remained low, pointing to deeper structural changes required. Some of these were implemented in the reforms of the nineties. The large capital inflows provide another opportunity. Private investment was responding before it was stymied by the interest rate shocks. Long-term foreign inflows ease fiscal adjustment and make it easier to adopt desirable complementary policies, such as an expansion in infrastructure, that can lead a resurgence in private investment.

The existence of such low and high growth equilibria, that respond to coordination, explain why macrovariables matter for firm's decisions. Especially in developing countries resources are very poorly utilized and there is a lot of waste. It is always possible to raise the efficiency of utilization of resources. The limits on the expansion of produced means of production are even lower in such countries.

The other implication of spillovers and the possibility of coordination of actions is that the optimal business strategy changes. Exploring these strategies will clarify our earlier point about the impact of individual actions on growth. The Economist recently examined the relevance of game theory in making day to day strategic business decisions, and summarised the lessons simply in the mantra: compete when my gain must be at your expense and cooperate when both can gain. A cooperative strategy is one that aims to maximize joint returns. But issues are slightly more subtle. Very often there are prisoner's dilemma (PD) type situations. Here the possibility of cooperating depends on being sure that the other will also cooperate. But this cannot be assured; cooperation does not occur and the outcome is one in which everyone is worse off. In a cooperative game (as distinct from a strategy) the equilibria never have this feature, although the surplus is distributed according to relative bargaining power, in such games. It is not possible to increase the profits of one firm without reducing the profits of another. The PD is a non-cooperative game. The outcome can have both players worse off; some potential surplus is destroyed by moves such as "burning ones bridges" to impose a cost on oneself or others, and gain an advantage in bargaining. Policies that stimulate growth and raise the returns to cooperation can make it the dominant strategy, and change the PD into a cooperative game. This stimulates the reciprocity that leads to the positive spillovers mentioned earlier.

Cooperation here is used in a wider sense that just collusion, such as when a cartel fixes prices to increase profits of only the members of the cartel. As activity expands all groups benefit. Sharp business practices can give way to ethical ones. Indeed, a growing recognition of these possibilities is responsible for a resurgence in the emphasis on ethics and values in the management strategy literature. In an open economy, reliability and quality are essential for the creation of ongoing trade contracts. It is too costly to be always searching for new partners. Competition can move from being destructive, where I must destroy you to get your market share, to constructive where your example stimulates me to improve my product and expand the market. Indeed, such competition is necessary for the improvement in quality that raises market returns. Competition makes cooperation possible. Policy and business actions can coalesce into a synergy that makes cooperation the dominant strategy, and allows the majority of businesses to expand together. The upward phase of the growth cycle is sustained, resources utilised at higher productivity, and economics need no longer be a dismal science.

Ashima Goyal

How does the new Monetary and Credit Policy (MCP) affect the average Indian? Twice a year the Reserve Bank of India (RBI) announces the future course of money and credit supply and financial reforms. Earlier we had a rigid system in which the RBI would set all interest rates. Starting in the nineties reforms have gradually freed almost all interest rates. Now the RBI has to use indirect methods to influence these market-determined interest rates. The October 1997 Monetary policy reactivated the Bank rate, or the rate at which banks can get refinance, and this was gradually lowered from 12 per cent to 9 per cent. Repurchase options were also encouraged. This is another measure that enhances the flexibility with which short-term credit can be generated in response to need. The new MCP continues these reforms. These and the cut in compulsory reserve requirements (CRR) will raise money available with banks and lower longer-run interest rates. The bank and short-term repo rate set by the RBI are emerging as risk free benchmark rates. These rates strongly influence short-term interest rates, while long-term interest rates respond to the supply of money. The RBI is moving from its earlier practice of setting growth rates of money supply towards responding to monetary indicators that include interest, exchange etc. rates. This will allow a more flexible expansion of RBI credit in response to need. RBI credit is the monetary base, which determines the money supply and overall liquidity.

Since there is a slowdown in industrial growth, a cut in interest rates had been expected to encourage investment. The Reserve Bank does favour a softening of interest rates, but today they cannot be discussed in isolation. Interest rates can fall only if inflation rates are falling, the exchange rate is stable, and the demand for credit can be accommodated without a too large growth in money supply. While lending rates should come down retail borrowing rates have to be high enough to give savers a real positive return.

The interest rate regime is very different in an open economy, where banks, exporters, NRIs and foreign investors can convert the rupee into foreign exchange if the relative returns to holding the rupee fall. Domestic short-term interest rates must equal equivalent foreign interest rates plus country risk as reflected in the forward premium on the exchange rate. The forward premium reflects the price of the rupee in the future; therefore it is determined by expected fall in the value of the rupee.

Two choices open to the RBI when the rupee is expected to fall are to raise interest rates or let the rupee fall. At present inflation is low due to supply side factors, including a good agricultural output, exports are stagnating and there is an industrial slowdown. Therefore, if the fall can be managed so that it does not lead to a self-fulfilling downward spiral, it would lower expected depreciation; short-term interest rates could come down; industry would be encouraged and competitive exports such as textiles revive. It is higher growth that can protect the rupee, not high interest rates. Rising interest rates can actually raise expected depreciation of the rupee by harming growth. It is better to let the exchange rate depreciate (but only to the degree that it will be non-inflationary), rather than use the interest defense, for extended periods. The RBI wants a softening of interest rates but has stopped short of lowering the short-term interest rate, combined with depreciation, as a stimulus to the economy. If short-term interest rates had been cut the rupee may have fallen from its current value of Rs 43 to a dollar to about Rs 45, as the forward premium is about seven per cent.

Apart from expected inflation and exchange-depreciation, another factor said to prevent a lowering of interest rates is high government borrowing requirements. But as the MCP points out, the RBI has been able to manage this without pressure on interest rates in 1998-99. Monetization of the Government deficit, or RBI credit to the government was lower, compared to 1997-98. The share of foreign exchange reserves in the monetary base rose because of the inflow on account of the Resurgent India Bonds. Therefore the share of RBI credit to the government fell. The government had to borrow more from commercial banks, which should have put direct pressure on the interest rate, but did not. Commercial banks are voluntarily holding 33 per cent of government securities against the statutory minimum of 25 per cent. If foreign inflows are used rather than hoarded, as growth resumes, a larger percentage of Government borrowing requirements can be funded by RBI credit, further lowering pressure on interest rates. The best way to reduce the large domestic public debt is to raise growth and lower interest rates; the widening gap between gross and net government borrowing requirements will be reduced as interest rates fall, and the borrowing requirements will themselves fall as revenues rise. If India's steadily accumulating foreign exchange reserves are used even more will be attracted as growth improves.

It is not necessary that you and I will have to be content with lower returns on our savings if nominal interest rates fall. First, if the fall mirrors a fall in inflation rates real returns will stay unchanged. Moreover lending rate can fall with unchanged borrowing rates if costs fall in the financial sector and spreads are lowered. As reforms promote re-structuring and efficiency; smooth treasury management lowers transaction costs; imposts such as CRR and SLR, and priority sector loans that lowered returns for banks are removed, costs will fall. If asset-liability management is adopted, spreads can fall without harming bank profits. Banks will be able to lend at lower rates even if they are paying higher deposit rates.

The MCP is moving cautiously in the right direction, removing restrictions to allow the financial system to respond more flexibly to our needs; but imposing non-discretionary regulations that make it safer. A little less caution could have yielded greater stimulus; but in a time of political instability caution is wise. To end let me refer to a feature of which we should all take advantage: a Regulation Review Authority has been set up to which we can all make suggestions for review of any regulation or requirement of the RBI which affects us.

The Interest Rate Controversy

Ashima Goyal

The future of interest rates has been debated vigorously. The Ministry of Finance would have liked interest rates to come down but while the Reserve Bank favours a softening of interest rates; it is worried about the fiscal deficit. It is useful to revisit the debate in the context of the new monetary and credit policy (MCP) measures.

The issues can best be understood by placing them in an analytical framework and historical context. It is not enough to say that the interest rate should go up or down. The statement has to be made in relation to expected inflation and real exchange rate depreciation. The interest rate regime is very different in an open economy, with highly mobile short-term financial capital. Leads and lags in export-import proceeds, arbitrage by domestic and foreign banks, NRIs and Foreign Portfolio Investors mean that domestic short-term interest rates must equal equivalent foreign interest rates plus country risk as reflected in the forward premium on the exchange rate. A large constituent of the forward premium is expected depreciation of the rupee. But it needs to be investigated if a rise in interest rates reflects rising country risk or causes it.

In two recent instances short-term interest rates overshot the arbitrage relation. In 1995-96 money supply growth was below its target, and a sharp rise in interest rates accompanied volatility in exchange rates. There were large arbitrage profits for incoming foreign inflows. In the October 1997 credit policy the RBI decided to reactivate the bank rate and establish it as a benchmark risk-free rate. It was lowered in successive stages from 12 to 9%. But the lowering of interest rates had gone too far, by December 1997 it was profitable for banks to start transferring money abroad. Arbitrage has to be respected in both directions. These episodes establish that the interest rate cannot be arbitrarily set.

More seriously, the interest rate defense cannot satisfactorily remove exchange rate volatility over the longer period. There is both theoretical and empirical evidence in support of this argument. The equilibrium real exchange rate equates the current account to sustainable capital inflows on the capital account. Therefore, higher real interest rates can actually raise the equilibrium real exchange rate by lowering the gap between investment and savings. The latter is the definition of capital inflows. The rise in interest rates meant to defend against short-term self-fulfilling adverse expectations can lead to a worsening of fundamentals and the equilibrium real exchange rate depreciates. Short-term expectations freeze into the longer-term as irreversible adverse impacts on investment occur. In that case the interest rate defense is unsustainable over a longer period, because it would only imply ever-increasing dependence on it, rather than covering for it. That is, rising interest rates can actually raise country risk. Also, higher interest rates attract short-term capital flows that left to themselves tend to appreciate the nominal exchange rate, while the equilibrium real exchange rate is depreciating. The gap between them is the expected depreciation that requires a rise in interest rates. It is better to let the exchange rate depreciate (but only to the degree that it will be non-inflationary), rather than use the interest defense, for extended periods.

Two choices open to the RBI when expected depreciation is high are to raise interest rates or let the rupee fall. Where inflation is low due to supply side factors, including a good agricultural output, exports are stagnating and there is an industrial slowdown, and if the depreciation can be managed so that it does not lead to a self-fulfilling downward spiral, it is the natural choice. A fall in the value of the rupee would lower expected depreciation; short-term interest rates could come down. Industry would be stimulated and competitive exports such as textiles given a stimulus. It is higher growth that can protect the rupee, not high interest rates.

Now interest rates are no longer administered. Does the RBI have the ability to successfully influence market-determined interest rates? A number of indirect avenues are becoming available as reforms steadily deepen money markets. Recent research at IGIDR shows that the short-term interest rate is more amenable to direct targeting, while the long-term responds to liquidity. An improvement in liquidity brings down longer-term interest rates, rather than raising them by raising expected inflation. Therefore apart from injections of high-powered money, enhancing the flexibility of the endogenous liquidity generation will moderate interest rates. Since 1997 monetary policy has been attempting this by encouraging repurchase options and refinance. The MCP, April 1999 continues these reforms. These and the cut in CRR will boost liquidity and lower longer-run interest rates. The bank and short-term repo rate set by the RBI, are emerging as risk free bench mark rates, making possible a move from monetary targeting towards using monetary indicators that include interest, exchange etc. rates. The RBI wants a softening of interest rates but has stopped short of lowering the short-term interest rate, combined with depreciation, as a stimulus to the economy. A cut in short-term interest rates would have required a rise in the rupee/dollar rate to the extent that the forward premium (of about seven per cent) affects expected depreciation.

Short-term interest rates have been raised whenever there were signs of volatility in foreign exchange markets. This periodic reliance on the interest rate defense has helped keep industry in a slowdown for the last 3 years. The table shows the consequences of this policy. The nominal exchange rate was constant in the face of steadily rising inflows and accumulating reserves over 1993-95. Bouts of volatility in the nominal exchange rate, in end 1995, end 1996, and mid 1998, were associated with rising short-term interest rates that eventually impacted on longer term interest rates. As our analysis leads us to predict, monetary tightening could not prevent recurrent exchange rate volatility. Short-term interest rates are more volatile, longer-term sticky but rise slowly after an episode of volatility, and then take much longer to come down when liquidity is restored

Source: Economic Survey, CSO; Annual Report, Reserve Bank of India; various issues

Note: * period April-Dec.; FDI rose by 1562 $m, but FPI fell by 682$m. ^Dec. 1998.

Apart from expected inflation and exchange-depreciation, another factor said to prevent a lowering of interest rates is high Government borrowing requirements. But as the MCP points out, the RBI has been able to manage this without pressure on interest rates in 1998-99. Monetization of the Government deficit, or RBI credit to the government was lower, compared to 1997-98. The share of foreign exchange reserves in the monetary base rose because of the inflow on account of the Resurgent India Bonds. Therefore the share of RBI credit to the government fell. The government had to borrow more from commercial banks, which should have put direct pressure on the interest rate, but did not. Commercial banks are voluntarily holding 33 per cent of government securities against the statutory minimum of 25 per cent. If foreign inflows are used rather than hoarded, as growth resumes, a larger percentage of Government borrowing requirements can be funded by RBI credit, further lowering pressure on interest rates. The best way to reduce the large domestic public debt is to raise growth and lower interest rates; the widening gap between gross and net government borrowing requirements will be reduced as interest rates fall, and the borrowing requirements will themselves fall as revenues rise. If the steadily accumulating foreign exchange reserves (Table) are used, even more will be attracted as growth improves.

Another argument against lowering interest rates is the loss to savers and to banks. Savers need to be guaranteed a positive real rate of return, therefore it is the lending rate that has to fall. This is feasible if costs fall in the financial sector and spreads are lowered. As re-structuring improves efficiency, smooth treasury management lowers transaction costs, many of the imposts such as CRR and SLR that lowered returns for banks are removed costs fall. If asset-liability management is adopted, spreads can fall without harming bank profits. Banks will be able to lend at lower rates in spite of being locked into high deposit rates.

Time to Unravel the Subsidy Maze

Ashima Goyal

There are a number of reform measures that will never be adopted unless every party agrees to them. Because any one can derive a political advantage by doing the opposite, no one will do it unless everyone does it. Perhaps the time is ripe to achieve this consensus. There have been a number of calls for the convening of a multi-party forum, in the context of the Kargil war. It is said that such a forum should be used only to isplay national solidarity, and in a time of crisis, the members must rise above petty politiking.

But whether or not such a measure is required for defense, the opportunity has risen to evolve a national consensus on other issues. The time is right because, first, the expenditure on war has made the rising revenue deficit more urgent. Second, the major reason these issues have eluded resolution is that political parties have wanted to use them to score points off each other. If one party was going to use subsidies as an election gimmick, it was very difficult for another to refrain from offering the same. If all can agree now and bind themselves to measures that would improve the government finances, no one party will be seen as withdrawing concessions that could loose them votes. Third, there is a chance that political parties will be able to rise above their one-up-manship, because the Kargil war is one consequence of the latter. Pakistan generals felt that with a caretaker government and divided polity, India would be easy prey. As so many young men loose their lives to defend the nation, if the old show even one/fourth of their sense of sacrifice it will be sufficient, and the political class will redeem itself. Perhaps the crisis will bring out the best of political nature also.

To succeed the discussion must follow two ground rules. First, not to blame each other for anything, second, focus on the particular set of measures that a party would suffer electoral disadvantage in adopting alone. Glaring examples of these are the pricing of electricity and water. As a first step it will be sufficient if each party can agree never to supply free water and electricity if it comes to power, although the ideal would be an agreement that user charges should be such that budgets balance, yet maintain full incentives for reducing costs.

The poor can be protected if necessary by well designed transfers, but protecting them by introducing distortions in prices, has serious consequences for efficiency. After the cost shocks of the seventies, prices of many publicly provided goods and services were not raised enough to compensate for the shocks. Or prices were raised only for the rich. But unfortunately the demand elasticity of the rich was high, and advances in technology helped provide alternatives to service them. The public sector departments steadily lost revenue, and this built in incentives to lower quality and investment, and therefore harmed the future provision of such services. There are signals that even the poor today are willing to pay higher prices for better quality.

As an example, consider the provision of electricity. Charges to commercial users are much higher than to domestic consumers, there is illicit tapping of electricity. Many states give free electricity to farmers. Frequent breakdowns and low voltage have forced the affluent to go in for captive power generation, and state electricity boards (SEBS) are in the red. The rich have found ways to deal with the system and the government looses money. In 1996-97, the cost of supplying one unit of electricity was Rs. 1.86 in Gujarat; agriculture was charged 21 paise, the domestic consumer 91 paise, and industry 2.34 paise. Cross-subsidization did not cover losses. SEBs in the country together lost Rs 10,000 crore in 1997-98, although 4000 crore of subsidies were provided by state governments. In India the cost of electricity to industry is three times that in France. In developed countries, tariffs are lower for industry than for other consumers, as it costs less to supply power to the bulk high voltage consumers. When industry sought to escape the high charges and poor quality through captive generation, the Gujarat SEB instituted the requirement of a no objection certificate without which an industrial unit cannot set up captive power! Nevertheless the share of electricity sold to industry fell from 62 per cent (1950-51) to 35 per cent in 1996-97. The share of agriculture has risen partly because a fixed and low tariff encouraged overuse of agricultural pumpsets. Countrywide the latter consume 20 per cent of total power generated. Although farmers are favoured, unreliable supply makes them unhappy too. In experimental reforms in Rajasthan farmers were willing to pay four to five times the usual tariff for assured quality.

Another example comes from irrigation. The subsidy for canal irrigation rates is almost 100 per cent. At the same time the cost of providing water through public canals has risen steeply and quality of supply has fallen. Farmers are willing to pay higher rates for irrigation that is more flexibly adapted to their needs; they have shown this by switching to tube-well irrigation even though they have to pay for the latter. The proliferation of private tube-wells (run on subsidized electricity) has adverse externalities, such as lowering of the water table. Total consumption of groundwater resources has risen from 4 million hectare-metres (MHM) in 1970 to 54 MHM in 1998. It is expected to exceed the recharge level of 67 MHM by 2005. In nineteenth-century Gujarat wells were designed to catch rain and flood water, so that water remained a renewable resource. Community, rather than individual, management prevented overexploitation. Such practices need to be renewed. Today subsidies tend to be captured by the rich. In West Bengal erstwhile landlords have become water-entrepreneurs. They pay a fixed electricity charge of Rs 1500, and no sales tax, and then sell water in the surrounding area. It is true that the water rates are sometimes regulated by panchayats, and the improvement in availability of electricity from the mid-eighties has coincided with a large rise in agricultural production. Both electricity and water are essential infrastructure but the only way to ensure their long-term supply is by pricing them to cover costs and discourage overuse; restructuring and decentralizing delivery mechanisms.

Similarly, the railways have been steadily loosing customers to diesel trucks, because freight rates have been raised to subsidize passenger travel. Since diesel is also subsidized this deals a double blow to government revenues, apart from raising pollution levels and freight costs. While the average rate per passenger kilometer was raised from 4 paise in 1980-81 to 15 paise in 1991-92, but the rise in the average rate per tonne kilometer was more over the same period (from 10.5 to 35.1 paise), although the demand for the latter category is more elastic.

One area where reform has started is telecom, where the same sequence of events had occurred. International call charges were kept high, to subsidize domestic calls. In 1998 the cost of calling America using Internet telephony was Rs 4 per minute but the public sector monopoly charged Rs 75 per minute. TRAI has announced lower charges for international and inter-state calls, raised those for local calls. There are arguments that MTNL is a government monopoly that makes fat profits at the expense of the consumer. This process clearly demonstrates the political economy of price setting: a rise in price is resisted both to protect the poor, and because it is feared that a government monopoly makes excessive profits.

These examples repeatedly demonstrate the picture of prices held constant in the face of cost shocks; coercive but ultimately unsuccessful attempts at cross-subsidization; budgetary losses combined with falling investment and quality. If the consequences of holding prices constant in the face of adverse cost shocks are understood, it is easier to sell the required restructuring of prices. The acceptability of these changes rises, if alternatives are adopted to protect the poor. The poor suffer most when food prices rise. The reforming congress government fell partly because the policies adopted led to a steep rise in food prices. But today inflation is at 3 per cent and another good monsoon has followed a bumper agricultural harvest. There are signs of an industrial revival; the availability of jobs will improve and income will rise. Over the long term, as computerisation extends the tax base, the cleanest way to protect the poor will be negative income tax; and only an efficient government will be able to offer it. The dis-incentives that have corroded the quality and potential of public services must be removed. Let all parties seize the opportunity and reach a consensus on user charges. Perhaps it could be called the Jai Jawan agreement!

Can Interest Rates Be Cut?

Ashima Goyal

The interest rate is in the news again. Events are pushing us towards real interest rate targeting. The fall in the inflation rate to record lows provides further evidence of the dominant influence of the supply side on inflation. Restructuring resulting in productivity improvements in manufacturing, a series of good agricultural harvests, and falling international commodity prices have kept inflation on a downward trend, although the growth of monetary aggregates has been above trend. If inflation is determined by the supply-side and is relatively stable, it is possible for monetary policy to influence real interest rates by acting upon nominal interest rates. It is well established that when financial shocks dominate real shocks, interest rate targeting does better than targeting nominal money supply.

But at present, financial markets are not perfectly integrated. There is a structure of interest rates in India, and they are imperfectly related to each other. In the circumstances, what should monetary policy do, and is there a best way for it to act upon interest rates?

The bank and short-term repo rate have been activated as policy tools, and short-term interest rates are responsive to these. Moreover, because at the margin there is a large volume of globally mobile short-term financial capital, short-term interest rates have to be in line with country risk, expected depreciation of the rupee, and comparable international interest rates.

Longer-term interest rates are less flexible. Although the prime lending rate of banks has shown considerable variation, it has never yet breached a lower bound in double digits. Since bank loans are predominantly short-term, and they have the largest volume of short-term deposits in the form of current and savings deposits, they are in a position to vary nominal interest rates on short-term loans and deposits without running into losses from asset-liability mismatches. But they are not as yet unwilling to do this. It is a question of learning to live with variable interest rates. Because the system was adjusted to higher inflation rates, and interest rates were expected to rise on average, institutions had an incentive to take more long-term deposits and make short-term loans. They now need to consciously plan to match the term structure of assets and liabilities and learn to hedge interest rate risk in a world of variable nominal interest rates. As competition from non-bank deposit taking institutions and mutual funds rises, they will be forced to do this; reduce spreads; and improve efficiency. Money market mutual funds are paying 8 per cent compared to 4.5 per cent on savings deposits. Therefore the saver will continue to get a positive real return, it is banks that will be forced to run tighter organisations, and offer a variety of financial services--which is a good thing.

The market interest rates on different instruments should depend on their risk (including collateral offered), liquidity and term to maturity. The major theories of term structure are the expectations theory, which says that long-term interest rates should only reflect expected future short-term interest rates. Second, the market segmentation hypothesis says that the demand and supply of bonds of a specific maturity will be little affected by neighbouring maturities if individuals have strong maturity preference. Third, liquidity preference theory expects forward rates to always exceed expected spot interest rates. The reason is that borrowers prefer to borrow at fixed rates for long periods of time. But investors prefer to conserve liquidity and invest for short periods. Therefore financial intermediaries raise long-term interest rates relative to expected future short-term interest rates in order to avoid the excessive interest rate risk of financing many long-term fixed rate loans with short-term deposits. The idea is that fewer creditors are willing to commit their funds for a longer term, therefore those that do require a relatively higher interest rate. This theory is validated by the empirical fact that yield curves are more often upward sloping.

This is one reason why financial institutions, whose borrowings and loans are for a longer period, have to pay a higher rate of interest. The same is the case with contractual savings such as PPF accounts. Although tax concessions on the latter further raise these returns, they are, however, for limited amounts. Moreover, research has shown that tax concessions on such savings do increase savings, so there is a case for letting them be. Long-term interest rates eventually follow falling short-term trends but here is valid case for change to be slower. Built in long-term inflationary expectations will also adjust to a lower trend inflation with a lag, and only if the lower inflation persists.

A revival in stock markets will offer an alternative avenue to savers, making it possible to lower interest rates on longer-term deposits without harming aggregate savings. It is a virtuous cycle because lower interest rates stimulate stock markets both as savers turn to equity markets from other avenues, and as the discounted present value of future profits, a major determinant of dividends, rise. Indian stock markets have not done well in the nineties both because the scope for easy gains vanished as regulation was tightened, and re-structuring and greater competition made the future of many firms doubtful. But reforms have lowered transaction costs and this should stimulate renewed interest in stock markets by the small investor, including those spread in smaller towns. The retail investor has always demanded higher returns from the stock market to compensate for the higher risks, or else has preferred debt or government guaranteed instruments. If mutual funds can effectively lower risk by diversifying portfolios and using derivatives, and returns improve with the revival, they will be able to attract the small saver. Second, the dust has settled on Indian re-structuring, with the winners emerging.

Until endogenous liquidity response improves as deeper secondary markets develop for different instruments, the onus is on the RBI to maintain liquidity across the spectrum. Research at IGIDR shows that the short-term interest rates respond to the bank and call money rates, while the one year treasury bill rate responds more to liquidity in the system, and the prime lending and commercial paper rates are not yet fully interlinked. Therefore, in the current circumstances, the RBI has two instruments at its disposal. If it wants to restrict intervention to the short-end, it can change the bank rate. If it wants a faster effect on longer-term interest rates it can use quantitative interventions. Among these are cuts in the CRR or buying government securities in open market operations (OMOs). They impact on credit availability, at different points in the term structure.

If only short-term interest rates are changed the impact on longer-term interest rates will be minimal. If to vary short-term interest rates, the CRR is changed, or OMOs undertaken, the effect on longer-term interest rates will be faster and less easily reversed. Therefore the authorities can safely reduce short-term interest rates in step with the fall in inflation while they watch to make sure that lower core inflation rates are established.

A slow and careful lowering of short-term interest rates feeding into falling long-term interest rates will stimulate investment and output growth, thus lowering country risk and expected exchange rate depreciation, and allowing the gap between Indian and world short-term interest rates to gradually narrow. The RBI can watch arbitrage in short-term capital flows by banks to gauge if short-term adjustments in domestic interest rates are out of line with expected depreciation. If so intervention should shift to the long end of the interest rate spectrum to change exchange rate expectations in the desired direction so that the required change in short-term interest rates can be made in the next round. The lag between short and long term interest rates also means that short-term interest rates can be raised, as a defense against exchange rate volatility, for very short periods. But the efficacy of the interest rate defense has come under attack because of its poor performance in the Southeast Asian crisis. The current consensus is that dirty floating, whereby continual variations in the nominal exchange rate allow any depreciation required to be quietly managed is best.

Although the RBI has done a great job of managing government borrowing requirements without it leading to a rise in interest rates, it will eventually be better to disassociate the treasury and money supply management functions. The RBI can then undertake OMOs independently of government borrowing requirements. This is the practice in the US. Price discovery of the yield curve for treasury bills can take place by an independent auction process, while OMOs and changes in the bank and call money market rate influence the level of interest rates.

Budgeting Without Blues

Ashima Goyal

Yashwant Sinha's first budget was widely denounced, the second won grudging praise. These lukewarm reactions were unwarranted, because the budgets were based on a consistent framework--reformist but tempered by the structure and special needs of the Indian economy. Thus government profligacy and discretionary controls were to be reduced, but public investment on social infrastructure was to be stepped up, agriculture, and sunrise sectors were to be stimulated. Concessions given for capital markets and construction helped to trigger a boom in these areas.

As the pendulum swings from scorn to hype it is necessary to identify requirements for the boom to be sustained. The government must now turn to real sectors. The financial sectors need stronger regulations not more stimuli. Real sector objectives are satisfactory, but implementation needs to be improved. Last year the shortfall on budgeted expenditure was 20.3 per cent on energy and 11.1 per cent on social services.

As reforms remove past concessions they hurt some groups and benefit others, but there are two general principles that can enhance political acceptability. First, moving towards equal treatment, with the additional revenues targeted to non-discretionary benefits for the disadvantaged group. Second, harnessing new technology whenever feasible. In particular, information technology very often is a useful substitute for discretionary action. These principles can suggest solutions to two major problems facing budget makers.

First, it has become imperative to raise user charges to reverse fiscal decay. Prices of many public goods and services were held constant, after the successive cost shocks of the seventies, contributing to a fall in the expansion of even essential public services, and in their quality. Such a rise in user charges will be more acceptable if higher quality accompanies it, and if politicians and administrators tighten their own belts when they ask the populace to surrender privileges. Structures need to be put in place to improve governance. The expenditure reform commission should design measures to improve individual incentives, instead of more controls and inspections. Government officials should be given a fixed allowance instead of free electricity and transport, which leads to wastage. They will economise on car trips if it saves their own money. Privatization should be seen as part of this efficient re-structuring. It is not enough to say that government cannot deliver. It has to focus on what it can deliver, or what no one else will deliver, and improve its effectiveness even in that. As a measure of its success in this, it is the primary revenue deficit that should be closely monitored not the revenue or fiscal deficit. The primary revenue deficit is the revenue deficit net of interest rates. Although this is in surplus, unfortunately its realised value has been falling for his government. As a ratio to GDP it was 1.23 in 1997-98 and 0.95 in 1998-99. Budget estimates for the current year were 1.69, but the revised estimates will probably turn out to be lower. The revenue deficit depends on past borrowing; therefore it does not fully reflect current efforts at improvement. Since interest payments comprise above 40 per cent of the revenue deficit, the latter will automatically fall in a lower interest rate regime. A rise in the fiscal deficit in transition, as the government efficiently participates in removing India's huge infrastructure and social welfare backlog, is acceptable.

The second problem is the treatment of the agricultural sector. Expanding the tax base is essential. Our tax/GDP ratio at 8.85 is one of the lowest in the world. But taxing agricultural incomes is a politically sensitive issue. Services, the fastest growing sector, are also ineffectively taxed. The way to get around this is by slowly moving towards the compulsory filing of tax returns. This is feasible as we build up a computerised database, and literacy rises. If the exemption limit is raised to one lakh rupees, all poor farmers would in any case be out of the tax net. Eventually, the most efficient way to help the poor will be a negative income tax. And if it is based on supplementary data such as purchase of consumer durables, the role of discretion and corruption in assessing tax automatically falls. Databases can synthesise diverse information and entitlements of citizens, leading to considerable simplifications in the long run. The collection of supplementary data for income tax purposes from 19 cities is a step in this direction. It should be expanded. Chandra Babu Naidu has shown the scope of computerisation in government.

Although urban incomes have grown in the nineties rural incomes have remained static. Inequality is also rising since the three poorest states have performed worst. The continuous initiatives to support agricultural prices, and subsidise public distribution of foodgrains, do not seem to have delivered. Therefore it is time that they were re-thought. Stable agricultural prices will benefit the poor more than agricultural price support that consistently raises these prices, in combination with an inefficient public distribution system. Since food is a large part of the average consumption budget, if agricultural prices do not rise, consumers benefit and inflation remains low. Farmers benefit, as with increased competition and reform industrial prices are stable or falling and terms of trade move in their favour. Other incentives for farmers can come from freeing restrictions, thus allowing them more choices, and improving their supporting infrastructure. A combination of food stocks, export-import, and exchange rate management can effectively stabilise food prices. America had much lower inequality as compared to Europe, it its developmental phase, because food was much cheaper. In the absence of a complete social security net, food that is cheap relative to the average income is essential.

The prognosis for India is good in the new century. Higher growth will help the government reverse fiscal decay. But to facilitate a second golden age, and find a place in history, it must go back to the principles that worked in the first--good infrastructure, openness and decentralisation.

Monetary Policy Expectations

Ashima Goyal

The Monetary and Credit Policy (MCP) changes the relative attractiveness of options available to the investing public. Twice a year the Reserve Bank of India (RBI) announces the future course of money and credit supply and financial reforms. Earlier we had a rigid system in which the RBI would set all interest rates. Reforms have gradually freed almost all interest rates. Since daily responsiveness to liquidity needs is being enhanced, the discrete measures that are announced in the bi-annual MCP are becoming less important--the MCP is making itself redundant. But since variation in and impact of interest rates have risen, monetary policy itself has become more important.

Now the RBI has to use more indirect methods to influence market-determined interest rates. The October 1997 Monetary policy reactivated the Bank Rate, the rate at which banks can get refinance, and this has been gradually lowered from 12 per cent to 7 per cent on 1^st April. Other measures included in the package announced on that date were a reduction in the Cash Reserve Ratio (CRR) to 8 per cent, in the Repo Rate to 5 per cent, and in Bank Savings Deposit Rates to 4 per cent.

Since inflation rates have been low (at 3 per cent) for a year now, foreign exchange reserves have increased recently to $38 billion, and the RBI has shown that it can manage the government borrowing requirements, interest rates can safely fall, without putting pressures to lower the rupee. The RBI is following trends in Asia, where interest rates are being lowered to boost the recovery, and inflation rates are falling. Around the world countries growing at higher than five per cent have low and falling inflation. The reason is that high growth facilitates re-structuring towards lower cost new technology. With low expected inflation and a strong currency, high nominal interest rates imply high real interest rates, which can lower growth.

The RBI is moving from its earlier practice of targeting money supply growth rates to responding to monetary indicators such as interest and exchange rates. This will allow a more flexible expansion of credit in response to need. Since measures have already been taken to encourage lower interest rates, the new MCP will focus on continuing reforms to deepen financial markets, and make them more flexible and efficient in managing risk. The Government debt market, derivatives and other hedging instruments will receive attention.

At present there are still structural rigidities in the system. Banks have yet to learn to live with flexible rates. In cutting the savings deposit rate--the only regulated interest rate in the system, the RBI has shown its concern for bank profits, and for giving them time to adapt. The Bank and short-term Repo Rate strongly influence short-term interest rates. Longer-term interest rates are more rigid, but they do respond to the supply of money. The cut in CRR will raise money available with banks and lower longer-run interest rates. RBI credit is the monetary base, which determines the money supply and overall liquidity; this is becoming more demand determined in the short-term, but the RBI has instruments of control such as open market operations.

Ideally the MCP should push the system to a point where real variables are stable around equilibrium values while small variations in nominal variables allow markets to adapt. With a stable rupee and low inflation the real Indian interest rate, for example, should be lowered to international rates. This is high enough to give a positive return to savings. Moreover, bank-lending rates can fall more than borrowing rates if costs fall and spreads are lowered. As reforms promote re-structuring and efficiency, helped by new technology; smooth treasury management lowers transaction costs; and the CRR is lowered, costs will fall. Use of asset-liability management is essential for banks in a regime of variable interest rates, and fee based services can help maintain their profits even with competitive pressure on spreads. As lower interest rates stimulate industry, returns from equity and mutual funds will rise, thus providing other avenues for savings. Individual investors will have to opportunity to participate in the fruits of growth at lower transaction costs; bank deposits and a deepening government debt market will continue to offer positive real rates of return to the more conservative. Banks earnings will also expand, as demand for new kinds of services will rise with growth.

The Trend Triumphant

Ashima Goyal

The Monetary and Credit Policy (MCP) follows the expected trends. There has been no further explicit change in interest rates, but measures have been taken to continue the deepening of financial markets. The proposed liquidity adjustment facility, to be implemented in stages, will set a corridor for money market interest rates and allow a more flexible expansion of credit in response to need. This will help push the system to the desired point where real variables are stable around equilibrium values while small variations in nominal variables allow markets to adapt. Potential volatility in such a system can be considerably reduced if measures are taken to hedge against risk. Therefore the idea in the MCP, of moving towards risk based supervision, in the prudential measures, is a good one. The aim, to draw upon international best practices and standards, but to adapt these to Indian conditions, also cannot be faulted.

The close link of domestic to international interest rates, is being recognised, in permitting the use of interest rates implied in the forex forward markets, as a benchmark in addition to other domestic interest rates. The interest rate regime is very different in an open economy, with highly mobile short-term financial capital. Even if domestic and foreign assets are imperfect substitutes, or the capital account is not convertible, there is enough mobile capital at the margin to force domestic interest rates for a small open economy to approach foreign. And because domestic interest rates tend to exceed foreign, this is an opportunity to lower interest rates and stimulate the economy. Domestic short-term interest rates must equal equivalent foreign interest rates plus country-risk as reflected in the forward premium on the exchange rate to prevent arbitrage by mobile short-term capital. Major constituents of the forward premium are expected depreciation of the rupee, and expected inflation. It is thought that relatively higher domestic interest rates are required when country-risk is high.

But raising interest rates can actually raise country risk. The reasoning is as follows. The equilibrium real exchange rate equates the current account to sustainable capital inflows on the capital account. Therefore, higher real interest rates can raise the equilibrium real exchange rate by lowering the gap between investment and savings. This gap is funded by inflows of foreign capital. Moreover, higher interest rates attract short-term capital flows that tend to appreciate the nominal exchange rate, while the equilibrium real exchange rate is depreciating. The gap between the two is the expected depreciation; if this is covered by a rise in interest rates, the vicious cycle continues. Therefore, the old idea that domestic interest rates need to be higher to reflect capital costs in a capital scarce developing country is not true, in today's age of mobile global capital. The trend the MCP is following shows an understanding of these features.

The MCP states that inflation was contained since of favourable macro-economic conditions. The RBI is predictably worried about the high Government borrowing requirements; but recognises that even so, inflation has been falling. The reasons for the fall, therefore, must lie on the supply side. Restructuring, the use of new technology, and more competition has lowered costs and prices in industry. Capacity has been built that can accommodate a rise in demand without inflation. Reserves of food and foreign exchange are also high, so that the current drought can be managed. Indeed, with higher growth, a higher share of productive activity will be able to shift to better technology and more efficient processes; costs will continue to fall. As these trends are understood, and low inflation rates persist, inflationary expectations will also fall. In time longer-term interest rates will also move downwards; this has already started; term lending institutions have lowered their lending rates.

As growth rates rise and interest rates fall, the fiscal deficit will automatically improve; it is useless to keep flogging that dead horse. By choosing to create conditions to stimulate growth, the MCP seems to appreciate this, inspite of the required polite noises about the fiscal deficit. The RBI has smoothly managed the large government borrowing this year, with an average growth in M3 that is 2 per cent lower than last years, and very low RBI credit to the government. So where is the problem?

The trends the MCP is following can help stimulate a triumphant era of vibrant growth for India.

Inflation, Food Prices and Poverty

Ashima Goyal

In the passionate debate on whether poverty has risen after reforms, the effect of inflation and food prices on poverty has been neglected. But rising food prices hurt the poor, at least in the short run, and lead to inflation in the longer run as wages rise to compensate. Therefore analysis of these issues is necessary.

After a peak in the early nineties, trend inflation has been falling ever since 1995, with a small blip caused by the rise in food prices in 1997-98, and the current rise. Will the latter be reversed? To answer this question we need to systematically examine the factors causing inflation. Among demand factors, the fiscal situation has been uniform throughout the nineties and cannot therefore be responsible for the break in trend. There was a monetary contraction in the early nineties and again in 1995-96, but money supply grew at respectable rates in other years. For example, it averaged 18 per cent over 1997-99, compared to 13 per cent in 1995-96. Money supply growth rates were high in periods when inflation fell the most. Although a slowdown began in industry in 1995-96, output growth rates have remained at respectable levels of above five percent.

Therefore we turn to the supply side. At a deeper level of analysis changes in profit shares, nominal wages and shifts in productivity determine core inflation. These are the items that add up to unit cost. Demand factors enter in an ex-ante fashion if wage adjustment is forward looking and responds, for example, to expected monetary accommodation. They influence inflation in an ex-post way if wage adjustment is lagged.

More than fifty percent of income is spent on food (by eighty per cent of population in urban areas and ninety five per cent in rural areas) therefore food prices play a major role in wage adjustment. The average wage level rises with average productivity and to compensate for food price inflation in the medium term. The implication is that a rise in agricultural prices would raise nominal wages and core inflation at this time horizon, unless productivity in nonagricultural sectors was rising sufficiently to absorb the rise in food prices without a rise in wages.

Industry has gone through a period of re-structuring that has created new capacities and lowered costs on average. The gradual removal of protection and threat of competition has put pressure on costs. Advances in information technology have helped, and will continue to do so in the future. That is why the burst of inflation in the early nineties, when the rupee was devalued, and food support prices raised steeply to restore some parity with international prices, was soon quelled. After the lowest inflation rates in four decades inflation has crossed 6 per cent following the rise in administered prices. But the largest rate of price increase in the nineties has been in food prices, which rose 25 per cent.

Poverty rises, in the short-term, with food prices, as there are lags in wage adjustments. Inequality rises, as wage compensation is less for lower income groups. Therefore a rise in agricultural productivity is the most efficacious and equitable way of containing inflation. Through the nineties India has had a series of good monsoons, so that growth in agricultural output has been reasonable. But still there have been fluctuations in annual rate of growths. While prices have risen in the nineties, productivity growth has fallen comparatively. Moreover, food prices have behaved erratically because of the procurement and price support policies.

Central issue prices were raised between1991 and 1994, then kept constant till 1997, when a dual price system was implemented as part of the targeted public distribution scheme (PDS), with lower prices for those below and higher prices for those above the poverty line. But large increases in procurement prices were granted and as a result the average sales realisation in the PDS system fell below the procurement price after 1996, and consequently there has been a rise in food subsidy in recent years. The steep rise in food stocks with the government contributed to this. Unfortunately the attempt to lower the subsidy in the current year, have targeted consumers while continuing to protect producers.

As the nominal exchange rate was relatively steady in 1999, and global food prices were falling, Indian prices for a number of agricultural commodities rose above world prices, for the first time in the nineties. Support prices had been raised, regardless of the recommendations of the Commission on Agricultural Costs and Prices, which wanted the government to allow foodgrain prices to find their natural level with respect to international prices. This is sensible advice. More agricultural liberalisation is around the corner because of the WTO agreements. On balance these changes will benefit farmers by opening export markets. Moreover, some trade in foodgrains, under a tariff umbrella, together with an appropriate exchange rate policy, gives another avenue to stablilise foodgrain prices. The latter will benefit the poor and lower inflation.

Rising support prices have not sufficiently stimulated agricultural productivity. It is time to try a new scheme of stable support prices. World experience with agricultural price support systems has shown that stability of price is more important for farmers than its rise. Moreover, under agricultural liberalisation, farmers can diversify their crop portfolio and earn a higher average amount by cultivating some high value added export and cash crops, while an international parity support price for foodgrains gives them an assured income component. The latter will ensure that enough foodgrains are cultivated to provide essential domestic food security. Since the farmers lobby has bitterly argued against the protection given to industry it cannot now ask for protection against imports.

The rise in food prices in the early years of reform was one of the major reasons the Congress lost the elections, the onion price rise shook the BJP, and statistics on rising poverty ratios are fuel for those questioning reforms. Therefore attention to these issues can pay huge political dividends.

Consumers Suffer From Subsidy Illusion

Ashima Goyal

As we face the third oil shock, it is worthwhile to introspect on the legacy of the first two. This oil shock is nowhere near the magnitude of the first two. If the current price is about $30 a barrel, in today's prices oil cost about $60 in 1980, and $70 in 1974. It is a shock because oil prices had fallen very low in the nineties. They will probably fall again. The rise in prices boosted worldwide attempts to find substitutes, lowered the world's dependence on oil, and therefore oil prices. The Government plans to pass on only one-third of the current price increase to consumers, and even this has drawn protests. But protecting consumers against earlier cost shocks has had deleterious effects. The first two shocks boosted Indian rates of inflation, but as a populist measure user costs of many public services were not raised for consumers, and subsidies were increased for a spectrum of commodities. There were two consequences. First, the decay in Government finances started from this period, second the quality of government services fell, together with investment in their expansion. This process is detailed in the India Development Report, 1999.

If, as consumers, we do not understand these long-term consequences, this is the first level of subsidy illusion we suffer from. It is because of this illusion that Mamata Banerjee can hope to make political capital by forcing a rollback of the partial increase in consumer prices of petroleum products.

But there is also a second level of subsidy illusion. Although the cost of these subsidies was partially met by rising government revenue deficits, falling public investment, higher prices and taxes for the rich, prices of intermediate goods were also raised to cover them. Thus cross-subsidization increased. Industry was charged higher tariffs for electricity to help subsidize the consumer and the farmer. For example, in 1996-97, the cost of supplying one unit of electricity was Rs. 1.86 in Gujarat; agriculture was charged 21 paise, the domestic consumer 91 paise, and industry 2.34 paise. The world over, industry, being a bulk user, is charged the least. The railways have been steadily loosing customers to diesel trucks, because freight rates have been raised to subsidize passenger travel. While the average rate per passenger kilometer was raised from 4 paise in 1980-81 to 15 paise in 1991-92, the rise in the average rate per tonne kilometer was more over the same period (from 10.5 to 35.1 paise), although the demand for the latter category is more elastic. Such creative pricing is built upon the second level of consumer subsidy illusion, because higher prices for inputs in production raise the prices of all the goods the consumer buys.

Prices are higher both because of the cross-subsidization, and because the poor infrastructure raises input cost. These distortions harm the entire productive structure. The impact of high prices for intermediate goods and poor infrastructure is particularly adverse as competition rises from imports. The consumer is fobbed off with a few rupees less for a LPG cylinder, and made to pay more indirectly in many other places. Consider the specific case of the subsidy on a LPG cylinder of Rs 150. Higher prices are charged for petrol to cover the subsidy. Let us say this is Rs 3 per litre. Then a family consuming 50 litres of petrol and one gas cylinder per month is in effect getting zero net subsidy. But consumer's do not perceive that what is given with one hand is taken away with the other. When the well-heeled audience of BBC's Question Time India, was asked that who would be willing to pay Rs 150 more for a gas cylinder, very few hands came up.

The previous argument needs to be qualified. The government has subsidized goods consumed by the poor, which form a large blocks of votes; but it has also subsidized intermediate goods where there is a strong interest group. Thus diesel is subsidized even though it is an intermediate good because there is a powerful truckers lobby. The strong farmer's lobby is given a support price, which results in huge food stocks and necessitates a food subsidy for the poor.

In these circumstances, it is often feasible for the government to link the removal of a subsidy to the removal of an equivalent hidden distortion that adversely affects the same group. Kirit Parikh has argued that meters can be installed to measure the quality of electricity supplied and farmers charged a higher price for better quality. Even the poor who are given net positive monetary subsidies can gain if expansion of food for work programmes, better water, sanitation and education facilities are linked to the reduction of subsidies. Dependency can change to vibrant independence. This process will make transparent the hidden costs of subsidies and remove subsidy illusion. If the illusion goes Mamata Banerjee cannot hope to make political mileage from a rollback of the price hike, but the Government also cannot withdraw subsidies without some compensation or guarantee of better performance.

The general principal should be that reduction in higher prices charged to the same set of consumers elsewhere, removal of a distortion that affects them, or the provision of better services to them must accompany subsidy reduction. Subsidies removed under the first level will impose short-run costs, but long-run benefits to consumers, but those removed under the second level may not impose even short-run costs. In many cases if the Government decreases the higher prices of inputs and other distortions imposed to finance subsidies, the price of the total consumption bundle can stay the same or even fall.

If the audience of Question Time India had been asked instead, would they be willing to pay more for a gas cylinder if they paid less for petrol more might have said yes. As consumers we need to be better educated so that we ask the government for the right things. Instead of being content to pay a few rupees less for a gas cylinder, we must demand an infrastructure that works.

Why Has Invetment Fluctuated in the 90s?

Ashima Goyal

A frequently asked question, in analysis of Indian economic performance of the nineties, is why hasn't there been a sustained rise in investment. This is regarded as a major negative and casts a shadow on future prospects. There have been industries that have suffered a decline, but they have been compensated by a strong sunrise sector; therefore we focus on potential macroeconomic causes.

To answer the question, it is necessary to examine public and private investment separately. Summary statistics for the eighties and nineties (Table 1) show the qualitative changes that have taken place between the two decades. Public sector investment has been trending downwards in the nineties. It was around 10 per cent as a ratio to GDP in the late eighties and had fallen to six per cent by the end of the decade. The Chidambaram budget was the first to recognise that the public sector would have to continue to play a major role in the provision of infrastructure, but the measures initiated did not reverse the decay in the public investment ratio, although they slowed its rate of decrease. Has this decay been compensated by a rise in private investment? The average decadal private investment/GDP ratio went up from 0.124 in the eighties to 0.153 in the nineties, partially compensating for the fall in the corresponding public investment ratio from 0.104 to 0.08. But since private investment was already at around 0.14 in the last years of the eighties, the rise in the nineties has not been that much. And there have been much more fluctuations. The standard deviation of the decadal ratio has gone up from 0.013 to 0.016. The standard deviation of public investment was also higher in the nineties at 0.0108 compared to 0.008 in the eighties.

Simulations in a macrodynamic model at IGIDR show that the systematic part of investment has a major effect on the medium-run growth path. Since investment has been irregular, so should growth have been in the nineties. But the standard deviation of growth has actually fallen especially after 1993-94. Larger fluctuations in investment have been partially compensated by factors that have raised efficiency and competitiveness, so that the average rate of growth (at 5.7) has been comparable to that in the eighties. Taking the average from 1993-94, growth has been higher at 6.63. But growth could have been higher if these fluctuations had not occurred.

The next question to ask is what has caused these fluctuations? The fall and fluctuation in public investment was first due to ideology, and is continuing due to the lack of resources with the Government. But what has affected private investment? Two variables whose fluctuations have influenced macroeconomic outcomes in the past, are agricultural output and oil prices. But the variation in both of these was lower in the nineties compared to the eighties. Therefore they cannot serve as the explanation. Lower correlations of current and lagged private investment with agricultural rates of growth confirms this. The correlations are lower in the nineties compared to the eighties.

The factors that have shown much larger relative variation in the nineties are nominal interest and exchange rates. Since nominal interest rates were rigid in the eighties, variation in real interest rates was entirely due to that in inflation. This variation was larger in the eighties, since nominal interest rats were not free to respond to expected or past inflation. Industry is concerned with purchasing power of the goods it produces. Therefore investment is influenced by real and not nominal interest rates. If interest rates rise, investment should fall, so that the correlations are expected to be negative. Correlations of private investment with the lagged nominal call money rate and the nominal and real prime lending rate of the Industrial Development Bank of India are shown in Table 2. These measure the extent to which the variables move together and their direction. They throw up a puzzle.

Correlations in the nineties are higher with nominal interest rates, and are negative! The result can be explained if nominal interest rates influence expectations of future real interest rates and output. Thus a rise in nominal interest rates implies higher expected real interest rates and lower output. Such expectations were rational in the nineties because our real interest rate turns out to have a correlation of 0.4 with both the lagged nominal rates. Interest rates may be serving as a focus for expectations that drive private investment decisions. Higher nominal interest rates signal lower confidence in the economy.

In the more open India of the nineties, short-term nominal interest rates have been raised in periods of expected depreciation of the currency, and affected long-term rates with a lag that is reducing. The correlation of both the nominal interest rates with rupee depreciation is 0.7. Our results are preliminary since we use bi-variate correlations, and correlation does not necessarily imply causality. But they do suggest that excessive interest rate volatility may be harming investment. Instead of repeatedly fire fighting with the interest rate defense, monetary authorities would do better to evolve a visionary exchange rate policy that allows them to smooth interest rates more.

Save Some Arrows in the Quiver

Ashima Goyal

Since monetary policy has to be more flexible now, formal statements can be restricted to structural changes, and announcements of the policy stance. The recent bi-annual statements of the RBI have followed this line of thinking. The October Mid-Term Review of Monetary and Credit Policy (MCP) made no changes in interest rates, but continued with measures to deepen and reform financial markets, and simplify procedures. The Annual Statement of April 27 also had made no changes in the Bank Rate, which had been lowered on April 1 to 7 per cent.

But while the April 27 Statement had said that the RBI would "continue the current stance..and ensure that all legitimate requirements of bank credit are met while guarding against any emergence of inflationary pressures due to excess demand" and promised reduction of the CRR, the October 10 Review only promises that "it will continue to be the endeavour of the RBI to maintain a stable interest rate environment'. Pressure on the rupee, from mid-May to early August, when it depreciated by about 3 per cent against the dollar, together with a net outflow by FIIs made the RBI reverse direction drastically in July. The Bank Rate, the CRR and short-term repo rates were all increased. The Bank Rate was pushed to 8 per cent.

Since there are signs of a slowdown, some stimuli are required for the real sector. But is the latter consistent with stable exchange rates? Although India still does not have full capital account convertibility there is enough mobile short-term capital to force the Reserve Bank to respect arbitrage, and keep Indian real interest rtes aligned to international rates. Short-term capital should be able to earn as much in rupees as it can earn in foreign currency. Consider dollar arbitrage. If US interest rates rose 50 basis points and India's average inflation rate was 0.51 points higher than last year's, Indian nominal interest rates have to be higher, but not by hundred basis points. First, the world over, a rise in interest rates is gradual. A steep jump has a number of adverse effects. Second, interest rates have to cover inflation differentials, but after the oil shocks US inflation rates have also risen to 3.5 percent, to that extent Indian nominal rates have to rise less. Third, slowing growth means that there is no excess demand in the system, so that a rise in interest rates is not required to lower inflation. Fourth, the interest rate defense is required when the exchange rate is fixed. But to the extent that the exchange rate is flexible and the rupee has depreciated, so that expectations of future depreciation have fallen, a rise in interest rates is not required to defend the rupee. In periods of exchange rate volatility the RBI uses a whole gamut of measures including a rise in interest rates, sale of foreign reserves, some depreciation, moral suasion. There may be an element of overkill. A good hunter should not need all the arrows in the quiver.

Realised and targeted growth rates have both fallen, but the half per cent rise in this year's over last year's average inflation is due to the fuels group, which rose by 25 per cent. Inflation in manufactured products and primary articles continues to be low. Food grains prices affect wages and are an important constituent of core inflation in India. These actually fell by 5.44 per cent. Broad money growth at 13.6 is lower than last years and below the target of 15 per cent.

Lower growth suggests that a monetary stimulus is required; the rise in inflation is due to the supply side and is not an indicator of excess demand. In spite of the slowdown in growth, commercial bank credit to the private sector has risen, exports have performed well, and government revenues compared to expenditures have risen, indicating improvement of the fiscal deficit. Government borrowing requirements have again been comfortably accommodated, this time with a larger percentage being financed by the RBI. The monetary base rises both when the RBI lends to the Government or when it adds to reserves. Since foreign inflows fell, a larger share of reserve money expansion could come from meeting the Government's needs.

The uncertainty on the oil front may make the Reserve Bank vary of lowering interest rates but it is possible to reverse the 0.5 per cent rise in CRR it had imposed. Although conditions have stabilised in the foreign exchange market, with oil prices still high, it cannot risk further rupee depreciation at this juncture. The cost of oil imports would rise further. But there is a need for softening of longer term interest rates. A cut in CRR could contribute to this.

The RBI has used the interest rate defense through the nineties on the grounds that the Indian financial markets are segmented and a temporary rise in short-term interest rates does not feed through into longer-term interest rates. And investment responds to expected real long-term interest rates. But segmentation is reducing. The July rise at the short end, fed through into the long in less than a month. Moreover, in the nineties a trend rise and fluctuations in nominal interest rates are correlated with slowdowns in growth. Private investment shows higher fluctuations in this period, and is negatively correlated with nominal interest rates, although it should be real interest rates that affect investment. The interest rate shocks seem to be adversely affecting expectations and therefore investment.

The RBI has kept exchange rates stable and accumulated reserves when market forces would have appreciated the exchange rate, but used the interest rate defense when supply exceeded demand for domestic currency. The Review recognises that this allows the market to make a one-way bet since the rupee moves only downwards. It is time to evolve an exchange rate management policy that gives controlled two-way movements in the exchange rate, and makes smooth real interest rates feasible. Fluctuations in interest rates affect a wider range of activities than do fluctuations in exchange rates. It is easier to hedge exchange rate movements compared to interest rates, and as swings in expectations are moderated and the real sector stimulated, volatility in nominal exchange rates would also fall.

Balancing the Budget

Ashima Goyal

In the nineties America achieved just what India has been trying to do, without success, over the past decade. Their budget deficit, which had mushroomed in the eighties, was converted into a surplus while the economy prospered. How did they do it?

Scattered through Olivier Blanchard (1999) are interesting insights on three sets of factors that made this achievement possible. First, an expansionary monetary policy complemented contractionary fiscal policy. Second, rules that restrained government expenditure were adopted. Third, there was good luck in the shape of a booming economy. The good luck, of course, was helped by good policy.

Steep tax cuts were given by supply-siders in the Reagan era of the eighties. The supply-siders believed in small government; they expected the cuts to stimulate harder work in the private sector, and thus increase output. But the expected increase did not occur, and since there was no equivalent cut in government expenditure, the deficit grew rapidly. It fluctuated around a peak ratio to GDP of 6.1 per cent in 1983. Volcker, the Chairman of the Fed, lower inflation, by the late seventies. Neither the rise in interest rates, nor the cut in taxes, had the desired effect of reducing government spending. The high interest rates led to capital inflows, strengthened the dollar, and increased net imports, so that a trade deficit was added to the budget deficit. It incidentally also provoked the Latin American crises as capital flowed out of those countries to the US. When Clinton came to power in 1992 there was consensus that the deficit had to be reduced, but the economy was just emerging from a recession. The new Chairman of the Fed, Greenspan, trusted Clinton's intentions and implicitly agreed to support government measures to reduce the deficit with an expansionary monetary policy. The latter would ensure that the economy was not plunged into a recession with the expenditure cuts. Average interest rates on one-year government bonds fell from 7.3 per cent in 1991 to 3.3 per cent in 1994. The economy entered a sustained expansion, which has lasted through the nineties. Inflation was also low. The deficit ratio fell steadily from 4.7 in 1992 and had turned into a surplus by 1998. Thus this combination of monetary and fiscal policy worked, while the opposite, tried in the eighties, failed.

Second, legislative rules helped reduce the deficit. The Gramm-Rudman-Hollings Bill passed in 1985, set yearly ceilings for the deficit with a target for a zero deficit by 1991. It had some effect, but the loopholes for creative accounting presented by design flaws prevented the realisation of the target. The Bill also lost credibility because a very large deficit was required to fund the 1990 crisis in savings-and-loan institutions. Therefore it was replaced by the Budget Enforcement Act of 1990, which corrected the design flaws shown up by experience. First, rather than restrict the deficit itself, constraints were placed only on spending. Caps that enforced small reductions in discretionary spending were set, but escape clauses were provided for emergencies. A pay-as-you-go rule meant that new transfer payments to individuals could be made only if these transfers were demonstrated to have assured funding so that they did not increase deficits in the future. In a recession, as revenues fell, the deficit could increase, since restraints only covered spending. This macro stabilisation provided another escape clause. Such flexibility lowered pressure to break rules, gave the Act more credibility, and contributed to its success.

Third, these policy successes were helped by strong stock markets, business and consumer confidence after 1995. High growth helps to lower the deficit ratio, since taxes, which are a percentage of output, rise compared to spending, which is more independent of output.

What are the lessons for India? First, when the Prime Minister talks of a tough budget he must make sure it is toughest on the government. The much-hyped Fiscal Responsibility Act must incorporate the successful features of the US Act. Poverty in a democracy leads to competitive populism, which makes it difficult to practice fiscal restraint. Therefore restraining laws can help. Restraint is even more difficult for weak coalition governments. Such an Act could have helped Vajpayee resist the rollback in petro-products prices. There have been many recent instances of successful judicial activism to restrain populist policies. The Mumbai High Court prevented the Municipal Corporation from paying an exorbitant ex-gratia that striking employees had forced it to agree to. The experience of both countries suggests that democratic governments respond to political or legislative imperatives more than to prices or income. Neither shortage nor high cost of funds was able to restrict the budget deficit in either country.

Second, India's poverty and growth requirements require that government expenditure to rise in certain directions such as infrastructure and human capital development. Such expansion can be compatible with caps and restraints on transfers if government expenditures are restructured, contracting in some directions to expand in others. Current inefficiencies in government expenditure patterns give scope to do this. The other desirable aspect of American fiscal reform had been the systematic removal of incentives for wastage. For example, there was a shift from matching to block Federal grants for state welfare payments; the former motivated the states to overspend. Many such changes are feasible in Indian fiscal practices. Revenues can rise if the tax base is expanded, user charges are imposed, and privatization of public sector enterprises improves their efficiency.

Third, the greater mobility of global capital makes it more feasible to adopt an expansionary monetary policy to complement fiscal restraint. Lowering interest rates to global levels becomes possible both because shortage of capital is alleviated and because this is the best stance to lower volatility in the external sector. It needs, of course, to be complemented by efficiency increasing reform. These measures will allow the optimal fiscal-monetary mix of a contractionary (in certain directions) fiscal and relaxed monetary policy.

Fourth, India is also entering a lucky streak. Our comparative advantage in IT and the global demand for it presents an opportunity to be seized. Only the correct policy stance is needed for business and consumer confidence to rise.

Learning From Japan

Ashima Goyal

Japan was the first Asian success story. Moreover, the success was achieved on its own terms. I had read a lot about Japan. In visiting it, therefore, much was familiar. Still, there were surprises. It is dangerous to generalize, but contrasts with mental pictures sometimes spark illuminating stylized facts. The impressions below are one perspective.

I knew about their commitment to quality, but the extent of Japanese foresight and meticulousness was still a revelation. In the hotel where I stayed, for example, the shower cubicle had symmetric pits to forestall slipping, bottles of soap were of different colours to make it easy to select among them. These small things indicated not only a concern for comfort, but also an understanding of cause and effect and their future working. In contrast India's chalta hai attitude comes from a system that delivers so many unpredictable shocks that it is easy to escape responsibility for error. Forward thinking can improve outcomes, but if structural reform improves the system it would increase the benefits of forward thinking and raise the number of people who find it worth their while to think things through.

Japanese love of technology and orchestrated effort is demonstrated in cities like Yokohama, which sprang up from the drawing board, as it were. A jump into the future can be planned and executed with precision. But this can cause delays. Japanese FDI is slow in coming to India as they wait to acquire understanding of the domestic market necessary for them to act.

Open spaces were few in driving though the countryside. Land is so scarce in Japan that each inch is made use of. Much of it is built up, still each shrub is lovingly tended, and gardens are beautiful. No wonder this was the home of the bonsai. The underlying Japanese concept is mottainai-that waste is a sacrilege against nature's rare gifts. As the world worries more about the damage we are doing to our environment, the idea of mottainai would be a useful one to adopt widely. Care and effort can stretch and conserve limited resources.

Tokyo looked much like any western city. It was only in the kabuki theatre that I saw a few kimonos; but there were very few young people attending the performance. The young prefer Western music, wear western clothes, some even dye their hair blond; but they are not comfortable speaking English. Japan took a conscious decision to keep Japanese as the medium of instruction to preserve the culture. They decided to buy Japanese goods while selling to the rest of the world. Morishima wrote a book in the late eighties called, "why has Japan succeeded?". His answer contained in the subtitle: "Western technology and the Japanese ethos", implied that the Japanese brand of Confucianism was vital. But it is not clear if artificial barriers essential to preserve it. In the nineties Japan did not do so well. Today Japanese newspapers are full of advertisements for teachers of English. A visitor to China came back saying that in modern China there are only three pre-requisites to make money: a knowledge of English, computers and the ability to drive. Knowledge of English facilitates use of current networking technology. Less restrictive teaching of English may have helped the Japanese ride the technology wave; they could more freely have chosen the aspects of Japanese culture they wanted to retain. If you can speak like the foreigner perhaps you do not have to look like him. Akio Morita, one of the founders of Sony writes about the decay in the insular Japanese school system, the fall in discipline and the emphasis on rote learning and giving exams. Since he had a hard time learning English himself, and expected the world to shrink further as communications improved, he decided to educate his children abroad. The exposure broadened their minds, made them confident and comfortable anywhere in the world; but also made them appreciate their Japanese-ness and choose Japan as their true home. The lesson for India is that globalization cannot be controlled. With maximum freedoms, choices and capabilities a country's citizens could still choose their own culture. It is natural to rebel against restrictions and to value anchoring traditions in a confusing menu of possibilities. Foresight is compatible with flexibility if decisions are not imposed from above. Some chaos is a necessary spur to innovation and growth; there can be too much control. Indian advantage with English and in development of IT constitute a fortuitous shock, that can make Indian chaos less limiting, but chaos still has to be moderated.

The Japanese take time to accept a foreigner; but if they decide to do so, they go out of their way to help. They can do so much for you that it is almost embarrassing. The flip side of the emphasis on duty and loyalty is the hierarchical structure where one out of twenty Japanese woman suffers from domestic violence, and companies are only now being forced to allow women to retain their own names after marriage. There are very few women in decision-making roles; wives continue to be docile, but young women now are more reluctant to get married. The one time labour market entry makes career gaps fatal. In India there is more diversity in the freedoms available to women, but it is also a patriarchal society. Raising gender sensitivity is a major agenda. The recent fracas over reservation bill for women in parliament points to the long road ahead. Asian value systems have emphasized duty compared to the Western focus on rights. Japanese youth continue to be polite and helpful in tomorrow's world, but today such behaviour can come only from choice and not by dictat. Equality of education and opportunity is the best way to ensure both the right choice and true sharing.

Back to the Budget

Ashima Goyal

It is budget time again, but hopefully the return will be in a spiral, showing signs of progress. With apologies to T.S Elliot, "because I hope to turn again, because I hope to turn.." It has to be seen if the Government achieves some of its objectives, and improves the design and use of instruments available to it. Each year the revised estimates (RE) show how far the Government has been able to live up to its promises recorded in the budget estimates (BE).

In order to raise growth, lower poverty and raise efficiency, fiscal policy can reform expenditures, taxes and aggregate deficits and debt. Reforms have aimed to reduce the size of and waste in Government, but since the 1996 Chidambaram budget the Government has also been aiming to increase productive expenditure. The low score card in both categories indicates that the second is not possible without the first.

The table shows that since 1996-97 the post- reform decline in aggregate public investment has been arrested but not reversed. The average level is much below the 10.4 % of GDP it was before the reforms, but it is not falling any more, since fluctuations are less. Sectoral shortfalls in plan expenditure continue, but are decreasing. Last year the plan outlay was less than the BE by 6.9 % compared to 15.9 % in the year before that. Energy, transport and communication accounted for 60% of planned expenditure but the big jump was in planned expenditure on social services. This was the Amartya Sen effect. It is to be seen how much was actually spent; this Government has found it difficult to spend the amounts promised on agriculture and rural development.

Expanding the tax base is essential. The long-term solution is to build a computerised database and eventually make the filing of tax returns compulsory. The Government cannot continue to rely on indirect taxes to compensate for the low tax base because domestic excise rates will have to be lowered, and anomalies removed, as freer imports come in under the new WTO regime. This is essential to maintain our high growth in consumer durables, for example. Revenue can rise with growth even at lower rates.

The primary revenue balance (PRB), which is the revenue balance minus net interest payments, reflects the success of current efforts of the Government to restrict its consumption to what it earns and to try and save. Although the PRB is in surplus, this government has presided over a fall in the surplus. The ratio of the PRB to the GDP had peaked at 1.13 in 1998-99. Last year its revised value fell short of the BE by 20%. But that was the year of Kargil, Orissa and pension payments. For the current year it was budgeted at 0.59.

There are rumours of a tax surcharge to finance reconstruction in Gujarat. This is not a good idea. First, it may lower the large voluntary contributions that are pouring in. Second, bond financing is a better option. Economic theory and evidence tell us that when the destruction of population, in a calamity, is proportionately smaller than that of material resources, the growth rate will be so large that the economy will recover quickly. Thus Carthage took a century to recover but Hiroshima and Berlin recovered rapidly after the World War. The high quality of Gujarati human capital and entrepreneurship is another guarantee of rapid growth. The bonds would soon be redeemed.

This budget should adopt some measures recommended by the expenditure reform commission and the Fiscal Responsibility Act (FRA). These represent long-term structural measures to improve government finances. Success will depend on the feasibility of the reform and on incentives for better governance. But sufficient attention has not been paid to the latter aspect. Consider the following scenario. What will happen if Mamata Banerjee says my project is more worthwhile than his. I must get funding. Or, if you didn't refuse him how can you refuse me? A PAYGO rule like that adopted in the US 1990 Budget Enforcement Act would ensure that only demands for productive expenditure from Mamata are met. The rule said that any new transfer could be adopted only if it raised new revenues or decreased spending on some other existing project, so that it did not increase the deficit. The FRA is a weaker weapon because it only gives the Government the ability to cut expenditure authorizations proportionately, while protecting "charged" expenditure. Russia has had difficulties, but China has managed the transition to an economy with less Government intervention very well. A major prong of their successful strategy was to create the correct incentives, increase competition and impose hard budget constraints for governments as well as the private sector.

Even so, the binding commitment to lower the revenue deficit by half per cent a year is welcome. Democracy has to contend with demanding interest groups. It is very useful to have a larger than the Government rule to which the Government can refer to refuse demands. But future loading may have contributed to the credibility of the FRA, which is a new and delicate institution. Higher cuts should be undertaken in the future, only after success is achieved with small cuts in the beginning. It is also good that there is an escape clause to cover crises or slumps.

All the best to the Government as it plans to make major changes in a difficult environment. If the reforms work and enable the Government to keep its promises, professional critics will be left with one less weapon; they will no longer be able to pounce on the gap between budgeted and revised estimates!

Credbility of the Budget

Ashima Goyal

A budget is credible if it keeps promises and forecasts are reasonably accurate. Economists add the twist that the Government's ability to achieve objectives depends on the responses of individuals. In the past the Government has been choosing populist policies that are not sustainable because private agents foresee their consequences and take actions that reduce the cake to re-distribute. The success of the policies announced in the new budget similarly depends on the actions of investors, savers and consumers. They will undertake growth-enhancing actions only if they believe the policies announced are sustainable. Past history and future fears are expressed in the common reaction that follows euphoria after the budget: will the Government be able to do what it says?

The answer is yes, if the budget has improved, first, the Government's reputation, second growth-enhancing structural changes, third their political feasibility and last macropolicy and Government finances.

The Government has a bad reputation: targets are never met, forecasts rarely come true. That is why meeting the deficit targets this time is a boost. Moreover, future budgets are to carry a report on actual implementation, thus paving the way for the adoption of the Fiscal Responsibility Act (FRA). The latter can serve as a commitment device to bolster a weak reputation. Budget analysis (myiris.com) shows that after a long time the primary deficit has become sustainable---Government debt is not exploding. The finance minister has also kept promises by removing earlier tax surcharges.

Note: BE: Budget Estimate, RE: Revised Estimate

In bringing about structural change the Government is moving according to a pre-announced plan. Most measures adopted are based on sound principles, which are clearly explained. Growth is to be stimulated by improving infrastructure, human capital and incentives, making the economy more flexible and encouraging high tech sectors. Incurring cost oneself, such as cut in government jobs and other re-structuring is a good motivational device. But the Government delivered only half of the promised rise in capital expenditure. The shortfall last year was most severe in agriculture and rural development; targets were not reached in industry and social services either (Table). The promised 20% increase for the next year must materialize. A large amount of spadework was required for momentum to gather in PSU privatization; similar work needs to be done to ensure that projects are efficiently chosen and executed. The FRA needs to protect productive expenditure.

Benefits to the poor are essential for political feasibility. Policies that improve primary and higher education, and micro-credit schemes for women help the poor in sustainable ways, by developing human capital and human dignity. If there is higher growth, which benefits everybody, it is easier to deny the short-term privileges interest groups demand. Targeted subsidies for the very poor should continue in transition. As discretion is cut the possibility of holdup by lobbies and special interest groups falls. Concessions should be given only if they lead to large externalities and are viable in the long-term.

Deeper structural reform is possible now: first, because of the preparation and learning that has gone before. Second, greater flexibility is necessary for domestic industry to survive import competition and expand future employment. Third, evidence that poverty has fallen in the nineties makes further change more acceptable. Fourth, safeguards have been built in such as raising severance pay and group insurance while making labour exit easier; offering packages for technological up-gradation while de-reserving some small scale industries. Political acceptability and viability rise together if distorting concessions are removed and growth-enhancing ones offered in compensation.

This middle of the road budget not only continues but also re-designs reform in the light of experience. The biggest failure of the nineties was in managing Government finances. The emphasis on the fiscal deficit and stabilisation through high interest rates only led to a cut in capital expenditure, and did not restore fiscal health. Although deeper structural reform may not have been possible earlier, real domestic interest rates closer to international levels were feasible. Higher growth would have allowed fuller utilization of the foreign capital inflows and further stimulated them. Such a policy would have required a supportive exchange rate policy to prevent excess volatility in foreign currency markets. Rather than the fiscal it was the revenue deficit that should have been controlled. It is often said that interest rates remained high because Government borrowing requirement (GBR) was high but it is also true that GBR was high because interest rates were high. High growth and low interest rates would have led to a faster reform of Government finances. Policy is now moving to a more effective combination where a tighter fiscal policy and structural reform allows more freedom to monetary policy. This was the Clinton-Greenspan mix of America's high growth decade. But it is important to give a positive real rate of return to savers. The return on contractual savings should be benchmarked to alternative saving avenues for households and borrowing for government. The Economic Survey reports a marked improvement in NPAs of banks, and other re-structuring. A fall in lending rates should come from a narrowing of spreads.

A well managed exchange rate and supply-side measures to contain inflation are required for the budget to succeed. Agriculture prices rose through the nineties, but this did not help farmers or increase productivity. Improving agricultural freedoms and infrastructure while stabilizing farm prices may work better. The Government has kept some promises; if it delivers more over the year, it can induce more of the right choices from us all.

Corruption: blame the system?

Ashima Goyal

Are Indians intrinsically corrupt? Can corruption be reduced? In an India Today opinion poll (January 15, 2001) 30 per cent picked corruption as the item that made them most ashamed of India, but it was inflation that the majority wanted the Government to fight first, implying pessimism about the possibility of removing corruption. No wonder Transparency International that ranks nations on the basis of perceptions of corruption puts India high on the list. As India reels from scams in defence deals, stock markets, banks and customs, it would seem that the perceptions are correct. But modern research shows that systems influence behaviour. Although the system is changing, it is also essential to change the perception of ourselves as a corrupt nation; more people follow practices that are regarded as the norm. Unless the system and perceptions both change, yesterday's Bofor inevitably becomes today's armsgate.

If controls and discretionary power are responsible for corruption, this puts the blame on systems adopted after Independence. If it is greed that causes corruption India's present is exacerbating the problem. Reforms increase incentives and opportunities to make money from vanishing power. But as the system continues to change, transparency increases and discretion falls, so will these opportunities. The first step to removing flaws is discovering them. Those who identify and use loopholes actually provide a service if their contribution is used to plug the loopholes.

Initially controls encouraged corruption, but it spread and was almost essential to survive in some types of work. In the fifties Raj Kapoor sang, "honto pe sachai rahti hai/jahan dil main safai rahti hai/ham us desh ke vasi hain/jis desh main Ganga behti hai", in an accurate reflection of social norms before the consequences of systemic changes had set in. But once corruption is widespread it is not only opportunities for, but also the acceptability of corruption that has to fall. A combination of systemic change and social sanctions are required.

It is useful to list some such measures. First, relating to Government administration. Controls and discretionary power are being dismantled. But the bureaucracy has to be restructured to remove overlapping jurisdictions and increase competition in the provision of public goods. Otherwise the Government servant acts as a monopolist, charging a high bribe-price for the public good he sells. If the transaction has to go through many layers to be completed, each extracts its price. The system becomes inefficient as well. An Indian babu is reported to have said, "I can stop a file anytime, but do not ask me to get it cleared." Sometimes the monopoly sale is a bribe that deprives government of legitimate revenues. A robust accounting system can prevent or minimize such theft. A smaller, sleeker, more skilled and better-paid administration is required with incentive structures in place, such as a bonus to tax officials on amount collected. Information technology opens many possibilities. Giving each citizen an electronic ID, instead of the dated ration card, would enable responsive e- governance, reduce black transactions and tax avoidance. "Clean" professionals should be allotted to sensitive posts, for a limited term, by a process free of political interference. A system of transparent open tendering for Government contracts can be facilitated by the Internet and e-commerce, and the role of middlemen reduced. A small secretive elite chooses inappropriate or fancy technology, since generic technology with open international tendering lowers opportunities to make money.

Second, politicians are considered the most discredited and corrupt section of society. But among her constituency Jayalalitha is regarded as a modern day Robinhood who woos her voters with saris and lungis. The tragedy is that these short-term benefits come at the cost of subverting the system and destroying the long-term livelihood of these very voters. If rules limit election expenses, prohibit personal gifts to voters, ban criminals from contesting elections and institute strict and transparent accounting of donations to parties, then politicians, knowing that no one can bribe voters or MLAs, may reduce illegal wealth accumulation and turn to real issues. In a democracy politicians have a real role in lobbying for the interests they represent. This ensures that every voice is heard and no one caste or group dominates. If political parties publish their accounts hidden agendas will be minimised. Collective action through NGOs and horizontal links with different groups are being encouraged and can further improve governance. Alternatives or competition must be developed for both the bureaucrat and the politician.

Third is the role of society. Research suggests that it is bribe givers who, if caught, should be punished more severely. Larger penalties on bribe takers only increases the bribe but does not always eliminate the act. The reason corruption is easier in a corrupt society is that the social costs of corruption fall. We must reduce our toleration of such behaviour; there must be social ostracism, public humiliation and loss of reputation for the corrupt. This is wider and deeper that mere legal punishment. The golden rule should be do not co-operate with the corrupt.

Fourth is the media, which has enormous power in making and breaking reputations. We have seen them in the punishing mode recently; we also need to see them in the rewarding mode. Our journalists have done us a signal service, both in discouraging corruption and perhaps starting a cleansing process. The spy-cam drastically increases transparency and the possibility of being caught. Any furtive transaction stands the chance of being made public. But if a researcher searches through the data until he finds evidence to support his pre-conceptions and then publishes, we would call him biased. Saying that everyone is corrupt only makes sleaze more acceptable. If there are stories of dishonest officers there should be stories of honest behaviour. Perhaps officials should start using spy-cams to catch, publicize and punish those who offer bribes.

Monetary Policy Matters

Ashima Goyal

Compared to the enormous media attention given to the budget the Annual Monetary and Credit Policy for the year 2001-2002, presented on 19 April, sneaked in almost unnoticed. Governor Jalan has been systematically downplaying the bi-annual statement. He ensured low interest by announcing that there would be no interest rate or CRR cut. But the statements have been quietly laying the groundwork to make monetary policy more effective. The relative difference in media emphasis is ironic because worldwide monetary policy has been gaining importance compared to fiscal policy. Bankrupt governments, populist handouts and long lags vitiate the latter. More openness in economies and the increasing importance of financial markets, asset prices and expectations have boosted the impact of monetary policy. Greenspan is in the news much more compared to the US budget. Earlier the Indian finance minister used to regularly hand out goodies; but these will dry up, as the budget becomes more standardised and rule-based. Although the impact of monetary policy is less direct, it is becoming more pervasive.

Monetary policy is already important, but for it to be effective a flexible well-integrated and regulated financial system, sensitive liquidity response, and finely tuned interest rates are required. Current policy continues the task of pushing the Indian financial system to get there.

The Statement acknowledges that the last two episodes of inflation volatility indicate that in the short-run inflation has been affected by non-monetary and supply side factors. In 1998 the decision not to tighten monetary policy when inflation peaked with certain food prices turned out to be correct as inflation fell. Similarly inflation is falling again as the oil shock wears out, without a sharp tightening in monetary policy.

The large Government borrowing has also been comfortably accommodated at an average interest cost that is lower by 80 basis points, implying that the high interest rates of the early and middle nineties were not justified: they could have been lower.

Similarly the weighted average lending rate of commercial banks fell from above 16 per cent in 1996 to below 14 in 1999. Over the years banks have been given greater freedom with respect to prime lending rates (PLR). Now banks are to be allowed to treat the PLR as a reference or benchmark rate rather than as a floor rate for loans of above Rs. 2 lakh. This is a welcome move and will contribute to a reduction in the interest rate spread, which continues to be high. Banks themselves have asked for this change-they are willing to lend at lower rates to good credit risks. Therefore the onus is on industry to become better borrowers. The RBI is still protective of banks. Last time the savings deposit rate had been lowered, the budget lowered small savings rates which compete with bank deposits all to allow banks to pay lower interest rates on deposits, but little pressure was put on them to squeeze spreads. Indian banks do have higher costs, but they now earn good returns on their lending to the Government, their NPAs have reduced, a VRS has been accomplished, and they have been exposed to Asset Liability Management. As reform continues banks will have to offer deposit rates that are competitive to a larger array of alternatives. But they will also have many new opportunities for innovative product development. Banks are heard more at the RBI compared to depositors and borrowers. Steps are being taken to mitigate the conflict of interest between managing monetary policy and Government debt; but there is also a conflict of interest between regulating banks and reforming the financial system for effective monetary policy. Despite the cooperative banks it is heartening that the exposure of the banking system to the capital markets is a modest 1.76 per cent of advances, demonstrating effective regulation. Exposure was much larger at the time of the Harshad scam.

The lessons of repeated episodes of foreign exchange volatility have not been acknowledged. Such bouts led to defensive maneuvers from the RBI, including raising interest rates irrespective of domestic needs. A proactive exchange rate policy could lower the frequency of volatile bouts. Our exchange rate policy is regarded as successful because we have not had a currency crisis, but policy must also prevent the external sector from harming domestic performance, while encouraging exports and the productive utilization of foreign capital. The Statement points out that in a narrow developing country forex market, with a higher relative inflation rate, market participants tend to hold long positions, that is, they expect the currency to depreciate over time. But it neglects to point out that currency would appreciate without intervention in frequent periods of net positive foreign inflows.

Therefore short-term two-way movement of the currency, within a band, is possible and could remove self-fulfilling expectations of depreciation. Arbitrageurs are concerned with short-term profits so that long positions would be abandoned even if net depreciation continued to be positive over the medium-term, under such a policy. The policy would also facilitate an efficient level of reserves. India needs to hold higher reserves than industrial countries because of dependence on oil imports and the absence of an assured international liquidity support, but holding excess reserves raises the cost of capital and reduces domestic absorption of foreign savings. International real interest rates present a desirable lower bound for Indian interest rates. Policy has narrowed the gap, but further progress is possible.

Monetary policy still does not aim for forward-looking stabilization. The Statement warns that most countries make frequent changes in response to events, and this should be expected here also. But other countries adjust monetary policy to suit internal requirements. Since our interest rates have been too vulnerable to exchange rate fears, policy has been unable to remove self-fulfilling pessimism that has the economy performing below its potential.

Reasoned Optimism

Ashima Goyal

Our Prime Minister has set a target of 8-9 per cent growth. As the economy struggles to achieve even 6 per cent this looks like wishful thinking. But there are reasons for expecting India to grow faster in the near future.

After the seventies the gap between countries in the West and in the East has fallen at historically unprecedented rates. What explains this? A distinguished US economist, Prescott, in examining this issue using historical cross-country data, finds that on starting modern growth countries grow at rates similar to industrial country growth rates. But when they reach around ten per cent of the 1985 US per capital income level, if the country is far behind the current industrial leader, it grows rapidly. The more behind the country is, the faster is its growth. The US doubled its income in 44 years after reaching this level in 1855; but when Japan reach this level in 1953, it took less than ten years to double its per-capita income. In general countries that reached that level after the fifties have grown much faster than those that did so earlier. Dividing seventy by the rate of growth gives the approximate doubling time for output. Thus a GDP growth rate of 9 per cent will imply that per capita income grows at 7 percent and doubles in ten years, bringing a rapid end to poverty and want.

Is India at this threshold? The US per capita income in 1985 was USD 11,013, ten percent of this is above a thousand dollars. India's current GDP per capita is only about $444. But after adjusted for purchasing power parity with the dollar, (PPP) it was $1,800 in 1999. China's (PPP) GDP per capita was $1084 in 1987, although without adjusting for PPP it was only $247. Moreover, China had its fastest rate of growth after its (PPP) GDP per capita crossed $1747 in 1992. Purchasing power parity for two currencies implies that a unit of domestic currency can buy the same basket of goods at home and abroad. The calculation is based on a common average set of prices for the goods and services produced in each country. Non-traded goods and basic services are much cheaper in India than they are abroad, therefore, using the current exchange rate for conversion underestimates the purchasing power of the average Indian.

The deeper reasons Prescott gives for the faster catch up are openness to new technology and more efficient forms of organisation. At the threshold level there is sufficient critical mass; networks of markets and associations are dense, so that transaction costs fall. Tacit hands on learning and quality can rise rapidly. Fast growing Asian countries are open and pragmatic, willing to learn from the world while adapting the knowledge to their own advantages. India only opened out in the early nineties, and the initial resistance to change and learning is now wearing thin. Moreover new information and communication technology (ICT), in which India has developed some expertise, helps in the rapid spread of best practices, and can improve transparency and governance. Indians are said to be poor at organising and to work better alone. ICT allows independence and networking to go together. New decentralised yet efficient forms of organisation become feasible. The association of India with poor quality is beginning to change as Indian's benchmark and compete with the best in the world.

Other structural factors suggest that India's time has come. There is a sharp improvement in the literacy rate, which is now at 62 percent. The poverty ratio has also fallen, narrowing the gap from East Asia in these basic attributes of human capital. Demographic changes also favour India. The proportion in the age group 20-59 has been at 35% for the past two decades. An ADB study estimates that it will increase to about 47% by 2010. This is the most productive age group and countries with a higher share of population in this group have done well.

But after a spurt of higher growth in the mid-nineties our growth rate seems stuck at 6 per cent. Even so, this is the second highest growth rate in the world. A series of negative shocks after the mid-nineties are partly responsible for under performance. The long list includes sanctions, the cyclone in Orissa, the earthquake in Gujarat, the Kargil war, oil price shocks, the East Asian crisis, stock market scams, corruption scandals, and the American slowdown. Policy has been unable to effectively counter these shocks.

What should we expect for the next year? Agriculture has done poorly two years in a row and as a normal monsoon is forecast, it should, if it follows past statistical trends, do well this year. Software is surviving the American slowdown; enabled back-office services and retail procurement are growing as foreign firms search for cheapest out-sourcing. Private investment is faltering; firms have excess capacity and are worried about what WTO will bring. But ironically it is exports that are growing faster than imports. The more far-seeing firms are re-structuring, improving quality, searching for thrust areas and export markets-those are the ones that will do well. Monetary and fiscal policy and reform efforts are improving, although a lot more needs to be done for infrastructure, especially in agriculture. As events reveal flaws improvements in regulation continue in capital markets. The mountain of food grain rotting with the FCI while there are starvation deaths and farmer suicides should also provoke structural reform in agriculture.

Although the short-run is uncertain, the prospects for the medium- to long run are good. Firms that use the slowdown to plan and position themselves will prosper. Instead of worrying about the faltering of the growth engine of the world, US, we should learn to see ourselves as a growth engine.

The Asian Option

Ashima Goyal

As India opens out, many new options are developing. Although India is in Asia it has traditionally looked west. It is not part of the major associations of Asian countries such as ASEAN (Association of Southeast Asian Nations) and APEC (Asia Pacific Economic Cooperation). But India's success in ICT (information and communication technology) has increased Asian interest in India. Many Asian countries want to develop expertise in ICT, which they regard as necessary for future competitiveness, and would like to learn from India. Thus the Prime Minister of Malaysia, in a recent speech, talked about countries learning from and sharing with each other how to use ICT for development. He especially mentioned learning from India in content development (http://www.sittdec.org.my/g15/). Demand for Indian ICT services is an entry point for other collaborations in what is the fastest growing region in the world. Moreover, it can also compensate for the effect of the American slowdown on the Indian software industry, and provide opportunities for Indian software professionals returning from the US. The global slowdown and the dotcom bust did not prevent a record number of companies taking part in an annual ICT fair CommunicAsia 2001 held recently in Singapore.

East Asian countries have shown themselves to be very open, pragmatic and willing to learn. Despite the traumatic experience of the East Asian crises they continue to be keen on globalisation. Without exception, they want to participate in the new global order, and to acquire modern institutions, standards, and regulations, that will lower their risk of doing so. The countries want to reform, not only because of the crisis, but in order to grow rapidly. After a good recovery from the crisis, they want to resume their earlier rapid gains from globalisation, which they regard as inevitable. They are eager to embrace new technology, and develop the human resources required to make full use of ICT. Arthur Lewis said long ago that "the fundamental cure for poverty is not money but knowledge".

There are other major international negotiations, today, in which Asia has common perspectives. It will strengthen Asian bargaining power if Asia can speak from a common platform. Although strong regional groups such as the North American Free Trade Area (NAFTA) and the European Union have emerged, there has been a relative vacuum in the Asian region--arising partly due to the weakness of Japan in the nineties. Links between South and East Asia are weak at present. Asian nations are diverse with varying levels of development. But it is beginning to be recognized that if the three big nations, Japan, China and India, come closer, the others will also. Commercial links between these three have strengthened in the nineties. Greater Asian regional cooperation including South Asian Association for Regional Cooperation (SAARC), ASEAN, and the remaining East Asian countries would be desirable, despite past border and regional conflicts. Strengthening of Indian-Japanese relationship could serve as a catalyst in inducing China to cooperate with the rest of Asia, as well. Analysts have recognized the usefulness of regional groupings in negotiations on the new international financial architecture (NIFA), WTO, and on the environment. When there are so many issues to collaborate on, the possibility of collaboration rises. Asian countries are also strengthening think tanks, which generate advice and debate that is independent of governments, understand the local context, help in the dissemination of standards and information sharing, and have the potential of bringing the countries together. The new ICT has made such activities more feasible.

Post currency crisis Asian countries are reforming but they have also realised the necessity of a NIFA. There is a perception that aid was arranged much faster for Mexico in 1995 than it was for Asia in 1997. Those who feel they are not getting a fair hearing in global groups have more incentive to form their own. The crisis has pointed out lacunae in international arrangements. Without substantial reforms to the global financial architecture at the international level, the likelihood of regional action rises. As regionalism improves the outside options of a group, so does its payoff in any international negotiation. An example of the direct advantage that can accrue to closer association is the agreement being worked out, among Asian countries, for mutual support in case of a crisis. Reserves can never be adequate in case of a crisis. Given the speed and complexity of modern financial transactions, it is difficult for a country to ensure stability on its own. Joining such an association would increase security, macro policy independence, exchange rate management and utilisation of foreign exchange reserves.

Regionalism is not incompatible with globalization. It can even raise the probability of optimal globalization, by improving the balance of global power and stability. A consensus may more easily be hammered out at the regional level and then taken to the international fora. This is the idea of 'open regionalism'. Nor is it incompatible with improved ties with other countries such as the US, where the huge Indian Diaspora and business interests have brought about a coming together. The modern world rewards strength, flexibility, and the quick following through of advantage. There must be many arrows in a quiver.

There is a history of regional conflicts and competition in Asia, but as more contacts take place, and trade rises, common interests will dominate. Europe, for example, competes with the US; even so mutual trade is very high. China and India can compete, but also trade with each other.

Our Prime Minister has visited a number of Asian countries recently, to a warm reception. Businessmen are turning to Asia, and Indian IT experts are going there. The Asian option is being exercised willy-nilly. But if the process becomes conscious it can be faster. The politician, the businessman, the professional and the researcher can all contribute and benefit.

Separating Hope from Hype

Ashima Goyal

If this is the age of knowledge it is also the age of analysis. Journalists, think tanks, policy makers, and academics are all explaining events and forecasting the future. But what is their primary task? If it is the latter then it is important to be right. And to be right the safest strategy is to follow the current trend, since memory for forecasts is short-term. This explains the dominance of hype. Other sources of hype in forecasts are first, optimism (or wishful thinking) or its reverse, pessimism. Second, overconfidence: analysts believe they are better forecasters than they really are. But the job of an analyst as a technician is to understand and explain the why of events and outcomes, to offer means to avoid problems and to magnify opportunities. That is, to offer hope. Forecasts are there, but they are conditional. Such an analyst will not always be right, even if he is able to understand and advice correctly, his advice may not be followed. But if he is struck by the "being right" infection, he will only give the advice which is likely to be followed, and end up telling people what they expect to hear; that is, following the current fashion.

Ideologues have the disease of being right in a particularly virulent form. They normally interpret events to always fit their own past pronouncements, or highlight those outcomes that support their positions. Their predictability gives them away. They inhabit passion and interest driven extremes. There is the academic trapped by past positions and reputation. There are think tanks that are wholly given over to policy advocacy, not analysis. They do perform a useful function by bringing out all aspects that support their position, much as a lawyer defends his client. But this is lobbying not analysis. A moderate position is never predictable because it is more nuanced and can find a point of balance anywhere on an arc between extremes. Because it is not predictable it conveys much more information, and is credible. That is why the best academics and think tanks covet the adjective independent. These are the ones whose advice will be valued in the future, when competitive advantage will come from new ideas and not from the comfort of advice that supports the status quo. A framework of analysis is always necessary, but it must retain the ability to respond to changes in structure, new events and facts on the ground.

To give independent advice analysts have to break out of all traps: those of the past, of the future, of being right. As Emerson said, 'Consistency is the hobgoblin of small minds. This is particularly true in times of rapid change; thought has to be nimble. An expert cannot rest on past laurels, or be bound by past pronouncements. It was easier to do so in an unchanging environment. Earlier an expert was judged by his forecasts, in the future it will be by his reasoning. In a regime of controls bureaucrats were always right and their orders had to be obeyed. In more transparent regimes authorities have to explain policies and decisions, be able to learn from mistakes and be willing to publicly change their minds for good reasons. This has to be welcomed.

One of the jobs of a manager is to boost the spirits of his work force, to motivate them. He is paid to be optimistic. Therefore he will always paint a rosy picture. This is hype unless it is based on a reasoned analysis of actions that will, with a large probability, improve outcomes. Then it is hope. In the context of India's development the optimist expects prospects to be rosy no matter what, the pessimist that we are bound to get something wrong. Both positions are hype. The first gives false encouragement, the second false warning, because the causal chain that can lead to the predicted outcome is not specified. The "if then" statement that logic or reason demands is missing. Unfortunately, since India has been performing below potential for a long time, both short- and long-term positions tend to be driven by hype. Good news is seized upon and blown out of proportion, bad is regarded as a reversion to the natural state. Our reactions to the ups and downs of sports illustrate this mind set. Thus when the cricket team wins three times in a row there is hysterical elation, when it looses once it is written off. The deep slow changes that are empowering the energies and ideas of people are overlooked. The important question is how to further enhance these changes.

Whether an analyst gives an encouragement or a warning, with a tightly specified causal chain, there is always hope, because the actions that can lead to an improvement or deterioration are reasoned out.

In the long run the conditional forecast or the reasoned analysis wins out. It turns out right more often. So one way to improve our analysis is to lengthen our memory for forecasts, and to appreciate their nuances. In India, for example, the debate has to move beyond positions that failures are due to insufficient reform or too much reform. Longer-term experience with reform, throughout the world, has lead to a tempering of extreme pro and anti market positions. Today it is recognised that both governments and markets have to work together, and evolve towards more efficient arrangements. To say that only markets can deliver, or that they can never perform is hype; to reason, apply and discover how to make them work better is hope. To say a slowdown implies a fall in potential growth is hype, to analyse causes and design policies to alleviate the former and boost the latter is hope.

The Monsoon Manna

Ashima Goyal

Will the good monsoon revive a drooping economy? After a number of years we have a really good, evenly spread, monsoon, just when the economy sorely needs a boost. Agriculture is a source of demand for industry. In the current demand recession when other sources of demand such as Government expenditure, exports, consumption and investment are all faltering, it looks like agriculture is coming to the rescue. Since it still accounts for about a third of output and two-thirds of employment, forecasts of 9 per cent growth imply a revival in aggregate growth to above 6 percent. And multiplier effects of the increase in demand continue. Over the past decades double digit agricultural growth in any year has stimulated industrial output in that and the next year. Low agricultural growth in the past two years is partially responsible for the slowdown.

More money in the hands of so many more people will increase sales, but industry has to focus on the rural and semi-urban consumer to make full use of the opportunity. Already, in anticipation of monsoon largesse there is a boom in sales of CTVs in non-metropolitan areas. There are three other questions that arise.

First, is agriculture in a position to take advantage of the good monsoon? Public investment has been stagnating (rate of growth 0.71 percent per annum) in the nineties, and the infrastructure crumbling. But private investment has risen more than the fall in public (at an average of 7.6 percent per annum), keeping total investment in agriculture at around 1.5 percent of GDP in the nineties. Many corporate houses have big plans for this sector. Growth will be good this year, but neglect of infrastructure must not be allowed to continue.

Rate of growth in	80s	90s
WPI primary articles	7.1	9
WPI foodgrains	7.2	11.2
Index nos. of agricultural production	4.2	1.7
Agricultural GDP at (1993-94 prices)	3.8	3.1
Wheat procurement price	8.4	14.3
Index nos. of wheat production	4.7	3.7
Agricultural price terms of trade (range)	+8	+7
Source: Calculated from Economic Survey 2000-01

Second, given the huge accumulation of foodgrain stocks, will the rise in output translate into a rise in agricultural incomes? Will prices crash? At Indian per capita income levels and price elasticity of demand, farmers benefit from stable prices more than from rising prices. Since demand for food products falls as incomes rise most countries begin support programs to moderate the fall in agricultural incomes after food falls to less than half the budget share. In India, because of the farm lobby, this type of support began much earlier, at the cost of much more essential infrastructure. There is evidence that stable agricultural prices lower inflation, poverty, and raise demand for both industrial and food products. Although the increase in agricultural price was lower in the eighties compared to the nineties, agricultural income, production, and price relative to manufacturing improved more in the eighties (see the Table). India's agricultural price policy needs to be reformed to keep agricultural prices stable (correcting for cost of production), not to keep raising them. Farmers only need to be protected against sharp fluctuations in crop prices. The supply response is better at stable prices, and agricultural incomes still improve.

The distinction between the procurement and support price was lost from the seventies, and the support price, at which farmers could make assured sales, approached the market price. In the nineties it had overtaken the latter, and by the end of the nineties domestic prices exceeded world prices. An indication that prices were set too high is the steady increase in food rose from 10.1 million tonnes in the seventies to 13.8 in the eighties and 17.4 in the nineties. In January 2001 it was 46 and has crossed 60 million tonnes today. Before liberalisation the farm lobby had argued that agriculture was discriminated against because world prices were higher than domestic and they were not allowed to export. Now when export is feasible grain prices are not competitive. Stable domestic prices would make our products more competitive and help the farmer find new markets.

Relative agricultural prices depend on what is happening to non-agricultural prices. Since the wage-price spiral does not kick in when food prices are stable, non-food prices rise less and terms of trade turn in agriculture's favour. This explains the surprising last row of the Table, which shows the maximum variation in the ratio of agricultural to non-agricultural prices over the decade. Thus ironically the farmer can buy more in real terms when he raises his price less. Manufacturing prices are also falling with increased competition and fall in protection. If these indirect systemic effects are understood such a policy change may become acceptable.

Third, other supportive polices are required. The monsoon can only give us a break; we need to build on it to realise our potential. Food stocks can be used to start massive food for work programs to improve rural infrastructure and water management. In the longer-term, both information and bio-technology can be harnessed. Low cost simputers and local area network based community centers can provide employment, improve information and compensate for missing markets. In Assam the markets are so poor that the farmer consumes his crop for three years and then thinks of planting another. A local net would help him contact a buyer. The Gyandoot project in Dhar, MP, and the Lokmitra in HP has already made a beginning. The farmer must be given more freedoms along with better information. Good marketing facilities would lower the spread between retail and farm gate prices, and give both the farmer and the consumer a better deal. Exports of agricultural products have shown more fluctuations than growth, but are quite significant at between 15 and 20 percent of India's total exports. With supportive policies there are possibilities of sustained rise.

In general, policies need to improve supply in agriculture and demand in industry. As we wait for manna from heaven it would be well to remember that even the heavens only help those who help themselves.

Financial Doldrums

Ashima Goyal

As a troubled financial sector gets special sops, it is time to ask what the policy stance should be towards this sector? A well-regulated modern financial sector is essential in a globalized economy. Financial innovation has been shown to contribute to development. Market based economies have, in general done better, because of the constant identification and improved satisfaction of consumer needs, including needs for financial products. But finance also has a tendency towards boom-bust cycles. Markets can discover prices and reveal information about the future trends, but the information is suspect because of bandwagon effects; market participants follow each other and are uncertain about fundamentals. Therefore both micro and macro policy should be geared to encouraging competition and innovation, but moderating these cycles. Regulation should change the incentives for behaviour that leads to crises. Monetary policy should encourage finance through stimulating the real sector, and minimizing shocks to finance. The ultimate justification of finance lies in improving real sector productivity. The only direct benefit given to finance should be providing it a better market microstructure.

Finance is subject to externalities. If a big institution is in trouble it can bring others down with it, provoking a cumulative downturn. Such systemic risk also arises in a recession and makes government intervention necessary. The problem is that government guarantees, or deposit insurance, make the financial institution less careful. For example, depositors do not ensure that banks lend prudently. Prudential regulation is designed to align incentives by putting the entity's own capital at risk, and providing a buffer to absorb shocks. There are controversies about ideal regulations and fine-tuning them is an ongoing problem around the world. Too strict regulations decrease profits, therefore actually increase risk-taking, and encourage creative accounting. Mechanical rules cannot fully account for the correlation of risks. A bank, the return on whose assets go up or down together has higher risk than another, which has a more diversified portfolio. Therefore regulatory oversight continues to be necessary. But rapid technological change creates new possibilities that make it difficult for regulators to keep up. The complexity of modern system is such that controls must give way to self-regulation and revelation of information. Innovative ways have been developed to get information from markets. But indirect risk based capital adequacy regulations still need to be supplemented by more direct ones. Regulators should, however, examine broad patterns, rather than oversee individual transactions. For example, there is a case for restricting a bank's financing of real estate or stock market loans; but discretionary controls, that lead to corruption, delay, and throttle innovation, should be minimised.

India's experience with financial reform illustrates some of these principles. Reforms offered a real opportunity for India to catch up, to leap from being extremely backward to being more state of the art than many countries, which are locked into older, less efficient technology. Good progress has been made in market microstructure, but the small investor has disappeared from the market and finance is contributing less to the real economy. Financial institutions are looking for well-established firms to lend to, banks only want to lend to the government or the consumer, and the IPO market has collapsed. No one is willing to lend to start-ups. Finance blames over-regulation. In most countries financial reforms led to over expansion of credit, regulators were not able to keep up since regulatory skills were often lacking, and major crises followed. In India we seem to be following a middle path because credit has dried up, but we have escaped with only minor crises. Better regulation and modern infrastructure are essential, but they have a short-run cost.

More attention to sequencing and consistency of reform, across financial sectors, with monetary policy, and the investing habits of the Indian public will moderate the cost. In transition innovative partnerships with government can reduce risk. Direct regulations can partially substitute for strict capital adequacy, and thus moderate fall in expected profits in the course of reform. Competition and more freedoms should encourage banks to develop information on loan quality, which is their comparative advantage, and reforms in bankruptcy law will make collateralisation of loans easier. One of the signals of an impending financial crisis is a rise in risk and therefore in interest spreads. In India the latter has always been high because of cross-subsidization. Financial institutions are used to unthinkingly riding the yield curve. Better loan information, recovery, and efficiency are the way out of this perennial crisis.

Households have to get used to moving from a stable system of assured returns, under government ownership, to more opportunities for a controlled participation in the risks and rewards of development. Earlier the government pooled risks, with the taxpayer subsidising finance if necessary. But this has limitations, and the government has no money. The market has to grow up and take over these functions. Now mutual funds can pool risks for households and offer a wide menu of combinations between risk and return. Developing a retail infrastructure is essential, and innovative marketing ideas are required. If the national savings certificate were to offer a mock gold necklace as a certificate, perhaps it will find more takers in traditional households.

Turning to the coordination of monetary policy, Indian finance has a history of dubious deals and the mistrust this engendered was one-reason interest rates were kept high. Modern transparent systems should diminish the mistrust. Lower real interest rates and the absence of sharp fluctuations in nominal rates help both the real and financial sectors. Such policies are being implemented worldwide to help the financial sector after the terrorist attacks. A lower interest rate regime will painlessly re-capitalize banks as the value of their holdings of government securities rises. Smooth variation in nominal interest and exchange rates will allow real rates to find the equilibrium values, which encourage output, savings and investment.

Beyond Money Illusions

Ashima Goyal

Worldwide central bankers are coordinating actions to stimulate economies in the global slowdown. The steps taken in the current monetary policy are in line with this trend, but they are slow cautious steps. There are reasons for the hesitation.

First, in India the counter-cyclical role of macroeconomic policy is not fully appreciated. Monetary policy is regarded as constrained by the fiscal deficit. But the RBI, over the past few years, has very successfully accommodated government borrowing, with a trend fall in interest rates, in spite of having to sell government securities to sterilize large accumulations of foreign exchange reserve. There are degrees of freedom available.

Second, the difference between nominal and real interest rates is not sufficiently internalised. Savers worry that their returns fall with the nominal interest rate. But if inflation is also falling real returns may not be falling. If savers understand that in an open economy the minimum real interest rate they get cannot fall below world real interest rates, this should reassure them, and give room for lowering nominal interest rates. Better retailing of and variety in savings instruments will also help savers.

Third, sudden sharp changes in interest rates disturb financial markets too much. Greenspan, for example, cuts the nominal interest rate only 50 basis points at a time. The advantage of smoothing, or successive cuts in the same direction, is that people internalise future cuts, the expected real interest rates fall, and stimulatory effects of lower interest rates are realised even before the rates themselves fall. What Indian monetary authorities are saying, however, is that there is a preference for interest rate softening, but this can be reversed whenever required. This warning unfortunately prevents expectations of lower interest rates from setting in.

Fourth, there is a tradeoff between variability of nominal exchange and interest rates.

Although the Reserve Bank wants to be free to raise nominal interest rates sharply anytime to quell excess volatility in exchange rates; it can make it clear that such a rise, if at all it occurs, will hold only for a very short time. The downward trend is real and persistent. The bank rate has gone from 12 per cent in 1997 to 6.5 per cent today, with a few temporary blips. A second, and longer-term resolution, will require an exchange rate policy that makes it possible to smooth interest rates more. The current policy statement talks of monitoring firms to make sure they hedge exchange risk. If some modest variation in exchange rates within a band is allowed, firms will automatically have an incentive to hedge, and the likelihood of having to use the interest defense will fall.

Fifth, the RBI is protective of banks, because as the regulator it shares responsibility for bank failures. Banks have to be given some time to learn to live in a flexible rate environment, but learning by doing, or being exposed to some flexibility is the best way. Meanwhile the CRR cuts are a gift to sweeten the medicine. Moreover, a slowdown is a time to pump in more liquidity. The RBI's moves to shed its regulatory and government debt management functions are also in the right direction. This will lower current conflicts of interest, and allow it to focus on monetary policy.

Monetary policy is expected to become fully effective only after about five years, as these issues are resolved. Beliefs have to adjust to change; people have to move beyond illusions. But not deriving the full effects should not preclude us from deriving the maximum possible current effects.

Indian real interest rates normally exceed global, although the gap has been coming down since 1995, with some aberrations. But after ten successive cuts the US bank rate is at 2 per cent today, and the excess in Indian inflation is not more than 2 percent. It is not, therefore, surprising that capital inflows continue and we have accumulated $10 billion more of high cost reserves over the last year. Because global capital moves in response to interest rate differentials, a gap leads either to continual inflows, or is filled by an expectation of exchange rate depreciation. There is scope for lowering Indian interest rates further. Why should stimulatory monetary policy be reserved for slowdowns in developed countries, while we, fearful of capital outflows, take action that increases the probability the outcome we fear?

The RBI has lowered its growth projections for 2001-02 to 5-6 per cent. The annual report discussed alternative growth trajectories and the difficulties, in a developing economy, of distinguishing trend from cycle. Do structural limitations imply that Indian potential trend rates of growth have fallen? There are structural problems but the latter half of the nineties, when growth rates have been lower, have seen a series of adverse shocks. In particular, private investment has fluctuated, and its correlation with one year lagged agricultural growth rates and nominal interest rates (both of which have shown large fluctuations) is high. Perceptions of country risk rise with volatile nominal interest rates. Macroeconomic policy can alleviate or counter such shocks.

This year again there are major adverse international shocks. But the diversity of our economy is coming to our aid; exports are not the only arrow in our quiver. Agriculture is expected to do well. In the past high agricultural growth in any year has stimulated industrial output in that and the next year, and private investment in the next year. Our comparative advantage in software and outsourcing continues to ride out the global recession. There are signs of a recovery in some sectors. If macroeconomic policy stands ready to support the recovery, and it gains strength, the structural reforms that are required to sustain it will become more feasible.

Equal at Home and Abroad

Ashima Goyal

Every Indian family has relatives abroad. Writers among and about the Diaspora have multiplied. One of the oldest and best of them has been felicitated recently. Naipaul's most recent book, "Half a Life", both the title and the contents, captures in deep and subtle ways, the mindset of a people divided and dispersed. The father of the protagonist rebels against tradition and lives his life hating half of himself. His son escapes but must work out the conflicts he carries within himself by switching to the other side. After being the victim of colonialism in India and England (and unable to become "white" in England), he must become its perpetuator in Africa. To discover, predictably, that neither side is happy or content. What is the source of this incompleteness? Colonialism is deeply unequal, and associated with a sense of shame and inferiority. Even today, when colonialism is long past, inequalities continue. An escape from roots is insufficient to escape their angst, unless the roots themselves are well nourished and healthy. A large disparity in lifestyles implies a drastic adjustment for the migrant. To seem different from his roots he has to disown them; leaving then means loosing.

It is easier to leave if one convinces oneself that one hates what one leaves, that one is relived to escape dirt and poverty. But no one can be happy being ashamed of one's roots. Guilt and imposed hatred do not make for peace of mind. As Adorno put it the migrant's historical dimensions are sapped, and his perspectives distorted. Connections with the home country are one way of relieving the thinness of knowing that afflicts a migrant. Many migrant writers come home to set the creative juices flowing.

Fortunately, changes are taking place. Greater prosperity at home makes it less necessary to escape, and makes the escape, even if it occurs, less of a traumatic rejection. New technologies and ongoing reforms make it easier to physically leave yet retain close ties, that may even be remunerative. It is possible for the migrant to make real contributions and earn real rewards. Such engagement removes both the traumas of rejection and associated guilt. There are material as well as psychological gains to staying in touch. It is no coincidence that Naipaul's own perceptions of India have become gentler and more hopeful over the years as his access to and engagement with India has increased. He has understood the real changes taking place and, in his words, "looked hard enough" to "see the seeds of the future" in the seemingly chaotic present.

Contributions of migrants help to decrease the distance and inequalities between countries. September 11 has made the world more aware of the dangers of inequality, and has made countries more open to endeavours that decrease it. Terrorism is closely linked to inequality and perceived unfairness. In the recent meetings of the World Bank and the IMF many attending nations were willing to give more aid. The WTO meeting at Doha has shown more willingness to engage, and yielded some gains for developing countries. A future round of global trade talks is on the anvil. There were compromises but also mutual gains. Developing countries gained in the priority given to implementation issues, TRIPS, transfer of technology and developmental goals including farm and export

subsidies, and increased access to European Union markets. Labor standards, which are seen as a developed country ploy to impose protection by the back door, were kept out of the negotiations; and safeguards were agreed to in environmental regulations, which have similar implications. Other sensitive issues were postponed. Considering the way the Seattle meeting of the WTO was scuttled, just tough negotiations could not have achieved all these gains, unless there was more openness on the part of developed countries. There is a realisation that fairness and equality are essential to preserve the gains from trade, just toughness will not do; and maintaining trade is essential for developed countries also. If the quick victories in the Afghan War reverse this trend it would be a major setback to international amity. More equitable global trade will enhance development; and migrants can contribute to increasing trade with their home countries.

In developing countries there is great suspicion of the WTO; it is seen as an organisation that helps the powerful. This perception is not correct; multilateral fora and global rules give more of a chance to the weak than bilateral engagement does. But these inequality-bred suspicions of home country residents often extend to migrants also. The famous anthropologist Sahlins wrote of perceptions of pacific islanders. While others regarded them as a poor remittance dependant economy their myths helped them see each mile a migrant covered, as a mile added to their world. Domestic perceptions will change more easily to such a worldview as the benefits to the home country from migrants and trade become more obvious. Such benefits are very clear in software. The largest percentage of Indian origin software professionals working in the US come from Andhra; synergy is helping that state make rapid progress in this area. Booming pharmaceutical exports have benefited from the sixties wave of Indian migration, of technical personnel, which has established valuable contacts. As transactions and communication costs come down, with some help from the Internet, these contacts can fructify more and more.

Learning from Crisis

Ashima Goyal

Few countries can rival the sustained drama of Latin American macroeconomics. Import substitution gave way to liberalising reforms, interrupted by the lost decade of the eighties, during which growth fell and inflation remained high. Although the rise in US interest rates triggered these outcomes, much of the damage in the eighties was caused by high and fluctuating domestic real interest rates. Huge inflation rates had to be stabilised. But this was done by restricting money supply growth or fixing exchange rates. As inflation rates fell the demand for money balances rose. Policy makers, however, had not retained the flexibility to respond. The consequent sharp rise in real interest rates harmed output. The fall in inflation was insufficient to prevent real exchange rate appreciation, which harmed exports. Since the reforms lost credibility agents responded in ways that further destabilised a fragile situation.

High real interest rates were expected to encourage savings and compensate for the earlier period of negative real interest rates. But savings did not rise. This experience is a useful antidote to the current concern about Indian savings, as nominal interest rates fall. Negative real interest rates are also undesirable. Savers require a positive real rate of return, but they must also be given a variety of savings instruments with a choice between risk-return profiles, and the opportunity to participate in the returns from growth. Savers are not as sensitive to interest rates, as they are to risk. A major reason why Indian savings ratios are stagnant in recent years is the perception of higher risks associated with available savings instruments, which have not been compensated by higher return. The aggregate savings ratio is highly correlated with the growth of aggregate output. As growth rates and stock market indexes rise, and the market microstructure of stock markets and mutual funds are improved, equity based savings instruments will become more attractive. Developing retail depth in government bond markets is one way to offer households more low risk and stable return options.

The East Asian crisis further demonstrated the damage that high real interest rates can do. High domestic interest rates under regimes of fixed exchange rates led to high short-term foreign debt, since foreign loans were cheaper. A further rise in interest rates as part of crisis management, in the context of such high debt, turned the currency into a banking crisis and made things worse. This year's Nobel Prize winner, Stiglitz, has been highlighting these issues. Since mobile global capital is often poorly informed about a country's fundamentals, a large gap between domestic and international interest rates can be taken as sign of the weakness in domestic currency and provoke capital flight leading to a crisis. Therefore the safest option for a developing country is to attempt to narrow this gap. In order to do this a credible but flexible monetary policy is essential. Even so, low positive real interest rates are only one enabling factor. Although they do stimulate growth, credit offtake, and the risk sharing embodied in equities, other factors also have to be in place.

Newspapers are full of the plight of Argentina, which bound its monetary policy in the straight jacket of a currency board. A recent conference in Rio de Janeiro gave me the opportunity to study the contrast with Brazil. Brazil was a late and reluctant reformer. It had long followed the import substitution model of development, but was disappointed by stagnating productivity and social conflict. Widespread indexation of incomes to prices contributed to high chronic inflation. After successive aborted attempts at stabilisation, it was only in the mid-nineties that it succeeded in bringing down inflation. Since then it has been following what is for Brazil a relatively tight fiscal policy combined with a flexible monetary policy. A recent Brazilian devaluation made Argentina's plight worse; Argentina's exports lost competitiveness but it could not devalue being tied to the dollar. Brazil continues to have problems such as high inequality, but there is progress despite repeated external shocks.

In his speech to the conference, President Cardoso spoke of a promising shift of the fiscal stance to developing capabilities in the populace. He said he admired the ideas of another Nobel Prize winner, Amartya Sen. For example, his government was making income transfers to poor mothers, for the education of their children, thus hoping to improve human capital and lower inequality over time. Mothers could be trusted to use the money for the benefit of their children. Special taxes had also been instituted on firms, to be used for dedicated research on related products. Such research was recognised as essential to reach targeted productivity levels.

The past import substitution regime had discouraged learning. There had been more process compared to product innovation. It used to be argued that import tariffs were essential to protect and encourage the development of domestic products, but without the necessity of exporting there was no pressure to develop new products that could compete in world markets. As a result innovation, cost reduction, quality improvement and productivity growth all suffered. Global best practices were not adopted. The lowering of import tariffs was aimed not at destroying domestic production, but at improving it to ensure eventual survival. Government intervention was turning from creating artificial protective barriers to helping industry upgrade.

The last major lesson from Latin America is that reforms that do not address fundamental distortions cannot work. After many false starts structural changes in the mid-eighties finally put Chile on a high growth path. Cosmetic changes require continual patching. Suppression only leads to eruption elsewhere. For example, indexation without control of revenue deficits encourages still higher levels of inflation. Revenue deficits cannot be controlled without a shift from short-term populism to building the long-term capacity of the poor. Macro policies that move the economy in this direction can retain both flexibility and credibility.

A Budget Tight on Promises

Ashima Goyal

Analysts, and the Government itself are developing a longer memory. The annual budget carnival is being linked to earlier ones. This increases pressure on the Government, which has to either keep promises or give a valid explanation for lapses. There are normally two kinds of promises made in a budget. First, regarding figures and second regarding policies. Not only will aggregate ratios and allocations be compared to budget estimates, but also the Government's record on reforms will be examined. The Government is itself planning to do so. One of the promises last year was that future budgets would carry a report on actual implementation. This explains the sudden pre-budget flurry of activity on the reform front after a long period of quiet. A Fiscal Responsibility Act can only be credibly introduced after the Government acquires a reputation for keeping its promises.

One pre-condition for promises to be kept is that they must be more carefully made. If it is so hard to achieve promised sectoral allocations, it means they are not linked to focused and implementable projects; but are rather a wish list or mechanical projection of earlier allocations. A lot more work has to be done before the budget to identify such projects and ensure their quick execution. More transparency and global accounting standards would lower the scope for creative or cosmetic accounting.

A second is adopting a feasible, efficient and fast track policy combination. It is useless wishing for the stars, but we can design rockets. In this context it is useful to revisit the debate on which is the best concept of the deficit. Each definition has some value. Thus the fiscal deficit gives the pressure on total resources. The concept used must be matched to the purpose. If we want to find the fastest way to lower deficits, it is the primary revenue deficit (PRD) we should focus on. In the context of structural change, the PRD indicates how current changes are improving government finances, inspite of past burdens. If the PRD is reduced but spending on physical and human capital formation is maintained and improved in quality, then growth would be preserved and deficit ratios fall the fastest. Tomorrow can be different from yesterday.

The idea of cyclically smoothing the deficit is also becoming relevant. In a developing country with per capita incomes far below potential, spending to remove bottlenecks is always required, but more so when demand falls below current capacity. Today India is going through a slowdown combined with low inflation, and huge stocks of food and foreign exchange. It is argued that high deficits imply enough of a demand stimulus, no more is required. But interest payments comprise half of the revenue deficit. These are transfer payments that do not directly stimulate demand. Moreover, more than three-fourths of government securities are held by public sector institutions. Thus RBI profit is included in the government revenues but part of this profit comes from interest on government debt held by the RBI.

The fall in inflation is part structural, and will persist but there is a cyclical part that will be reversed. Average inflation rates have fallen because of beneficial changes on the supply side. Some of these are more competition, fall in costs, stabilisation of food prices and fall in other administered prices. Institutional changes such as discontinuation of ad hoc treasury bills, which make monetary policy more independent of fiscal policy make for a fall in expected inflation. So does more openness, which brings in the influence of the lower inflation regimes in most countries of the world. Therefore the sharp fall in inflation does not imply that we are in a debt-deflation cycle. But it does give a signal that action is required. A part of the fall in inflation comes from the cyclical slowdown, and offers an opportunity for boosting demand without inflationary consequences.

The fall in inflation also allows nominal interest rates to fall without real rates of interest becoming unacceptably low. The lower interest rate regime has stimulated construction activity and demand for consumer durables, and needs to be complemented with a fiscal boost to revive the economy. There is evidence that public sector organisations and activity are slowly becoming more efficient; this money may not be wasted. Markets cannot do it alone without the Government and reform and reorganisation in delivery of government services is also vital.

Budget day also demonstrates the process of formation of, and the power of, macroeconiables enter and have a major effect on individual decisions. Well-designed, complementary macro and structural policies can coordinate expectations onto a higher growth path. These expectations help make higher growth feasible. A restructuring of government spending, in sustainable directions, can have stimulatory effects even if aggregate spending does not increase. An example of such a process comes from Irish experience with reform. Fiscal restructuring in 1982 was largely based on tax increases to bring down a huge deficit. It did not work and only provoked a slowdown. A second attempt in 1987 was more credible. It included structural changes such as a rise in the tax base. A sustained boom resulted as agents took actions that demonstrated their belief in the feasibility of the reforms.

The Nehruvian era emphasized long-run growth through huge capital intensive projects but it resulted in a short-term view on the part of both Governments and the governed, as populist subsidies came to dominate a bankrupt government that lived from budget to budget. Interventions should move towards those that improve the productivity of the people, and are sustainable in the long-term. This Government also has miles to go and promises to make; but the promises it makes should be those that we can help it keep.

Not Enough Stimulus

Ashima Goyal

A major new feature of the budget is the conscious attempt to achieve targets, to record hits and explain misses. The website of the ministry of finance (http://finmin.nic.in/fub.htm) now carries a section on the implementation of policies. The record is reasonable, partly because of the flurry of activity just before the budget. Deadlines seem to have forced the ministry to concentrate, and a reputation for meeting deadlines is a prerequisite for a credible budget law.

The distinction between structural and cyclical features has not been well understood or communicated. Making such a distinction can both explain one of the major target misses and address criticism about the absent boost to demand. The target for the fiscal deficit was 4.7 as a percentage of GDP, the realised value is 5.7, and the budgeted value for the current year is 5.4. The fiscal deficit is the excess of government expenditure over revenue and stimulates demand. But since expenditure includes interest payments, which are largely a transfer, the primary deficit is a better measure of excess demand on government account. The primary deficit is fiscal deficit minus interest payments. This was targeted to be only 0.2, was actually at 1.1, is budgeted to be 0.7 in the next year, and constitutes a pure demand injection. Given high government debt, structural reforms require a lowering of the deficit, but the cyclical slowdown requires demand stimulus. It all right to exceed targeted deficit values. A deficit target should be set as an average over a cycle. Tax collections also fall during a slowdown, thus automatically raising the deficit.

But is the demand injection sufficient? Here there are two issues. First, the composition of demand; second, its size. The fastest way to lower government debt is to restrict revenue expenditure but raise capital expenditure. This time revenue expenditure was actually less than budgeted, but target budget support to the plan was more than achieved. Even so, more than half of plan expenditure comes from internal and extra budgetary resources of public enterprises; here there was a shortfall, so that total plan outlay increased about 18 percent compared to the promised 20 percent. Last year above twenty percent had been promised, but only a 13 percent increase delivered. But the budgeted increase in central plan outlay for the next year is only 12.7 percent. The table shows the increases promised, and actually made last year, and promises for the next year.

The finance minister has said that the projected level of public capital spending is the highest in the decade. This is true. But it has taken a long time to implement the decision to reverse the fall in public infrastructure investment that took place as part of the macro stabilisation of the nineties. Public investment, as a share of GDP, has inched up slowly, painfully, to 7.1 per cent in 2000-01 compared to the nadir of 6.6 reached in 1997-98. Last year, for the first time, a momentum has been built up, why is this not being kept up for the next?

Part of the answer maybe the new desire to achieve targets. The increase has been kept at achievable levels. It is also well targeted to sectors that need it, such as energy, agriculture and social services, and is part of the restructuring whereby government capital stock is changed from less to more socially productive uses. Selling off inefficient public sector enterprises can help fund state of the art infrastructure. New institutions must ensure accountability and delivery in infrastructure. Public-private partnerships can multiply government seed money. Moreover, borrowing for efficient capital expenditure is good policy. The Chinese government, for example, borrowed heavily to build infrastructure in the eighties, and these were all extra budgetary resources.

There is an argument made, for example, in the economic survey, that today's fiscal deficit is tomorrow's revenue deficit, unless government borrowings are used to earn returns that exceed interest payments. Today user charges are becoming more politically acceptable, so that infrastructure investment can earn direct returns. But such expenditure also has large externalities. Tax revenues will increase with growth and the fiscal situation improve. As long as the rate of growth exceeds the real rate of interest government debt is sustainable.

The last point brings us back to the question of demand injections. The budget has done something, but less than it could have; in contrast China's fiscal stimulus designed for the 1998 slowdown was 2.5 percent of their GDP. The move to link small savings interest rate to the yield on government securities has increased flexibility in the interest rate system, and the potential for further stimulus. The responsiveness of the RBI can rise. Although the current interest rate cut is only 50 basis points, smoothing interest rate changes through repeated small cuts is a good idea. When interest rates are expected to soften, expected real interest rates, which affect demand, fall more than nominal interest rates. The relatively sober fiscal policy, and low inflation rates, will allow monetary policy to be more supportive of the fledgling recovery.

The budget continues positive supply side and structural changes on many fronts. Taxes have risen but marginally and have been graded to fall more on those who can afford to pay. But tax slabs need to be linked to inflation and changing average income profiles. India's tax/GDP ratio is one of the lowest in the world at below ten percent. So attempts to raise the tax base by bringing in services are essential. Taxes must be spread equitably; huge burdens on a small captive group lead to evasion. More should be done to link taxes to specific benefits, such as the cess on petrol being used for highway development. People will be willing to pay a lean and efficient government that delivers.

Learning with China

Ashima Goyal

There are many reasons for the dramatic rise in Indian interest in China. First, China is doing better than India and shaking off ages of poverty rapidly. The similarities and contrasts between the two countries make comparisons fruitful. Second, China is a major competitor; but it is a potential collaborator as well. Indian manufacturers worry about cheap Chinese manufactured goods. Although there is no evidence of a massive inflow, this fear has even been blamed for the stagnation of private investment in manufacturing. Still, Indian software firms are setting up shop in China; a Chinese airlines has started a direct flight between Beijing and New Delhi; bilateral trade is an annual $3 billion, and set to expand. Each has a huge potential market the other can benefit from. A dense network of mutual interests is the best way to transform old hostilities. There are many opportunities for gaining from each other's comparative advantage, just as Europe is intrinsically a competitor for the US but their mutual trade is large.

Are the countries intrinsically different? It is fiercely debated if similar policies are at all possible. A dictatorship can be more decisive than a democracy, and impose greater costs on its citizens, but more than the difference in governments it is the difference in clarity and focus that is crucial for growth. Each form of government has some advantages, but also disadvantages compared to the other form.

The Chinese saw how much they were falling behind the more open East Asian countries. Reforms were started in the late seventies with a clear commitment to openness and to the business model, although in the operational aspects they were pragmatic--crossing the river while feeling the stones. Openness was believed to be necessary for modernisation. The new mantra was the possession and creation of wealth, not communism. As the number of people who profited from the new system rose rapidly so did their commitment to it. In contrast India's switch to a more open policy was crisis driven, hesitant, suspicious. Although it lacked China's advantage of more even human development, it had more market institutions; China often had to build these from scratch.

The two countries were similar on most performance indicators; China really overtook India only in the nineties. Since Chinese data and systems are non-transparent Chinese prosperity may be overstated, but the improvements in outcomes and standard of living cannot be doubted. One consequence of China joining the WTO will be that their accounting systems will become more standardised and transparent; it will become clearer how much China is really growing. But the lack of transparency allowed China to follow unconventional macro policies that worked. According to the governor of the Chinese Central Bank, Dai Xianglong, the level of national domestic debt is actually much higher than official reports had previously indicated. Yet the government made large borrowings to invest in improving China's infrastructure, and design fiscal stimuli in periods of slowdowns. Loan interest rates were kept low yet households were paid real positive interest rates on savings since deposit rates were indexed to inflation rates during the occasional periods of high inflation. Foreign investors continued to flock in and China continued to grow. International institutions and rating agencies sometimes enforce uniform but inappropriate macropolicies.

There are few checks and balances on State propaganda in a closed system, but the positive spin seems to have worked for China. All the self-criticism and identification of flaws in India's more open system has not succeeded in removing the flaws. The lessons we need to draw are first, the value of belief in ourselves. Second, pragmatically designing policies that stimulate growth, learning, and innovation.

One of the ways in which India is regarded as being far behind China is in attracting and using foreign inflows. Against the huge FDI volumes of above 40 billion that flow annually into China, India gets a pittance. But the table gives us some surprises. Once we remove inflows from Hong Kong, Macao and Taiwan, India and China attracted similar amounts of FDI in the first decade after each began allowing FDI to come in. This was the eighties for China and the nineties for India. Thus India can hope to attain the Chinese nineties average annual level of about 10 billion US dollars in the current decade. It can do better if it is able to persuade its NRIs to contribute like the overseas Chinese were persuaded.

Savings in China were low initially but grew rapidly post-reform because the marginal household savings rate was high. Foreign inflows were not required to supplement domestic savings, but the Chinese welcomed them to boost technology, learning and exports. Evaluative studies show that they have indeed contributed to all these aspects. Since China was consistently running a balance of payments surplus in the nineties, she actually began investing abroad, in energy resources, for example. This explains the first three rows of the table. Although India received lower inflows than China she used more of them as a conventional supplement to domestic savings or to add to reserves of foreign exchange. The first row measures capital inflow as the current account deficit and the reserve gain. Since China often had a balance of payment surplus, and was not adding so much to reserves in the eighties, measured capital inflow is higher for India. But unlike China we have been accumulating reserves rather than using foreign inflows to enhance investment and growth, even in the first decade of reform. The Chinese used their inflows more fully, in the first decade, even though they needed them less. Our marginal savings ratio is also high, and the Chinese experience tells us that if we are able to raise growth savings will rise. It is if we use these inflows effectively now that we will lower our future dependence on them.

Passions vs Interests

Ashima Goyal

As Gujarat continues to burn it is essential to find solutions. To hope to do that we have to understand both ourselves, and the deeper causes underlying events. It is natural to turn to the words of one of her greatest sons, Gandhiji: "an eye for an eye will make the world blind". Many of the solutions being offered are based on revenge and punishment, but these sentiments are among the origins of trouble. It is necessary to turn to reconciliation. Other countries and people have benefited from Gandhiji's advice, and as the world is torn once more by bitterness and revenge, some people are remembering him again.

I cannot do better than reproduce a moving letter written by S. Ratcliffe from South Africa, "As the tanks roll into the West Bank I am reminded of the Nazi concentration camp survivor, Victor Frankel's words which stand as a poignant reminder to us all when he proclaimed the commonplace truth: "...that no one has the right to do wrong, even if wrong has been done to them". South Africa stands today as living testimony to the alternative. We were led through the process of national reconciliation by a man who rose above the temptation to be resentful, even though he was the victim of persecution. It requires looking into the eyes and the soul of your adversary and seeing that they too are human. It also requires looking into your own heart and owning up to your part in creating the situation. This is both an individual and collective responsibility." (developmentex.com, newsletter, 18th April, 2002).

Gujarat has a history of Hindu-Muslim conflict, and accumulated bitterness. The shared border with Pakistan encourages smuggling, and other irritants. Therefore RSS shakas set up in Gujarat found greater success than elsewhere. Bhiwandi near Mumbai has a similar history of conflict, and has suffered many ugly riots in the past. But it has become a model of peace and amity. There are two reasons. First, mohalla committees, where neighbours regularly talk to each other, get to know each other, and resolve small problems before they become big. The second reason is economic prosperity. A well known economist, Albert Hirschman, had a book called "The Passions versus the Interests", in which he argued that economic development created interests that diverted passions that earlier had been invested in ventures like the Crusades. People had more to loose from war and destruction. Even in Gujarat, Surat, which is relatively prosperous, has remained peaceful. In Ahmedabad a large number of workers have recently lost their jobs, in textile mills etc. Youth with poor career prospects form a fertile breeding ground for lumpen elements.

Gujarati resilience and enterprise is admired everywhere. This spirit made possible a quick recovery from the earthquake. It was one of India's best performing states. Modern endogenous growth models emphasize the contribution of human capital to growth. Indeed, the models predict that growth is very rapid after the destruction of physical capital, such as happens in a war or an earthquake, provided human capital remains intact. Unfortunately, today Gujaratis are themselves destroying the latter. Businessmen of both communities must take the initiative in reconciliation moves. They understand that both communities have made major contributions to the economy, and Gujarat can be prosperous only if both can work together peacefully once more. It is heartening to see that some such reconciliation moves have begun.

Last but not the least is the role played by politicians. Vote bank politics has created bitterness and set the communities against each other. All parties are equally responsible. But the structure of elections has been a contributing factor. Once the Congress began to decline, and there were multiple competing parties, swing votes were very important for winning in our majoritarian, first past the post system. Identity politics, based on caste and religion, came to dominate. The Congress cultivated the Muslim vote, which encouraged a Hindu backlash. Defections and frequent elections, as Governments fell and elections at the State and Centre were separated in 1971, meant that politicians were concerned only with the votes that would get them to power. Once in power they were concerned with "loot" in order to buy votes and legislators in the future. Frequent elections kept this pressure up continually and harmed longer-term development. Indeed, Narendra Modi's inaction and the NDA's support to his Government despite accumulating evidence of the State Government's failure and even complicity, are said to be motivated by the BJP's recent election losses, and the assembly elections due in Gujarat. Playing the Hindu card has become imperative for the BJP.

What is the solution? Electoral reform is possible in the longer-term. Hung assemblies that give importance to identity based splinter groups can be reduced if we follow the French system whereby in the absence of a clear majority there is a re-poll among the two parties with the highest totals. Another alternative is a move to a proportional system, with some limits on the minimum size of parties. This would decrease the importance of swing votes, and ensure the majority is represented. State and Central elections can be coupled once more, so that governments are not continually being tested. These changes require careful debate and discussion. Meanwhile there are signs that the political system is moving towards single party led broad coalitions, one towards the right and the other towards the left of the political spectrum. This would lower electoral pressures, but for this to happen the large parties have to become more inclusive and sensitive to regional aspirations. Meanwhile the media and the people have major roles. If we understand what is happening we can refuse to let politicians turn us into puppets, and release our worst feelings, to serve their petty purposes.

Monetary Policy: to surprise or to take into confidence?

Ashima Goyal

Bimal Jalan is vexing news breakers because he is refusing to make news. But they should take heart because he is taking them into confidence. In modern monetary economics there are two schools regarding the conduct of monetary policy. The first argues that since fundamentals determine the real interest rate, only monetary policy surprises can effect output and that also only in the short-run. The second that monetary policy does change the real interest rate over the short- to the medium run, and thus has persistent effects on the real sector. In this case announcing the direction of movement of interest rates, and adjusting nominal rates in small consecutive steps to get there is good monetary policy. This expected direction affects long-term interest rates. As markets factor in this direction of change, these should change more than short-term rates. Thus taking the private sector into confidence will help monetary policy achieve its purpose. The RBI's actions put it in the second school. The Annual Monetary Policy Statement has announced that the regime of soft interest rates and narrowing of spreads is to continue. The warning given of a possible future 50 basis point cut may be able to nudge the longer-term interest rates, that matter for demand, downwards.

The Statement has become a statement of intent and a report card on ongoing structural reforms. It also gives a useful review of national and international macroeconomic trends. These are hopeful, barring more shocks and scams, and the RBI is set to encourage the economy to do better than it has in the recent past. The Governor is hopeful also because he thinks the economy has become more shock proof; it has absorbed repeated shocks in the past few years, continuing to grow at a steady clip. The rate of growth may have been lower than potential but it did not fall into a crisis post-shock, as it was wont to do in the sixties and seventies. Some real interest rates are moving downwards, even so real returns on savings continue to be positive. As more and more households borrow to finance house construction and purchase of consumer durables, the class that saves is also beginning to benefit from lower real interest rates.

In the past year yields on Government securities have fallen by two to three hundred basis points. The bank rate does serve a signaling function, although the RBI now relies more on indirect market operations to manage liquidity. There is concern that loan interest rates have not fallen much. Causes identified for this include NPAs, high overheads and cost of deposits, poor recovery of dues and high government borrowing. A number of measures follow to chip away at these. Banks are encouraged to offer flexible rate deposits at the same time giving customers the option for fixed rate deposits; consumers will have more margins along which to adjust. Banks have to declare their maximum loan rate above the PLR. This, together with other information on rates will be put on the RBI's website, thus raising transparency for borrowers and competitive pressure on banks, giving the market more information, or taking it into confidence.

Banks are also encouraged to be pro-active in managing risk according to the Basel norms. Their large investments in government securities make them vulnerable if interest rate rise. They have been asked to put part of their profits in an investment fluctuation reserve, now when the going is good. Foreign borrowing norms have been eased for banks, which will also bring domestic interest rates closer to foreign. These and other measures should gradually increase flexibility through the entire spectrum of interest rates, and increase integration of financial markets.

There is no analysis, however, of optimum reserve accumulation, or of the opportunity cost of the huge foreign exchange reserves stock built up. Current international research is supporting managed exchange rate regimes compared to the earlier emphasis on floating or currency boards. To that extent the RBI's "middling" regime, is validated. But although the RBI's interventions have successfully quelled excess volatility they have led to a steady accumulation of reserves and trend depreciation of the rupee. This one way movement builds in expectations of depreciation and is one more reason interest rates are sticky, and short-term interest rates have fallen less than long-term. There is a large space and many variants of policy available between the two extremes of fixed and floating exchange rates. More genuine two way movements in exchange rates would develop the forex market and give the RBI more freedom to manage interest rates. The savers lobby, which resists convergence between foreign and Indian real interest rates, does not realise that in a more open economy a gap between the two often signals an expected depreciation which lowers the purchasing power of their rupee.

Traditionally financial markets in India have been regarded as dominated by the speculative element. Reforms are supposed to change that by tightening regulation and changing to modern anonymous market microstructures that displace human capital at least in the distribution of financial products, allowing it to concentrate in the provision of content, where capacity to collude is more limited. Human capital released from repetitive mechanical tasks that automated systems can perform more efficiently, can concentrate on value added activities of financial innovation and analysis. If the RBI is willing to take the market into confidence it is sign that it believes Indian markets have matured as this process moves forward. But the RBI is somewhat inconsistent. It continues to be suspicious of forex traders and will not provide them any expectational anchors. But it has such a high opinion of the government debt market, even with its nexus of Mumbai based brokers, that it is going slow on movement to an anonymous modern system in the trading of government debt. Or does the group composition and interests differ in the two cases?

Incentives: Markets and Beyond

Ashima Goyal

It is sometimes feared that a market driven economy will replace "noble" incentives by monetary ones. Economists' models of utility maximisation, and strategic thinking where competitors aim to outwit each other feed this fear. Perhaps as Burke wrote, "The age of chivalry has gone; that of sophists, economists and calculators has succeeded". But ironically, modern research in economics is making the point that pure self-interested behaviour can make everyone worse off and contributing more potential ways to align individual interests and social interests. Therefore, rather than teaching people to think selfishly, economists are often thinking of workable ways to mitigate the extent and consequences of such behaviour. Even economists misunderstand this point. In an American survey students in the economics department tended to do more of "selfish maximising", compared to others. The Webster dictionary defines a cynic as "one who believes that human conduct is motivaconomists sometimes take this as a self-definition.

Ignoble incentives arise even when markets and economic freedoms are suppressed. In India we know how morals were corrupted in the control regime. Markets left to themselves, however, encourage greed. Reputation and trust, or fear of punishment can contain the consequences of human greed. Which works better? The collapse in East Asia was blamed on their poor regulation and connection based market systems. But Enron, Anderson and now Worldcom have occurred in America's tightly regulated systems. Laws inspire creative means of avoiding them, unless there is internal motivation. Even selfish maximisation must be embedded in a framework of morals. Maximisation is only about the best way to achieve objectives, and there is nothing to prevent those from including others' utility. Strategic behaviour can lead to conflict or coordination failures where everyone is worse off, but it can also lead to cooperation, depending on the structure of interaction. To discover the structures that can bring out the best in people and societies is an active research area. Competition, transparency, and openness are obvious pre-requisites because any kind of power corrupts.

Externalities, where my actions influence you but I do not take this into account in choosing the level of my action; asymmetric information, where information available to market participants differs; and strategic behaviour, where I plan my action taking into account your future response to it, all can result in market inefficiencies. Finally there are coordination failures, where, for a number of reasons, the economy may be trapped in a low-level of performance. But the positive aspect is that potential surplus exists. It is possible for policy intervention to make someone better off without making someone else worse off.

Information imperfections imply that incentive structures have to be much deeper than just monetary, since monitoring cannot be perfect and prices do not convey all the necessary information. A principal has to motivate his agent: the shareholder and banker must motivate the manager, the manager his workers. The voter must motivate the politician, the latter his bureaucrat. Agents retain some rent because their information exceeds that of the principal. Since input is not perfectly observable, the incentive structure must reward performance relative to others and subsidize inputs, without too narrow a targeting of rewards to prevent a substitution away from vital non-observable activities. It must provide insurance or smooth returns, motivate agents to work, yet prevent them from keeping too much rent. Variable rent or returns increases incentives to work, but lowers insurance. It must encourage them to take risks, yet prevent them from taking too much risk. It must not give them too much discretion, which will increase their rent, yet leave enough flexibility for them to adjust to unforeseen circumstances. Examples of market inefficiencies are: insurance premiums are too high because agents undertake risky actions; firms are risk averse and capital is under supplied because capital markets are incomplete; prices do not clear markets in order to provide incentives for individuals to obtain information. But policies and market innovation can reduce the inefficiencies.

Adam Smith's famous invisible hand embedded in a moral framework, works because of competition or the absence of power. A baker alone cannot raise his price, since he is a tiny part of the market. But the reverse of this is the problem of collective action. My contribution is a minor part in the provision of a social good. If I stop it, it does not reduce the provision of the good, but saves me considerable effort. The good is under-supplied because everybody's business is nobody's business. As each free rides on the other everyone is worse off. The problem is aggravated if the polity stimulates conflict among groups. Fighting over the distribution of the cake can prevent it from growing. As it has in India where short-term transfers have harmed long-term growth, and sustainable re-distribution. As groups seek favours for themselves the common good suffers. Moreover, Indian controls, monitoring, and administered prices destroyed public and private incentives to work hard, invest, and produce quality output, while they allowed politicians and bureaucrats to obtain too much rent. They were often well meaning but their indirect effects were not foreseen.

Small changes make bigger ones possible. Deep institutional change, which alters incentives for the whole range of market actors, and their interactions, can trigger a shift to much better outcomes. To some extent, as the cake increases, conflict reduces. But credible mechanisms to increase trust in society are required. One key maybe using surpluses released to increase the return to developing human capabilities. This decreases exclusion in a way that has benefits for all. Markets will then release human potential, not human greed. Thus investments in education and infrastructure, will further strengthen externalities, and establish beneficial cumulative expansions. Such changes will not only be about celebrating strength, but also about equipping the weak and giving them many entry points into expanding opportunities.

Fleeting Bonanza?

Ashima Goyal

Domestic airlines in India have started attractive new travel schemes including major discounts. Air Sahara kicked off the process, to be followed by Jet Airways, which introduced apex fares for 37 sectors on July 5. Steep discounts for advance bookings went up to almost fifty percent. On July 6 Indian Airlines announced similar fare cuts for 41 sectors. These schemes have been welcomed, and price-sensitive Indians have taken to the skies in a big way, but there are lingering suspicions. Will it last? Is there a hidden catch? Perhaps the bonanza is fleeting, and may be discontinued after the slack period, which initiated the discounts. Moreover, it discriminates against business travelers, who cannot book in advance. Travel agents are also unhappy, since their commission per ticket falls with lower ticket prices, and they are doubtful about a sustained increase in total sales.

We will try to refute these points, using some basic microeconomic concepts. Social benefit is the sum of producers' profit and of consumers' benefit in excess of price paid. An industry provides maximum social welfare if it maximizes the difference between the satisfaction that consumers derive from consumption of a good and the cost of providing it. A competitive industry does this, but a monopoly only maximizes profits, while oligopoly falls in between. At the social optimal output, the price the marginal consumer is willing to pay just equals the increment in cost from producing it. A monopolist produces less than the social optimal because in lowering price for the marginal consumer, he has to take a reduction in the price other consumers pay. Therefore any measures that raise total output raise social welfare. Under perfect competition excess profits go to zero, and under perfect price discrimination consumer's surplus is all extracted, but in both cases, the optimal level of output is produced. Perfect price discrimination means that a monopolist can charge each consumer the maximum price she is willing to pay. Therefore his marginal revenue does not fall with additional output and he is able to produce the social optimum. Apex fares allow airlines to do more price discrimination, and therefore increase output and welfare.

Price discrimination is difficult in practice because it is hard to segment markets. A consumer who is eligible for a low price can resell to another not so fortunate. Airlines are well placed in this respect. For example, they can identify frequent fliers and offer them special discounts. This is second-degree price discrimination or discounts based on quantity of purchases. Under this high demand sections retain some consumer surplus, but that of the low demand sections is forced to zero, or this segment is not serviced at all. Apex fares are an example of third degree price discrimination-- by kind of traveler. They bring the low demand segment back into the market, therefore increasing equity and output. For example, airlines can give lower fares to the holidaymaker who can plan his holiday in advance. The businessman cannot do long range planning, so this valuable market segment, accounting for more than 80 percent of ticket sales, is not disturbed. This last minute frequent flier, does, however, continue to accumulate miles. Since travel on apex fares can be barred from inclusion in frequent flier miles double discounts are avoided, while different segments continue to avail of their own set of discounts.

Domestic air travel in India, is not of course, a monopoly. Indian airlines have had to contend with some competition for many years now. But where liberalization and increased competition have lowered prices and benefited consumers in a number of sectors, the price of domestic air travel has been remarkably sticky. One reason is the comfortable cohabitation with Indian Airlines as the price leader. But competition has been gradually intensifying, and improving the quality of service. A destructive price war is unlikely, however, as these airlines have, over time, learnt to live together.

Another way to look at these changes is as marketing innovations that allow consumers new margins of adjustments related to their preferences. The new combinations available raise their welfare. This is the essential dynamism of markets. Thus the frequent flying businessman values pampering and extra comfort and is willing to pay more for it. Weaning the middle class holiday making family from train travel opens new markets segments, giving them the option of faster travel. Those who would rather savour the countryside can continue to travel by train. From the airlines' point of view, they derive network externalities as the networks, of which they are a part, become denser. Penetration pricing that can lock more people into air travel is good strategy for them.

Another service the apex fares will do is help remove the idea that air travel is a luxury good. Aviation fuel is heavily taxed in India, cross subsidizing low diesel prices. High prices keep out the masses and justify the high taxes, in a vicious circle that raises transaction costs and inefficiencies in the economy. In a continental country of India's size air travel is not a luxury. It is a necessity to connect people, places and markets. An explosion in air travel is possible and will raise more taxes for the government at lower tax rates (and commissions for travel agents). But airlines have also been slack. Apex fares could have been introduced a long time ago.

Maybe apex fares are only an experiment, but they represent a move in the right direction. Price discrimination increases airlines' profits. But since this raises output or seat utilization in the short-run and expands the market in the long run, it benefits consumers also. Competition works to reduce profits and deliver even lower prices to consumers. If airlines think harder and remain dynamic they will continue to make money. As long as competition encourages healthy innovation, a price crash will only make the airlines more buoyant.

Fitting Markets to People

Ashima Goyal

Why are one billion people hooked on to cricket, and celebrate wildly when India wins (rarely) a close fought match, filled with sudden reversals? Why do they idolize those who, like Tendulkar, set unusually high standards? Interesting recent research suggests part of the answer might be that unexpected rewards increase the production of feel good chemicals in the brain.

It turns out that we may be biologically wired to make us incapable of being fully rational. Many decisions are made below the level of consciousness in award mechanisms that were wired in to help our animal ancestors survive. An unexpected happening activates these brain circuits, a decision is made and response started, outside conscious awareness. Full consciousness comes into play only later. Neuroscientists have found in experiments that dopamine production is changed in the mid-brain, and learning takes place, only when something unexpected happens. Dopamine neurons increase their firing when an unexpected reward is obtained, and the behaviour that led to the reward is therefore encouraged. Dopamine is the chemical associated with addictive behaviour.

Macroeconomists have long studied irrational exuberance or animal spirits that explain booms and busts in investment, or excess volatility in stock markets. This is partly due to the behavioural features studied above, and partly to a lack of information on fundamentals, and the tendency to copy others. The reward mechanism makes investors discount the probability of a crash, and behave as if a boom will continue indefinitely. If speculators bought when prices are low and sold when they are high their activities would stabilize prices. Instead they follow "stop-loss" strategies buying when others are expected to buy, but stopping at a target profit. This strategy creates bandwagons, a sustained rise and sudden fall in price, and yet makes money. Of course, there are other kinds of market players, hedgers and arbitrageurs who do smooth prices, and many innovations in financial markets are concerned with limiting incentives for speculation. An example is margin requirements. Having to pay a margin to the exchange makes it difficult to continue to buy stocks on borrowed money.

Akerlof, one of this years' Nobel Prize winners, has long worked on building psychology-based foundations for behaviour that explains macroeconomic outcomes. He believes that these kinds of theories will, at long last, provide acceptable microfoundations for macroeconomics.

Just as margin requirements limit returns to behaviour that accelerates booms, stock options in manager's pay packets have the reverse effect. This has been recognised after the Enron and WorldCom failures, and changes such as expensing stock options are meant to moderate these adverse incentives.

If this analysis is accepted, general conclusions follow for the conduct of macroeconomic policy. The reward mechanism can be used to encourage activity, but it has to be prevented from causing sharp booms and slumps. Thus smoothing is required to ensure moderate sustainable booms. Stabilisation policy should neutralize sectoral shocks, so that a slowdown, if it is necessary, is gradual; a sharp slump is avoided.

Indian macroeconomic policy unfortunately has not always followed these principles. India has often suffered from sectoral shocks, whether agricultural drought or oil shocks, but the response has been to cut aggregate demand, or even if populist consumption expenditure is maintained, investment is cut. The latter prolongs the slump beyond the period of the shock and aggravates it. This policy is followed even when there are surpluses in the system, like the current huge stocks of foodgrains and foreign exchange that can be used to absorb the adverse sectoral shock, and prevent it from having a persistent effect on investment and growth. Stabilisation is misunderstood to imply aggregate austerity, because it was first used in Latin American countries, which had huge rates of aggregate excess demand and inflation. But in India it should be understood only to require a reduction in Government's revenue deficit, while stimulating both private investment and public investment in infrastructure and human capital formation.

Research on a group of young women at Emory University in Atlanta, found that these reward mechanisms are also triggered off by unselfish cooperative behaviour, and the rewards were higher the longer cooperation was sustained--the brain may be wired to cooperate. This suggests a possible solution to a long-standing puzzle --participants choose the cooperative strategy more often than is rational in experimental Prisoner's Dilemma games, where an individual gets the most if she alone defects. But since the other also defects they end up getting the least. So the payoff to mutual cooperation is the highest in equilibrium, but getting there depends on the other's response and therefore requires trust.

Again, Indian policy, unfortunately, damaged this intrinsic desire to cooperate. A system of controls and discretionary power created dependency where one group tried to outsmart the other for a share of government largesse, although this reduced the total available. Corruption spread and mistrust grew. There is the well-known story that a basket of Indian crabs does not require a lid. If anyone is in a position to escape others will pull it down. The much better alternative is a system where people are empowered to work hard, cooperate, and share rewards as the total available grows.

There is a long list of second-generation reforms that is circulated, but many of these address only symptoms of the malaise. The root cause is people's motivations and when these change the symptoms disappear. Labor laws, for example, are very much there on the list. But with increased competition and changing perceptions labor has lost much of its power even without a formal revision of exit laws. Most industrialists would agree that it is much easier to retrench labor and get productivity from them today. That law has become toothless, like many others. Indeed, continually emphasizing it on that list probably makes it appear bigger than it is and lowers entry by outsiders such as foreign firms.

Social Innovation and the Firm

Ashima Goyal

Corporate social responsibility is very much in the news. The Birla group has been recognised recently for their sustained contributions in this area. And they are not alone in such activities. Many corporates are adopting villages, sponsoring education and training, improving the environment and infrastructure.

Why is this happening? Is it charity or does it directly or indirectly benefit the firm? Such activities contribute to social capital, a higher stock of which raises a firm's productivity. But a firm might be willing to free ride on others' contribution to social capital. But if everyone thinks like that social capital will be under-supplied, and everyone will be worse off. This is an example of a collective action failure and the Prisoner's Dilemma, which destroys potential. It is often said that Indians do not work well with and for others, but the growing corporate social responsibility suggests otherwise, and therefore needs to be explored more deeply. Past failures may have been due to past structure and stagnation.

A longer-term perspective, with more weight for the future, can resolve a collective action failure. So can rising personal rewards to social responsibility. A final factor is more losses for those who do not contribute. All three are at work in the Indian situation, but the first two dominate.

First, as the Government retreats from the commanding heights, civil society and corporates are slowly coming in to fill the leadership vacuum created, and seeing a future that they help to make. As business is given more respect it is willing to take up more responsibility. There is a sense that only social progress will guarantee sustained personal progress. Moreover, as brands and reputation become important, companies are developing a longer-term perspective. Worldwide firms have often contributed to local communities; this improves labour relations, and expands their customer base. Over time, it improves the quality of the resources they can draw upon, and therefore contributes directly to their competitive edge. Sharing management practices with the community, helps them improve local efficiency, and spread better standards. They gain directly also since alliances with NGOs and community institutions, expands the resources they can command to meet their own targets. It is not possible to continue long as an island of quality in polluted surroundings. IT companies, for example, know that the spread of high quality education is essential to fulfil their future manpower needs, and they are willing to contribute to ensuring it. A recent survey found Indian IT companies at the top in social responsibility charts.

Second, the green movement has made consumers more conscious of what firms do to the environment. In developed countries more than half the consumers avoid the products of companies that are not socially responsible. Professionals are more willing to work for companies that contribute to the community, and are happier and more productive in such companies. A possible explanation for such effects is provided by neuro-biological research that suggests the brain may be wired for unselfish cooperative behaviour, since such behaviour generates a "feel good" factor. Research also indicates that market capitalization is higher for such firms, suggesting that even shareholders reward such activities. All these features increase direct rewards for a social conscience. Missing out on these rewards is an indirect punishment for the lack of one.

As such social processes set in firms would be of two types, with only a minority contributing. But expenditures on the community or on maintaining the environment serve as a signalling device and qualify this minority for the rewards outlined above. Such rewards for cooperation change the structure of the interaction from a Prisoner's Dilemma type to a simpler coordination failure where there are two possible equilibria, one with more and the other with less social capital. Since social capital increases with the number of contributing firms, as more firms undertake such activities the rewards to these activities rise. There could be a critical mass beyond which the majority become socially responsible.

Such arguments apply with equal force to foreign firms, especially as Foreign Direct Investment (FDI) becomes important, and new firms enter. Developing countries are keen to attract FDI.

Government restrictions are being eased and incentives offered. China welcomed FDI without hesitation as necessary for modernisation. And its success is partly due to this stance. But domestic consumers, employees, and shareholders would reward an entering firm if it demonstrated social responsibility. Profits would rise with the welcome. Expenditure on the local community would also signal a long-term perspective, which is of value to host countries. There are suspicions about the motivations of foreign firms, a fear that they lack commitment, that they may be here to exploit resources and poor environmental standards. Social responsibility would allay these fears.

Expenditure on the local community is of course not a substitute for corporate ethics and a high standard of corporate governance. Enron, for example, invested Rs 600 crores in community relations and turnkey work in Dabhol, building a hospital, widening roads and planting fruit trees. After the initial phase of local agitation it had won favour with the villagers. But such handouts cannot fool people for long when they cover illegal activities.

In order to prevent any misuse accounts for such activities must be transparent, fully audited and reported in the balance sheet. This will also aid public awareness of such activities. So will active association with community associations. The latter can serve as intermediaries and help a firm leverage its assets and identify business opportunities. Then social responsibility turns into social innovation. The Ford Foundation has catalogued many case studies where partnership with low-income communities has moved beyond philanthropy to yield mutually profitable new businesses. For example, an American retail chain helped in the celebration of local festivals and expanded its sales. The OECD has also issued guidelines for social responsibility. There is great scope for India and Indian businesses in this new direction.

Comments as an expert in the debate on monetary policy

Ashima Goyal

As financial markets deepen and modernize, the economy becomes more open and the RBI more independent, credit policy's role expands. The ability to fine tune interest rates, using indirect means rises, and so does their impact on the economy. An example of the latter is household construction activity's response to lower rates. Only monetary policy can make the quick responses that are often required to external and internal developments. Delays limit fiscal policy, and large debt and deficits reduce the flexibility of government expenditure. Real rates become more stable and variation in nominal rates falls in deeper markets.

There are a number of elements, however, which moderate monetary policy's impact in India. But each of them also defines monetary policy's special role and future direction. First, better coordination with fiscal policy is required to achieve genuine countercyclical macropolicy. Growth has been below potential under a series of temporary shocks, since 1995. The huge stocks of food and foreign exchange indicate that demand is the constraint. The latter is the arena of macropolicy, but it has not responded adequately. Second, policy has yet to fully adapt to its role in an open economy. Fiscal deficits are blamed for the absence of stimulatory macro policy, but if there was excess demand it should spillover into a large current account deficit. This has not happened. Foreign inflows should lead to a rise in non-tradable goods prices, but inflation has been falling. This should make us think.

Third, dualism between the modern and the traditional sectors persists. The large rural population is still poorly integrated with modern India, and this limits the reach of credit policy. It continues to be necessary to design special institutions for these areas, that harness local initiatives, and work with markets. Fourth, efforts to improve non-discretionary prudential and self-regulation of institutions and markets need to be more vigorous. These would increase the profitability of arbitrage or stabilizing speculation compared to market manipulation and noise trading. Information technology can be more fully used to this effect. Authorities have always been afraid of speculation in India; these measures will allow them to trust markets more and set them free. Fifth, although NPAs arising from a history of priority lending, soft budgets, and poor governance have been reduced, the spread between deposit and lending rates continues to be high. The fall in deposit rates exceeds that in lending rates in most banks, and limits the flexibility of the interest rate structure. As banks find it easier to recover dues, they must give cheaper credit. Remaining administered rates need to be flexibly linked to market determined Treasury bill rates. Developing a variety of savings instruments is a priority; the government could then move away from the assured return schemes that are partly responsible for UTI's hemorrhaging. Governments are better positioned to absorb risk; therefore such schemes had a place in encouraging savings in a thin administered financial sector. But in deeper markets, consumers can choose from a spectrum of low return-low risk to high return-high risk assets. Sixth, the RBI has too many functions. There is a conflict of interest since it has to worry about the effect of monetary policy on the health of banks and on the cost of government borrowing. Some institutional redesign would help.

Policy formulation is cautiously following de-regulation of the financial sector. Consider the forex market. The exchange rate was officially supposed to be market determined from 1993, but the markets were almost non-existent. The RBI kept absorbing foreign inflows and the nominal exchange rate was ramrod stiff until 1995, after which the RBI kept plunging in to suppress volatile responses in immature markets. Apart from the fear of crises, in the absence of hedging avenues losses to merchandise trade from exchange rate volatility were too high. The Sodhani committee (1995) recommendations to deepen markets began to be gradually implemented. Forex derivative contracts have recently been introduced, markets are now playing a more genuine role in nominal exchange rate determination, and may even be able to stomach some limited two way movement in nominal rates. Similarly, banks have to learn to cover interest rate risk, and savers accept varying returns before interest rates can be truly flexible.

Although liquidity adjustments should be more frequent, the biannual statements continue to be useful as statements of intent, and to give a report card on structural changes implemented. Comparing forecasts with actuals is a valuable discipline. Markets are calmer when policy is more transparent. As central banks through the world work more with markets, they want to surprise them less. The Bank of England, for example, brings out a detailed and comprehensive monetary policy report.

A Decade of Diversity and Shocks

Ashima Goyal

The economy is again poised for an upswing but there are contrary signals. We have been disappointed so often in the past few years. It is necessary to understand the medium-term trend as well as the short-term prospects, in order to escape these swings, and settle into a trend higher rate of growth.

"Diversity plus shocks" is a useful framework for interpreting India's performance. The hypothesis is that increasing diversity has helped us grow despite repeated shocks over 1995-2002. But better policy could have moderated the shocks. Eclectic factual support is drawn from tables in various chapters of NCAER's recent mid year review of the economy that surveys India's mid-term performance and short-term prospects.

Growth forecasts for the current year are around 5 %, although agriculture is in the doldrums. A revival in industry and services based on other sources of demand is expected to compensate. Examples are exports, FDI, and government infrastructure expenditure, which have shown healthy growth recently. Thus one sector covers for shocks affecting another, openness and the size of the country both increase its diversity. Openness can be a source of shocks itself, but it is also a source of diversity.

Why are exports rising although the global slowdown is not fully reversed? Firms have been restructuring, raising firm level efficiency and competitiveness, turning to global markets when domestic demand was insufficient. This is especially evident in the sunrise sectors, but is, to some extent true more generally. Fixed assets have been maintained, and the share of exports/imports has been increasing. These trends suggest a counter to the view that Indian manufacturing is dying. Recently, the production and import of capital goods has also perked up, a sign that the excess capacity built in the mid 90s maybe on its way to being absorbed.

Agricultural exports have not done as well as expected and fluctuations have occurred, but fruits and vegetables exports seemhese have good employment potential. Private investment has been rising in the nineties, after a shortfall in the eighties. Again last year's good performance counters those who saw structural problems, and doubted that if, unless these were removed, agriculture would grow rapidly again. This is not to deny that major reforms are required in agriculture.

Services have consistently done well. But there is a view that the boom in services is temporary, due to the pay commission bonanza. An interesting table in the mid-year review shows that banking and financial services is the part of services whose share has increased the most comparing the 80s to the 90s. The share of public administration remains the same. Therefore there are long term changes in services. NPAs have fallen, and government securities interest rates are now low enough that there is a possibility of their turning up marginally, so banks should start looking at other assets, and be willing to take more risk. Spreads should come down and banks meet the complaint that they have been neglecting the credit needs of small firms. In the first quarter this year, growth in banks' credit to the commercial sector is higher than last year, and exceeds that to the government.

Public finance is a worrying area, but falling interest rates have been lowering the debt burden. Interest rates have been low and liquidity high despite high public sector borrowing, so the latter is not a constraint on growth, and high growth is one of the best ways to lower the debt burden.

In an open economy, a fiscal deficit should spread to a current account deficit but it has not, why? Even if the government is pre-empting private saving, since it spends more on non-tradables, this and foreign inflows, should raise non-tradable prices, but inflation has been falling. Broad money growth has been flat in the nineties while food prices have been falling, and industrial productivity rising. Therefore supply side factors are more responsible for the fall in inflation, and it would have occurred even with somewhat higher growth.

The post mid 90s temporary shocks included floods, droughts, wars, terrorism, earthquakes, sanctions, financial crises and scams. But the economy absorbed them without going into a slump. There have been some hopeful developments in every sector. It is a sign of a mature economy that asymmetric or sectoral shocks do not have aggregate effects. We are still not fully mature and therefore the shocks were able to lower growth rates below potential. Countercyclical macro policy can be used to neutralize temporary shocks, but it has not really been practiced in India. The fall in public and fluctuations in private I are one factor that have prevented us from reaching our full growth potential. Business has been waiting for stability in order to begin investing, and the government could have done more to provide it. Even so, business may be beginning to believe in stability, after waiting so long been for a sustained disaster that did not come. The stable softening interest rate regime has helped. Lower interest rates have encouraged housing construction, and road building has stimulated industry.

A lesson should be taken from the experience of foreign exchange reserves accumulation in the late 70s.That was used to boost public investment. But subsidies and government consumption were also expanding. The latter are the basis of today's deficit. A more nuanced view is possible today. A reduction in subsidies, and structural reform oriented towards improvement of governance and of human and physical capacities, should accompany an expansion in public infrastructural investment and an encouragement of private investment. Then sectoral surpluses could be freely used to relieve bottlenecks. As long as we remain below potential growth, using reserves will not require an appreciation of the exchange rate that could harm exports.

It is not true that higher growth cannot occur unless deep reforms take place. Macropolicies can stimulate growth, make it easier to reform, and the latter can reinforce growth, allowing it to reach potential.

Tax Exemptions and Savings

Ashima Goyal

Savings are in the news again since the Kelkar committee has recommended that tax exemptions for savings should be withdrawn. With interest rates steadily coming down over the past few years, stock markets in the doldrums, and old favourites like UTI in trouble, savers seem to be facing continual set backs.

Theory tells us that aggregate savings are not very sensitive to interest rates and the Indian experience has corroborated that expectation. The ratio of gross domestic savings to gross domestic product has risen to 23.4 from a low of 21.7 in 1998-99. It is nearing its average value over 1994-95 to 1997-98 of 24.1, and is much above the eighties average of 19.4. The household sector has exceeded its mid-nineties average of 7.9. It reached 9.9, up from a low of 8.4 in 1998-99. Nominal interest rates have been falling in the latter half of the nineties, although since inflation also fell, the fall in real interest rates was lower. The recovery in household savings is all the more remarkable because in India the distinction between real and nominal interest rates is not clearly understood, and the perception of the fall in returns to savings is greater than the reality. The rising ratio reflects rising per capita incomes and higher growth. More of sudden jumps in income are saved. Indian savings ratios tend to reach a temporary peak with a jump in foreign inflows and are then smoothed, but at a higher level.

Theory also tells us that economic agents are quick to respond to opportunities for arbitrage. Indian savers are no exception. The table shows how household financial savings have responded to differential returns. Although the share of deposits has revived after a dip, shares and debentures continue to shrink. Government small savings, provident funds, and insurance have attracted more savings because of both administered higher interest rates and tax shelters. As these interest rates were also lowered the share of the other two categories fell marginally but insurance continued to rise. Since government provision of social security is becoming more and more inadequate, and a variety of schemes are becoming available, savers are beginning to turn to these. The share of mutual funds and government securities although still low, at between 1-2 percent each, is rising.

Source: RBI Annual Report 2001-02

In any savings portfolio if the relative returns to any one component rise dramatically it will be flooded. Returns have to be aligned, and markets left to themselves achieve this. In a modern financial system it is not possible to continue with fixed interest rates for some components. How much have tax exemptions contributed? Tax laws have always induced innovative evasion. They have been compared to the grain of sand in an oyster that have yielded pearls in the shape of financial derivatives and other innovations. The average tax-paying household in India, in making its savings decisions, will first fill up the PPF and other quotas qualifying for exemptions, then look for the highest (risk free) interest rates available, and so on. Tax exemptions, in themselves, cannot lead to flooding because they are available only within limits per household.

Theory indicates that while savings are interest inelastic, savers are sensitive to risk and to transaction costs in saving. As long as the real interest rate is positive savers care more about risk. The sharp fall in household investment in shares obvious in the table reflects a high-risk perception due to the series of scams and the rapidly changing industrial scenario. In Asian countries high growth and government institutions that lowered transaction costs explain the high savings rates. It was only in the 80s, after the high growth period had started, that Chinese savings ratios reached the mid-thirties. Although there were fluctuations in inflation the government ensured small positive real rates of return on bank deposits, thus lowering risk. Government postal savings accounts mobilized large savings in Japan. Provision of tax shelters for savings helps to explain the relatively higher Canadian savings rate compared to neighbouring US. Moreover, tax breaks for housing mortgages decreased savings in the US. India certainly cannot let the real interest rate on savings become negative as in the US.

Economic theory does give a rationale for tax-incentives when the social contribution of any activities is greater than its private returns. To reach its potential growth India needs more of both savings and investment.

Removing tax exemptions is less important from the point of view of aligning returns on savings schemes, so at a time when the latter is being gradually accomplished, it is not sensible political economy to attract fire by touching the tax exemptions. The improvement in the government budget from a gradual lowering of nominal interest rates, in many government savings schemes, so as to give small positive real interest rates, will be higher than that from doing away with tax breaks to savings. Giving individuals higher returns on a small part of their savings, to encourage social security, when a full range of savings instruments is not available, has some justification. More low risk avenues need to be developed for savings, before removing existing ones.

There is a rationale for low tax rates and minimal exemptions. But where the salaried classes bear the brunt of taxes, fairness requires care in targeting them yet again. Although the proposed reforms are tax neutral for the government, the lower income brackets, who are eligible to pay tax and who fully use their savings tax concessions, will end up paying somewhat more tax, and their savings will be discouraged.

Of course tax concessions must be well designed. Those susceptible to misuse by non-targeted sections need to be removed. If a clutch of overlapping measures to encourage housing, distorts resource allocation, or favors a particular type of financing, the measures should be simplified. But protecting pensioners and encouraging women to work serves has externalities for society.

Gender for Governance

Ashima Goyal

There is concern about poor governance and corruption in India. Giving women more rights and more equal participation in public life can help to improve both. Recent research suggests that women tend to have values that enhance governance. A higher proportion of women compared to men believes that corrupt actions can never be justified. Women in business are less likely to pay bribes. The reason may be that they are risk-averse or that they are more ethical. They are more likely to be altruistic, and community-oriented. Time magazine gave its person of the year award to three Americans who blew the whistle on corruption last year--and they were all women. Where women's influence in public life is higher corruption is lower. But unequal rights and low socioeconomic status limit women's ability to influence decisions in their communities. They are under-represented in national and local assemblies.

Altruistic behaviour can have an evolutionary advantage. A person known to give up self-interest gets opportunities that a pure rationalist does not, even though he gains less than the latter would in each exchange. The rationalist tends to be excluded from potential profitable interactions.

If inputs from women are useful to society, then why have women been systematically excluded from positions of decision-making and power? Although complex trends are involved, as modernization began the gap between men and women increased, since productivity and the opportunity to acquire skills rose much faster in work outside the home. In largely agrarian economies women used to work equally in the fields. But with development, opportunities expanded for men more than for women. As male relative power and position increased the moderating voice of women in governance was lost. Electricity and labour saving gadgets have saved women's time. Together with the more recent information and communication technology revolution (ICT) they have the potential to increase flexibility in training and work, and to compensate for women's lower mobility. ITES facilitates distance and part-time working. ICT makes it more feasible to maintain training and develop new skills, awareness and interests, so that time can be more productively utilized, some of it in community work.

But since asymmetric power or perceptions of inequality are deeply ingrained, change requires supportive policy. The distortions lead to a deep ambivalence even in the perception of women's relation with technology. Either they are thought to be technologically inept, and the adoption of technology that would help them is delayed, or new technology and home-working is regarded as one more way of exploiting them.

Since many skilled women are underemployed, they have the time and inclination to contribute to society. Jagdish Bhagwati recently quipped that the explosion in NGOs is due to the spread of women's education since women would rather do good than do well. Citizen groups and NGOs, many of them dominated by women, have been active in enforcing civic rights and improving urban infrastructure. Some panchayats with women leaders have worked wonders. But women can do much more. One of the reasons for the success of the feminist movement was its decentralised structure. Women enjoy doing things together, and their activism was a by-product of local group activities. In India every housing society has a women's club. If each of these undertakes some civic responsibility, the potential for contributing to governance is enormous.

If such clubs publicize the failures of politicians and monitor policies that impinge on the locality, it will increase the accountability of politicians and change their incentives towards ensuring delivery. Stronger rights to information make this more feasible. The Philippines has had remarkable successes with this type of monitoring. It requires setting up a few prototype structures, and then widely communicating their methods and successes. Such activities will also expand women's horizons, and mature them for a greater role in society. Women tend to have a narrow vision and interests, but this is partly because of their restriction to family life. Their empathy would shift to larger areas of interaction as civic institutions are strengthened and make more room for women.

Civic society has become more active. Efforts by women's groups would complement those of NGOs, business, and other consumer associations. But for such programs to have a chance gender sensitization is essential. Differences in the way men and women work and speak must be recognized and allowed for, conscious efforts made to boost women's confidence, and the biases that slip into speech and activity and reinforce stereotypes eliminated.

Last month we also had a celebration of women CEOs. In management women are said to have a more cooperative rather than competitive style of working, to be good listeners and motivators, and the value of this, especially in large networked teams is beginning to be recognized. The word "coopetition" has been coined to capture the desirable mix of cooperation required together with competition in modern firms.

It is not that women have a monopoly of the soft qualities of trust and cooperation that constitute "social capital", but that gender stereotyping has harmed men by depriving them of some of these qualities. Indeed, as women seek emancipation by imitating aggressive men, they are depriving themselves of these qualities, and as a result often undergo severe stress.

The issue is urgent because the low valuation on such qualities is literally killing women. In the Indian State of Punjab the traditional male qualities are admired. Most families want sons. Today sex selection techniques are available. The 2001 Census shows an alarming fall in the female to male sex ratio in the 0-6 age group. It has decreased from 875 females per 1000 males in 1991 to 793 in 2001. The all India average is 933. Such trends will cause acute social problems in the future. Development alone is not the answer because sex-selection tendencies are more among the better of. Only if softer values come to be respected, and women are given power and responsibility, can girl children be saved.

Winds of Change in Indian Education

Ashima Goyal

The US-based physicist Richard Feynman told an interesting story about education in developing nations, which was his explanation for why creative scientists are rare in such countries. He was taking a class on the subject of refraction in a Latin American city. According to him the students understood the subject and were comfortable answering questions about the theory of refraction. Yet when he asked them why the sea, visible from the class window, was blue no one could answer.

I teach economics to Ph D-level students. In the teaching of economics we often debate the value of abstract analysis and principles versus facts and live issues. One argument is that issues are endless, and if a student has a good grasp of the principles of economics he/she will have the skill sets to analyse the variety of future problems with which she will be confronted. The counter argument is that she must first be aware of what is happening in the economy and the world to be able to apply the principles of this subject to important issues. In this debate between the primacy of theory and data a vital middle area, that of applying principles to understand the world, is ignored. It is this students need to practice.

India's much-criticised education systems encourage students to work hard, memorise and think along rigid preset lines. But we must be doing something right. Software tycoon Bill Gates recently endorsed the Indian education system. He pointed out that it produces computer savvy people. Students coming out of Indian schools characterised by intense competition, discipline, and emphasis on high grades tend to be better at applying mathematical principles than the average American student. However it's undeniable that students shaped by this system are uncomfortable with out of the box thinking and classes requiring active participation.

After reading about techniques that stimulate learning in classrooms I once experimented with a system of five-minute slips. Each day, after class, students had to write down one new thing they had learnt, and to pose an unanswered question on a slip of paper. These slips were discussed in the next class. There was widespread resistance to being forced to think; to having their "relax and take lecture notes time reduced"! And since everyone had to do it, the unease was aggravated.

Within India's education systems --- primary, secondary and tertiary --- as shaped since independence, discipline, and a thorough grounding in principles is required. But it needs to be combined with flexibility. This objective can be realised by reducing the tools and facts students must master and by teaching them how to pose questions, and how and where to search for answers. Although there is a knowledge explosion today, the facilities to search for information and knowledge have also greatly improved. Intelligence, which education must discipline, is the ability to focus and pose the right questions.

A welcome development is that a multiplying number of corporates are entering education. This is a beneficial development because it will ensure greater attention to the teaching of applications. The assumption of this social responsibility is in their own interest since educated people and ideas are raw material for the corporates. However in the crystallising knowledge economy, corporates need to be aware of the growing importance of basic research.

Fundamental questions, with no immediate profitable application, also have to be asked in research. Over a period of time, however, the spin-offs from such basic research will impact corporate balance sheets. Moreover, since externalities are involved, there is a role for government funding of such research, with strong and objective peer monitoring. Society needs to understand that just as judges must be independent, it is important for researchers to be independent, and have some security of tenure. This allows them to ask fundamental questions, not driven by anyone's need or greed. In applied or policy oriented work it allows advice to be in the common interest, as against advocacy for some special interest group. Lower salaries can accompany the security of tenure, with the freedom to spend some time on short-term contracts and projects, which are more remunerative. Flexibility is required for teachers also!

Another major benefit of corporate involvement in research will be a rise in resources available to this sector. Though government seems to be unaware of this, improvement in education is closely related to the resources devoted to the cause. Today India is benefiting from resources earlier devoted to higher education while simultaneously suffering from the low level of input into primary education. Even so, there are few countries, at our level of per capita income, where people have such a variety and diversity of skills. Improved education infrastructure and improved job prospects after education will attract more students into the education system, improve literacy levels, and reduce child labour. Running educational establishments on more rational and/or commercial principles will also improve resources and infrastructure. It will give students the right to demand better standards, and force them to make more responsible use of the education they get.

Greater investment in education --- which will improve self-confidence --- combined with more openness --- allowing winds from different lands blow freely --- will remove the tendency to blindly imitate the West. It is the Indian tradition to take the best from all over the world, while valuing our own culture. This will happen more as our prosperity increases and we can be proud of what we are and have. As an example, consider how the global concern for the environment, has percolated down to the nation's schoolchildren. Students in Delhi have been instrumental in changing the way we celebrate Diwali, making it a safer and more environmentally friendly festival. Education and ideas have great power.

I have touched upon many issues in this short piece: from teaching in schools to teaching for research, and have tried to understand the winds of change blowing in this sector, linking them to our past and to our potential future. It is a liberty I take, having been in education for many years and having thought over these issues often.

(Ashima Goyal is a economics professor at the Indira Gandhi Institute of Development Research, Mumbai)

Measuring Government Deficits

Ashima Goyal

The deficit is regarded as a key snapshot of the government's fiscal health, and for markets around the world India's rating is going to rise or fall in inverse ratio to the fiscal deficit. If the government is able to meet, or exceed, the target markets will welcome it as a sign of a government in control.

But the irony is that a deficit can be meaningless because of the acute definitional and measurement problems. Of course one check on this is consistency of concepts and practices; another is an educated public. Third, figures reported must have an economic rationale, and those emphasized must reflect the government's objective. Key economic distinctions are between deficit figures that capture, first, current policy initiatives as against the effect of the past or of luck. Second, flows that affect aggregate demand. Third, below the line features such as the government's borrowing requirement, liabilities, or repayment burden. Fourth, changes in the balance sheet, or the government's net worth.

How does our fiscal deficit fare against these criteria? It indicates the financing requirements and addition to government debt, and should be emphasized only if the main objective is sustainability of government's finances. But even here it has flaws since it does not adequately reflect the effect of current policy measures on sustainability. It is often said that a high deficit causes high interest rates, but this depends on how it is financed. To the extent monetary financing raises growth and lowers interest rates it lowers the burden of debt. Higher growth and lower interest rates are effective ways of reducing public debt. The fall in Indian interest rates has reduced interest payments on debt, and will show up in the fiscal deficit. Residual rigidities in interest rates are due more to features of the financial system and the exchange rate policy followed.

The revival in industry and in imports, which is boosting tax collection, will also help achieve the fiscal deficit target. The success of the new road schemes demonstrates that lower interest rates and rising government spending on infrastructure can stimulate the economy. There are those who would downplay these trends, since they believe only deteriorating finances can force the government to reform. They are keen to convince the government that it is in dire straits, or that it is the beneficiary of good luck rather than good policy; and good luck can reverse. But private investment has become much more volatile after the reforms so it is important for public investment in social and physical infrastructure to remain at high steady levels. A government convinced of its inability to borrow will hesitate to ensure this. The share of public investment in GDP has revived only marginally from its lowest point reached in 1997-98.

The finance capital lobby keeps pointing out the measurement omissions that, if removed, would increase the size of the deficit. Examples are state deficits and government guarantees. But the states do not have sovereign rights and therefore their deficit does not have the same impact as the Central Government's does. Similarly, there is only a probability that guarantees will be exercised, and especially in a developing country there are other possible future changes such as higher growth or successful tax reform, that could increase the net worth of the government. Adjusting the deficit for inflation, or correcting for a cyclical slowdown would lower the deficit. The primary revenue deficit measures the current demand injections and should be allowed to widen in a slowdown. Interest repayments are transfers that have little effect on demand. It is also possible to remove the effect of trend changes and calculate the core deficit; thus separating the effect of luck from that of policy. Another piece of good luck coming for the government is the revaluation of the foreign exchange reserves because of the rupee appreciation. This should boost RBI profits and the Government's coffers. The finance ministry should report on all these aspects.

Even so, the revenue deficit and wasteful expenditure have to be cut, perhaps using constitutional binds such as the fiscal responsibility act. It is also essential to look into the incentive aspects of government spending decisions and accounting systems. Government guarantees should be avoided not so much because they could add to future expenditure, but mainly because they encourage more risky and opportunistic behaviour from those who receive such guarantees. Government budgeting systems have been unchanged since 1974. It is essential to change from plan based incremental budgeting to project or output based accounts and management information systems. The latter give clear low level accountability, continuous feedback for decision making, and create incentives for the efficient delivery of output. The responsibility for starting such a system is squarely with the ministry of finance and the budget should be used to initiate some changes in this direction.

This finance minister is politically savvy, and is widely expected to give a people friendly budget. How can he do this yet keep deficits low and increase productive spending? The way is to focus massively on administrative simplifications, to use new technology to put in modern systems such as the tax information network (TIN). As waste falls, funds will be released. Exemptions should be removed but gradually. Those encouraging wasteful tax arbitrage should be the first to go. Eventually, only those that yield major externalities should be retained. The debate on the Kelkar proposal has clarified the begun rewarding this government for small signs of good governance; the finance ministry must make a big push to deliver more. If the public becomes more forward looking, recognises, and rewards thorough going tax-expenditure reforms, this can work as a strong political compulsion on the Government to deliver reform even as its budgetary situation improves, thus silencing critics. Better measurement will help it do both.

Participatory Budgeting

Ashima Goyal

Three key words that describe this budget are growth, goodies, and governance. Initiatives towards better governance redeem it both from populism and from what could otherwise have been a risky gamble on growth. Principles that combine well to push the economy in the right directions underlie many of the choices made in the budget.

Consider the sectoral boosts. The excise tax cuts have made industry happy, and partly because of these cuts, there has been little complaint from industry about the reduction in peak customs duty to 25 per cent. Thus the government has lowered tariff barriers in line with its WTO commitments, and yet avoided protest from domestic protectionist lobbies!

The move will lower input costs and improve competition in industry. Further simplifications should be possible in the future.

The marginal rise in fertilizer price has generated the maximum protest since it takes on the powerful farm lobby. But it seeks to correct the distortions in fertilizer use that is causing nutrient imbalance in the soil, and by provoking public debate, make clearer the resource misallocation and waste that accompany price based subsidisation.

Another unpopular subsidy reduction is the cut of one per cent in small savings interest rates. Here dissent has been muted, perhaps because public debate has made clearer the distinction between real and nominal rates, of the necessity of market determined rates aligned to world rates, in a more open economy, and of the incongruity of a few administered rates in a flexible rate regime. But there are a group of people adversely and even unfairly affected by the changes; these are the vulnerable group of pensioners who locked in their lifetime savings based on assured nominal rates. But the measures announced under lifetime concerns would reduce some of their difficulties. There are new initiatives on pensions, healthcare and other concerns of senior citizens. Although the antodaya anna yojana adds to the food subsidy, in a drought year the poor need consumption support, and it would reduce the financial burden of our excess foodgrain stocks.

These measures attempt to develop a social welfare net, in more economically sensible ways, than the earlier price subsidisation. They are pre-conditions for moving from a subsidy to an enabling culture. In this budget, many groups will find that their gains equal losses, but there is a net gain, a movement towards better governance and incentives. Sometimes, for lobby groups, the problem is not so much what they get, but that others gets more. Each such group should be asked to show that concession given to it would benefit others also. Although major exemptions have not been withdrawn, the measures under life time concerns are part of the preparations to make this possible eventually. Reforms announced in tax administration, will release efficiency gains, decrease discretion, corruption, and bureaucratic hassles.

The initiatives under infrastructure are welcome, but their success depends on viable private public partnerships having been already put in place. In this context the picture in the Table is alarming--last year also the Central Plan relied on extra budgetary resources, which did not materialize, but this year the ministry goes ahead and pins its faith on these! As usual, there were shortfalls in forecasted capital expenditures last year. Therefore expenditure reform is as vital as tax reform. Transparency and achieving forecasts are the first step for being able, in time, to meet fiscal responsibility requirements. But even more important are systems and mechanisms that make it possible for the Government to deliver. Among these is improved accounting not only to give more information to the public, but also to make better more timely information available to government departments themselves. In this context the proposed cash limits are welcome, but much more needs to be done. Better budgetary procedures could restrain budget creep.

Rate of Growth	Budgeted 2002-2003	Revised 2002-2003	Hoped for 2003-2004
Central Plan Outlay	12.7	7.05	8.06
- Budget support	10.94	13.2	5.8
- Extra Budgetary Resources	14.2	1.58	10.33
Nominal Income	9.5	5.5	11.3
Calculated from Union Budget 2003-2004

Even so, this is the right time to give the economy a fiscal impetus. Industry is showing signs of revival, after many years, during which the economy suffered repeated shocks. Most countries accept a countercyclical movement in their deficits. Tax revenues fall in a recession and expenditures are raised to boost demand. It is not surprising that 6 years of sub normal growth have coincided with fiscal deterioration. There was an agricultural shock this year, and further external shocks are expected, but a fiscal boost may help avoid the traditional industrial slowdown that follows an agricultural slump. In India, however, much of the revenue deficit goes in transfers, which have a limited effect on demand. Replacing transfers by spending on infrastructure would be a better way to boost demand. Therefore while the fiscal deficit should move countercyclically, a primary revenue surplus, and a real interest rate on debt lower than the growth rate is the path to a sustainable public debt. The budget does propose to use falling interest rates to creatively reduce the cost of loans for State governments and improve the balance sheet of banks.

Banks have been given some help, but are also being nudged towards improving credit delivery and at lower loan rates. The reduction in small savings rates gives them the opportunity to attract more household deposits, but they need to be innovative both in offering new savings avenues and in giving credit. Banks could consider giving credit to domestic entrepreneurs who have assured demand created from the private public partnerships and outsourcing in the infrastructure projects announced. They would have to cover only performance risk. Such action would help make that Rs. 60,000 crores target achievable.

The day after the budget India chased and won a daunting total of 273 runs against Pakistan in the World Cup. Innate skills were able to overcome self- and collective doubt. The huge support for the team had dissolved into the usual criticism. Better governance is the key that can release our innate skills, silence criticism, and overcome self-defeating doubts about debts and deficits.

What are our Optimal Foreign Exchange Reserves?

Ashima Goyal

One of the reasons productivity is low in developing countries is the high level of inventories they carry. Inventories are high because shocks dominate which in turn makes it difficult to plan for the future and eliminate costly buffers. But improved systems could reduce the level of inventory and save costs.

Forex reserves are also a buffer against shocks. Developed countries keep minimum reserves since they have easy access to liquid international capital markets. But emerging market economies have often struggled with a scarcity of foreign exchange. They regard billions in the forex kitty as a sign of wealth. But it can also be a sign of inefficiency.

Reserves have ballooned in the nineties because of the surge in cross border capital flows. There are underlying long-run changes, such as fundamental technological innovations, the aging of developed country populations, the rise of institutional investors, and the opening of most countries that will sustain these flows.

What determines the optimal level of forex reserves? In the era before large capital flows this used to be calculated in terms of months of import cover. Three months was regarded as adequate. But today it is the capital account, which is the major source of foreign currency movements. Reserves must be adequate to fully cover short-term debt since this can leave quickly in times of crises. Moreover, with capital account convertibility for domestic residents, they could decide to stop holding the domestic currency. Therefore reserves must cover some percentage (about twenty percent) of broad money that could be mobilised against reserves. The first is the potential external drain, the second the internal one. The general principle, much like the variance at risk analysis for banks, is that Central Banks must calculate liquidity requirements over a wide range of possible shocks. Reserves must be adequate to cover for these contingencies. The Central Bank should not need to borrow abroad, to meet foreign currency demand, for at least a year.

In applying these rules to India we run into startling paradoxes. First, the short-term foreign debt was always low. It has been reduced to 0.6 per cent of GDP in 2002, when public sector foreign debt was only 0.25 per cent. Second, we still do not have full capital account convertibility for domestic residents, so that there are limits on a potential domestic drain. Estimates of optimal foreign exchange reserves for India give about 10-20 billion dollars, when current reserves are at 77 billion dollars.

Optimal reserves also depend on the exchange rate regime being followed. Reserves are needed to defend a fixed exchange rate, but are not required with a fully floating exchange rate since the exchange rate itself can adjust. With the reforms India has moved from a fixed to a managed float, to that extent its reserve requirements should have fallen but actual reserves have increased. Reserves are still required because mobile capital can itself be a source of volatility for a developing country with limited market access.

This leads to country risk and the precautionary motive for holding reserves. One argument is that excess reserves encourage high-risk macroeconomic policy and excessive inflows, but it can also be argued that reserves have to be high as insurance when macro policy is lax. Asian countries hold maximum reserves; India should consider joining informal swap agreements that will lower the need for precautionary holdings, allowing productive utilization of reserves such as through a current account deficit that directly and indirectly makes more capital goods available for investment.

But in India the problem has been compounded by a current account surplus for two years now. This is surprising because the well known twin deficits argument suggests that a high fiscal deficit, if it is putting pressure on domestic resources, must manifest as a high current account deficit, as imports exceed exports in order to meet the excess demand. The absence of these pressures suggests that there is no physical crowding out of private spending by government excess spending. After the investment burst of the mid-nineties growth slowed leaving excess capacity. Financial crowding out if it is occurring is due to the inability of the financial sector to deliver credit on attractive terms to the private sector.

Therefore the fiscal deficit is not affecting the external balance at present. Moreover, resolving it and problems in the financial sector will take time. Meanwhile, monetary policy can still contribute. In the early period of inflows monetary policy was conservative in sterilizing reserve accumulation and keeping money growth low. Whenever the reserve bank buys dollars it increases rupees, but then it has been selling government securities to mop up the rupees and reduce money supply. This raises interest rates and can be risky in the opposite sense of keeping growth too low. With capital mobility interest rates cannot far exceed world rates. While first generation crisis models blamed lax Latin American macro policy for currency crises, newer models of the East Asian crisis have shown that too restrictive monetary policy that keeps domestic interest rates in excess of world rates can encourage overborrowing abroad and compound the currency with a banking crisis.

Therefore the current policy stance of soft interest rates is valid. The temporary peak in inflation is due to cost shocks, which will reverse. An economy at full employment requires an appreciation of the exchange rate to absorb foreign inflows since a rise in domestic absorption occurs through a rise in imports. But in an economy with excess capacity the rise in absorption can occur at unchanged real exchange rate, through output expansion. The current hesitating emergence from a slowdown, moreover, justifies countercyclical monetary policy. In the Indian context of high internal public debt, limits are required on government consumption expenditures. Stimulating investment is the safe way to increase demand since it will also expand capacity. About 30 per cent of infrastructure spending should leak into a rise in imports, thus absorbing reserves.

Inflation: Here Today and Gone Tomorrow

Ashima Goyal

Inflation has been trending downwards ever since 1996, with small peaks, one in 1997-98 caused by a rise in food prices, and another in 2000-01 due to a rise in fuel prices. The current rise to about 6 percent will turn out to be another of these transient peaks, and will soon be reversed. The average annual rate of inflation for the past year remains low at 3.3 percent. Inflation next year should be between 4-5 percent.

With the conclusion of the Iraq war oil prices are already falling. And although we had a drought last year and prospects for the monsoon are uncertain, the large stocks of foodgrain will ensure that prices of essential commodities remain stable, and the huge forex reserves combined with an appreciating rupee will put downward pressure on other prices. Strategic imports can damp the rise in edible oil prices. The current account of the balance of payments is also in surplus with the rise in exports and large remittances--we can safely import more. Relatively stable food prices despite drought conditions is the reason inflation measured in consumer price indices is lagging behind that given by the WPI. The former gives a weight of 57 percent to food articles compared to 27 percent in the WPI. But the latter gives a weight of 14 percent to the fuel group compared to only 6 percent in the CPI.

The main reason for the downtrend in inflation is the greater openness of the economy. In the nineties inflation fell in many developing countries approaching the developed country range of 1-2 per cent. Inflation in India cannot depart far from that of our trading competitors without putting pressure on the rupee. Higher inflation would require a continuously depreciating rupee. The reason for falling global inflation is partly the emphasis on inflation targeting and the greater autonomy given to central banks, and partly rising global productivity.

The Reserve Bank has also acquired greater immunity from automatic financing of the deficit. But in the Indian context, more autonomy of the Central Bank should allow it to be a little more relaxed about inflation than the Central Government is. In a democracy without full indexation of wages the poor are highly sensitive to inflation. Elected governments tremble when onion prices rise. The government administers many prices, which it finds difficult to raise. There is the recent example of the rollback in the MTNL tariffs for landlines.

The Reserve Bank has to focus on the inflation it can control at minimum cost in terms of foregone output. That is, it should target inflation due to excess demand in the economy. If there is a permanent supply shock, lowering demand would also lower inflation. But if there is a temporary supply or cost shock, lowering demand to reduce inflation would entail a temporary and avoidable loss in output. Therefore the concept of core inflation as the target variable for central banks has gained importance. This is inflation minus volatile components due to food and fuel.

Although demand must not be contracted when food prices rise, measures such as imports or food stock releases should be used to stabilise food prices. In India wages are sensitive to food prices over the medium-term, inflationary expectations and a wage price spiral can set in. Therefore supply-side food price management is a useful arrow in the anti-inflationary quiver.

Another reason there should not be over-reliance on demand contractions to contain inflation, is that an economy with efficient growth and rising productivity is undergoing a series of permanent positive supply shocks which tend to lower inflation and can accommodate rising demand. Since it is difficult to know when demand is excessive--it is possible to contract demand too fast and hurt growth. Therefore the inflation target used for monetary policy should be a medium-term inflation zone forecast. If core inflation forecast is in the acceptable zone, money supply should not be contracted, and supply shocks should be allowed to gradually lower inflation.

The political class had always raised the minimum support prices to appease the farmer lobby, thus ratcheting food prices upwards. But falling world food prices, large food stocks, more openness, and a fall in our own rates of inflation has lowered these rates of increase. Indian prices for a number of agricultural commodities rose above world prices, for the first time, in the nineties. This is not sustainable in a more open economy. So moderation in food price increase will lower Indian inflation.

Changes in the items that add up to unit cost, namely, profit shares, nominal wages and shifts in productivity determine inflation. Demand factors such as monetary or fiscal expansion enter in an ex-ante fashion if wage adjustment is forward looking and responds, for example, to expected monetary accommodation. Otherwise lagged wage adjustment with accommodating monetary policy can maintain inflation.

Indian fiscal deficits are high but similar deficits have been accommodated in the past with falling inflation, so they will not raise inflation. Money supply growth remains moderate, as it has in the past few years. In any case, there is no very exact relationship between money supply and inflation. Causality runs both ways, money affects demand but demand also affects money supply. Will the revival in industry put pressure on prices? Again the competitive pressures of a more open economy will tend to keep prices down. Industry has gone through a period of re-structuring and lowered costs on average. Falling interest rates have also contributed to lower costs. Although industrial prices have been falling relative to agricultural in the nineties, all the improvements in efficiency have not been passed to consumers and mark-ups have been rising. As anticipation of WTO 2005 kicks in competition from imports will squeeze margins further to the benefit of the consumer, and further moderation of inflation.

For much of the nineties, the fall in nominal interest rates has lagged the fall in inflation, so that savers were actually earning higher real interest rates than they did in periods of high inflation. One aim of financial reforms is to ensure real positive rates of return to savers, unlike in repressed financial regimes where interest rates are administered and high inflation implies negative interest rates for savers and harms savings. Although nominal interest rates remain soft a transient peak in inflation will not lower expected real rates of return. Moreover, in a flexible interest rate world nominal interest rates will adjust to persistent inflation, maintaining real interest rates.

But savers need to be concerned to the extent that world real interest rates are much lower than Indian rates, and Indian real interest rates will, over time tend towards these lower rates. Not only do higher interest rates harm domestic activity they also attract more inflows, which appreciate the exchange rate and harm exports. Low interest rates and a competitive rupee are necessary to maintain growth, and high growth benefits the majority and removes poverty. For higher returns savers must be prepared to accept more risk in equity markets, or diversify their portfolios in new instruments offering a range of risk and return, thus sharing the rewards of growth.

New Agenda for Finance Panel

Ashima Goyal

The 12th Finance Commission has been constituted in November last year, and given its terms of reference. It has been asked to improve the governments' fiscal position while protecting investment and ensuring equitable growth. These broader terms of reference offer a real opportunity for the Commission to remove obstacles to major reform. The terms cannot be fulfilled without innovative reform. There are many national initiatives to solve intractable problems; it is time for another one. Three main points to consider are:

Conflicts of interest or the absence of trust imply that India is unable to implement some reforms that, it is almost universally agreed, would be beneficial. For example State governments find it difficult to raise user charges for water or electricity, partly because one party fears that the other will extract political mileage from such a measure. The Finance Commission (FC) can play a coordinating role whereby political parties can say the Commission has collectively tied their hands, and thus excuse themselves from the electorate. This will make universal implementation of some reforms more feasible. The Commission may actually be doing the parties a favour by freeing them from habitual and unsustainable ways of pandering to the electorate, in which they are stuck. Therefore it need not fear a political backlash. Many new regulatory bodies are being set up, but they are not at the national level, and therefore cannot coordinate across States.

Second, to lower deficits and improve debts it will be necessary to attack on multiple fronts. The debate should be about what is the fastest and politically feasible way to move to a sustainable fiscal regime. Low interest rates, high growth, broadening of the tax base, and improving incentives to pay and collect taxes would be the best way to increase primary surpluses and successfully achieve the objective.

Third, the key focus should be on improving individual and government incentives to move in the desirable direction. The term "incentives" is slightly different from the term "efficiency", as FCs have used it in the past in the debate on equity versus efficiency. While efficiency is concerned with rewarding those who have performed better in the past, and equity with compensating the laggards, incentives are concerned with motivating better performance in the future. Therefore there is less of a conflict with equity. If transfers to low income States are focused on improving infrastructure and human capital, all of which contribute to improving future efficiency, richer States will be more willing to pay the higher taxes required for transfers. Higher efficiency in a neighbour will benefit them also. A transparent non-discretionary formula, with a clear logic, would help improve trust and acceptability by the States.

Examples of measures that have the effect of improving such incentives, in the context of specific recommendations the 12th FC has been asked to make, are:

With respect to the distribution between the Union and the States of the net proceeds of taxes, the recent practice of sharing with the States a proportion of all Union taxes, since then the Union has incentives to collect all taxes with equal vigour.

In allocation between States welfare payments should be made as block grants. If matching grants are used for such purposes, States have an incentive to overspend. But offering them matching or proportional incentives for their tax collection effort will encourage States to collect more taxes. Welfare payments should be targeted to infrastructure, education, and human capital formation. Increasing entitlements and assets of the poor is the sustainable way to lower poverty.

Improvement in government accounting practices would build in incentives to "restructure public finances restoring budgetary balance, achieve macroeconomic stability along with debt reduction and equitable growth". There should be a shift from input to output based, transparent, and timely accounting systems that help allocate responsibility for outcomes right down the hierarchy together and improve information for decision making.

Front loaded Fiscal Responsibility Acts with escape clauses that make them credible, and caps for expenditures so as to allow countercyclical fiscal intervention, would help increase primary surpluses while protecting productive public investment. If Governments must be encouraged to accumulate surpluses in booms so that they can run deficits in slumps. With a cap for expenditure instead of a deficit target, deficits automatically rise as tax revenues fall in slowdowns, thus giving the desired countercyclical fiscal stimulus.

In order to expand the tax base, although it has proved difficult to tax agricultural incomes, it may be worthwhile to look at land revenue since the machinery to collect this still exists. It may be tied to computerization of records and improved property rights.

In order to "ensure the commercial viability of irrigation projects, power projects, departmental undertakings, public sector enterprises etc. in the States" the FC may be able to coordinate different political parties to agree to establishing independent regulators to set user charges, so that price setting is freed from political interference. No party will then be able to make political capital or loss from this form of short-term populism. The regulatory structure must be designed so as to be resistant to capture by politicians, bureaucrats, organizations or consumers. Incentive properties of the user charges must be carefully looked into. Price caps that cover average costs give high-powered incentives since the residual cost savings stay with the public service provider. They encourage cost reduction, which benefits the consumer. The regulator can also enforce quality and environment standards.

Improvements in State tax collection exceeded those in the Union in 2002; the fiscal reform facility introduced by the 11th FC surely contributed to this, suggesting that incentives work and it would pay to strengthen them.

Rupee must Travel a Two-way Street

Ashima Goyal

The Rupee has appreciated against the dollar by around 3 percent since January this year. This is not a large amount, but is attracting a fair amount of attention, partly because of the sheer novelty after a decade of trend depreciation. It is instructive to remember that in 1990-91 it required only 18 rupees to buy a dollar compared to more than rupees 46 today. This is a depreciation of 158 percent.

With the reforms, India adopted the Asian recipe for development, which required a competitive rupee to stimulate exports. The modest appreciation is not an abandonment of this policy and may actually imply a more effective implementation of such a policy. The reason is that while keeping the rupee competitive is good policy, one way movement of the rupee is not. Moreover, as productivity improves, some appreciation is possible, thus benefiting consumers while retaining that competitive edge.

Under the blanket protection of reforms, for a variety of reasons, although industry and services have become more competitive, agriculture has lagged. This is ironic because earlier it was industrial prices that exceeded world prices while agricultural prices were much lower.

The appreciation comes at a good time for the economy. It will lower the price of imports that are priced in dollars. More imports are priced in dollars than just imports from America itself, which are not large. This will benefit importers and firms whose demand for imported capital goods should be rising as the economy enters an upswing. It should further stimulate investment. The fall in oil prices will help to lower inflation. The Euro area actually accounts for a larger share of Indian trade than the US does, and its share of both exports and imports is about 20 percent. The depreciation of the rupee against the January value of the Euro should encourage more Indian exports to this region.

Although IT companies, often directly linked to the dollar, are worried about a squeeze on their profit margin, exports to the US are only about 20 percent of India's total exports. Asia is a new and booming export market. Since these countries are also India's export competitors with respect to exports to the west, exports will not suffer to the extent these Asian currencies have also appreciated against the dollar. The rupee has depreciated against the Yen. Exporters may be able to pass on higher prices to their customers that will compensate them for the fall in the value of the dollar, without a large fall in demand, as long as the export prices remain competitive. If their major export competitors are also raising their dollar prices, exporters' earnings will not suffer. But the rupee should not appreciate at a higher rate than its major export competitors.

A blanket depreciation of the rupee makes Indian producers lazy--they rely on that to make them competitive rather than on improving efficiency. A low rupee makes imports too expensive and exports very cheap. While producers gain on the whole, it hurts the consumer and the producer who has a high import content. Employees suffer erosion in real wages, but gain through an expansion of jobs.

Since Asian countries are the ones with large stocks of foreign exchange reserves, and often a surplus on the current account, international policy opinion wants a correction whereby surplus currencies appreciate and those with large current account deficits, such as the US, depreciate. The US, given its slowdown, is considering the Asian strategy. But unfortunately, for the US, one of its main exports is the dollar. And a large fall in its value will lower willingness to hold the dollar. Thus dollar securities form a large part of India's dollar 78.5 billion reserves, but India's exports are almost double its imports from the US.

But the world is eyeing our reserves, and because of them, may push us in directions we do not want to go. It would be better if we could use them productively before such an eventuality. With the reforms we also moved more towards market determination of the exchange rate, with occasional intervention by the RBI, ostensibly to smooth volatility, but actually also to prevent the rupee from appreciating. Opening out and global changes brought in large capital inflows, and the least effort way to achieve to achieve exchange rate objectives for the RBI was just to go on accumulating reserves, and allow the rupee to depreciate to compensate for the excess of Indian inflation over world levels.

The current rise in rupee is mainly due to the weakening of the dollar, since the rupee is depreciating against other major currencies, and the RBI continues its policy of accumulating reserves to prevent the appreciation of the rupee.

These reserve accretions are sterilised by reducing RBI credit to the government, and this, together with other rigidities in the financial system, means that the gap between our interest rates and international ones has risen. This only invites more capital inflows seeking arbitrage. Sound businesses raise cheap money abroad, making it more difficult for our banks to lower loan rates for the higher risk domestic borrowers that remain. Finance is then hurting real activity and building an unsustainable situation. Although nominal interest rates have been steadily falling, the arbitrage gap has been rising. The recent US interest rate cut has contributed to it.

Having freed a market, which is rapidly gaining in strength, the RBI is reluctant to challenge it. But the market often looks to it for guidelines. One way movement of the rupee encourages too much risk taking. All those involved in international transactions should realize that two way movement of the rupee is possible, and it will pay them to adopt hedging strategies, so that small rupee movements do not unduly affect their profits. Teaching them this lesson will be a useful contribution of the current appreciation. It will be doubly useful if it also teaches the RBI the feasibility of such movements.

Arbitrage and the Interest Rate Spectrum

Ashima Goyal

Can do after Cancun

Ashima Goyal

The US chose to protect a few thousand US cotton farmers at the expense of millions of African farmers, and of scuttling the Cancun talks. The Bush administration has systematically destroyed global agreements, where its own interests were involved, whether the Kyoto protocol, or the UN process during the Iraq invasion. Moreover, since the American electorate is polarized, split evenly for and against Bush, and elections are near, swing votes are very important—such as those of the small block of cotton farmers.  

Removing impediments to multilateral trade benefits all nations; each gives some and gains some. At Cancun the issues were neatly posed in this way, with developing countries slated to gain from agricultural subsidy reduction and the developed from some concessions on the Singapore issues. But the hard position taken by the US and EU turned this natural bargain into a polarized opposition, where rich-poor rhetoric dominated and the talks collapsed. Potential cooperation turned into a game of chicken where as neither group swerved from its position, collision destroyed the trade talks.

Sometimes in global negotiations, if the strong are accommodating the group reaches a better outcome. The post world war Marshall Plan in Europe is an example where US generosity triggered prosperity for all. But today the US is behaving like a poor needy country, perhaps with some justification. America's poverty rate has now risen to 12.1% for the total population, and among blacks is almost 25%.

So what happens next?  More openness has helped India over the past decade. We have discovered many areas of strength. Despite qualms, Indian industry has shown the ability to restructure and to reach international standards and quality. Exposure and competition has stimulated catching up. Multilateral fora are essential to maintain such openness. Moreover WTO is democratic, with one vote per nation. In many international bodies voting power depend on economic muscle. The WTO’s decision-making process has been indicted as untransparent and non-participatory. That same economic muscle succeeds in dictating agenda items and pushing unilateral drafts, without considering even majority opinion. But Cancun has demonstrated that this strategy can boomerang, and may have paved the way for reform of the negotiation process. New technology makes it feasible to design inclusion yet fast dialogue and consensus building for future rounds.

Getting “nos” to purely self-serving agendas, such as the UN refusal to the US request for aid in Iraq may help the US realize that they also need the rest of the world, and to get they must be willing to listen and to give. A straw in the wind may be the US recently rejoining UNESCO, after withdrawing in 1984.

Open regionalism can strengthen bargaining position. Thus the recent Indian initiatives to improve ties with ASEAN + 3 and work towards a free trade area are to be welcomed. As one of the fastest growing regions of the world Asia has the ability to be an endogenous growth center and expand trade within the region. It could acquire sufficient strength to make the rest of the world eager to reach agreement with it. A fair agreement is easier to reach between more equal parties.

Learning has been the primary benefit from more openness and sometimes it is easier to learn from countries closer to us, and whose development history is more recent. A Belgian economist once told me that Indians lack the civilized norms necessary to become a developed nation. His perception had been coloured by the experience of being almost crushed in a stampede at an airport.

Last week I was returning form a conference in East Asia. At Mumbai’s Sahar airport three jumbos landed around the same time and a melee ensued. Indians who had queued quietly in the order and discipline of Singapore’s Changi airport began pushing and jumping queues in the mayhem at Sahar. It is not the people who lack norms but the systems that fail them. If at 12pm you face the prospect of standing at immigration for 2 hours and your neighbour pushes ahead you will also push. A little bit of foresight and direction in queuing would have prevented the incident.

Changi airport has instituted a drive to find 101 ways to delight the customer. Someone came to me with a questionnaire about the quality of service—one of the questions was if the girl at the counter had smiled at me. Going out from Sahar also there had been a long queue because only one immigration counter was open, the other officers were all eating their dinner, together! As we move towards an open skies policy with East Asia we need world class airports and their customer orientation. Coopetition with these countries may help us get such facilities and prove our critics wrong. 

Macroeconomic Policy for Sustained Growth

Ashima Goyal

The mid-term review of monetary and credit policy combines continuity with change. There is a major new thrust in “people friendly policies”, whether in lubricating the financial sector’s interface with the public, or in improving credit delivery systems. This is a very welcome focus, since a major unmet challenge for our financial system is to deliver credit to the small enterprise.

Banks in Andhra Pradesh have had good success in working with self help groups. Especially women groups have a great record in repayment. Such mechanisms need to be replicated more widely. Peer monitoring should be encouraged in general—where members of a group stand surety for each other and therefore have an incentive to ensure repayment by each other. Before nationalization of banks local recruitment meant that bank officers had a depth of local information. This needs to be re-generated and used intensively again. Competitive credit rating for small firms would help them get credit; the setting up of multiple credit-rating agencies should be a priority. In addition to such measures, banks need to continue to explore new kinds of instruments and activities. There have been few bank closures or crashes in the recent global slowdown, and American banks in particular have done well. They were helped by interest rates that were kept low and smooth, but their diversification into new types of activities and use of hedging instruments also helped smooth shocks to their balance sheets. Indian banks have also been exploring new types of lending. The share of non-priority sectors apart from industry and trade in non-food gross bank credit has doubled to about 40 percent compared to its value in the mid-nineties, major new areas are housing and personal loans.

An odd feature is the flat yield curve. The rate for the one year Treasury bill is actually lower than that for the 91 day T-bill. Either market expected inflation is very low despite high expected growth or RBI intervention is driving the result. Since the RBI is still the dominant market player, the latter explanation is more likely. The heavy sterilization has been designed to tilt the yield curve. Perhaps the belief was that reducing long-term interest rates would stimulate growth, while higher short term interest rates would keep the rupee strong. But as a result it has become too strong. In India’s current state of rupee convertibility it is easier to bring money in than to take it out. Anyone can bring money in, but domestic residents cannot take money out. There are limits on banks open position in forex. Therefore short interest rates lower than international are more sustainable than vice versa. Fewer outflows will be stimulated in the former condition, and more inflows would occur in the latter. The RBI has been aware of the one-sided nature of capital flows in India, so the gap between the short interest differential and the forward premium had been carefully kept negative all through December 1995 to September 2002. After that it turned positive as international short rates fell and Indian did not follow. Today RBI’s interest rate policy cannot afford to ignore international rates, but it gave up interest rate flexibility at the short end where it was easiest to achieve. Concern for savers cannot be the explanation since long-term interest rates impact them more.

Table: The Monetary Squeeze

Source: Calculated from RBI Handbook of Statistics on the Indian Economy, www.rbi.org.in

The softening in interest rates disguises the fact that monetary policy has been tight during a slowdown. The Table shows that although lower money growth was required because inflation and output growth rates fell, reserve money growth was much lower than nominal GDP growth thus keeping up a monetary squeeze during a time that a monetary stimulus was required. The reason was aggressive sterilization of the large foreign inflows by the sale of government securities. Foreign inflows have not increased liquidity in the Indian economy. Rather, they have, since of RBI intervention, lowered it. Broad money growth was similar across the two periods and compensated to some extent. Bu it is not the banks alone that are to blame for their large acquisition of government securities at the expense of other lending. The RBI, which has been selling them, is also responsible. We may have been in the classic high capital mobility trap, where sterilization only raises interest rates and invites more inflows. The RBI relied on capital controls to give it degrees of freedom, but the huge reserve buildup shows that these are porous; some re-thinking on interest and exchange rate policy is necessary.

The fall in inflation occurred because of industrial restructuring, fall in taxes and tariffs, more competition from abroad, and now the rupee appreciation will contribute further. A more relaxed monetary stance will not be inflationary; inflation would have fallen even with a softer monetary stance in the past.

The new governor must be given time to demonstrate his independence of mind and deep knowledge of Indian economic structure. These are the most important qualities, to give us a macropolicy for sustained growth. Professor Sachs has said that America will never go into a long-term recession like Japan did because they have just too much monetary expertise. Stiglitz has written that we must do what America does, not what it tells us to do. Greenspan continues to keep interest rates low as America goes into a major recovery. We must not start talking of overheating at the beginning of an upturn. As productivity and potential growth rise rapidly, it is difficult to say when we are exceeding it.

It used to be said that interest elasticity of expenditure is low—but all of industry is acknowledging the contribution of lower interest rates to their profits and to re-structuring; low rates have also contributed to the housing and consumer durables boom, while savings GDP ratios have not suffered.

A fiscal correction is required, however. Recovery is a good opportunity to lower the revenue deficit as taxes rise and PSU shares can be sold in a booming market. While monetary policy remains stimulatory, and spending on infrastructure is maintained.

The author is a professor at IGIDR.

Instilling Business Sense into Babus

A visit to Shenzhen last month was an opportunity for seeing Chinese development at close quarters, and acquiring insight through dialogue, after a long acquaintance with China only through books and articles.

Prosperity is very visible in the tall buildings, and wide clean roads. It is true that Shenzhen is not China, and although special economic zones (SEZ) cannot come up everywhere, economic development zones are proliferating, with good facilities. The poor in China now are only 5-10 percent of the population. In many ways there is a complete U turn. A red banner on the porch of a hotel said, “Welcome to the VIP in a land rover or jaguar”. Chinese seem to have a natural affinity for markets, and for making money. In Shenzhen’s markets, bargaining is systematically conducted, even across language barriers, using entries in a calculator. The leeway they have to reduce prices is amazing. Their opportunity cost for a large range of goods is very low, given large manufacturing capacities, and a competitive ability to clone a variety of products.

But an underlying consistency drives the U turn. The goal continues to be development and economic power but markets and openness are the new means to achieve it. Although proud of, and pleased to show their achievements, they are not complacent. One is sometimes asked, “Did you think that you would find this in China?” Shenzhen looks to Hong Kong and Hong Kong looks to Manhattan (with apologies to Lord Byron). The Chinese love poetry, symbolism, and appreciate a clear direction from leaders. Perhaps that is why Prime Minister Vajpayee visit seems to have been a great hit. It is mentioned all the time, and along with Indian expertise in IT, is used to justify a serious Chinese interest in economic partnerships with India. Openness for them means a willingness to learn and follow potential advantage anywhere.  

Much of the admirable Chinese infrastructure was built in the nineties, and by a government that used deficit and bond financing to do so. Infrastructure was developed after the opening out and export orientation since then it was necessary for comparative advantage. Before that the government concentrated on State owned enterprises (SOEs). A similar demand is building up in India and should result in a similar response. The mantra was that if you want to develop an area build a road there. Budget deficits including quasi fiscal activities of the Peoples Bank of China (PBC) were high (see table). Thus the government followed pragmatic macroeconomic policies suited to their structure. Lack of transparency and the obvious successes kept international pressures at bay. Although there were bursts of inflation and volatility in macroeconomic variables, inflation has been low in recent years because of the rise in productivity and steady exchange rates. The Chinese are resisting pressures to appreciate their currency and delink it from the falling dollar, since they are clear on their goal of stimulating exports. It was the boom in exports, which by absorbing their surplus labour, made reforms a win-win situation for them. They have told the Americans that since they held the renminbi constant during the East Asian crises and thus helped to moderate the crisis, they should be left free to take their own decisions now. This is another example of their ability to do what is best for their economy. They do adapt and change but only at their own pace and time.

Source: Table 1.2 in D.J.S. Brean, 1998, Taxation in Modern China, Routledge: New York

Indian financial sector reforms have proceeded faster than Chinese, and India’s financial sector is in better shape, although Chinese banks have delivered more credit. NPAs in Chinese banks are said to be 44.5 percent of GDP while Indian banks have reduced them to 6 percent. The quasi fiscal functions the banks have performed, absorbing subsidies to both households and SOEs under an inverted yield spread, are responsible for the poor shape banks are in. But serious reform has started to harden budget constraints for SOEs, bring in commercial considerations, and appoint asset management companies for bad debts. Positive real interest rates on savings deposits were maintained and these are still the only avenues available for household savings. The large household savings imply that huge resources are available for investment, and financial reform will help to leverage these better. These high savings, gradual financial reform, and the rapid growth of efficient private and foreign firms imply that China will escape being caught in a bursting financial bubble.

Another admirable feature of Chinese reform has been the use of incentives to coopt the bureaucracy in the growth process and of innovative institutions such as SEZ and township and village enterprises (TVEs) suited to their structure and stage of progress. As they put it, it was finding the loose bricks in the wall of bureaucratic resistance, and turning them away from rent seeking. The SOEs as a source of bureaucratic power were not immediately affected. TVEs are owned by the lowest level of government, and served as a way to reward bureaucrats from growth, even without full property rights, by giving them rights to potential income streams. TVEs are seen as transitional structures, turning now into SMEs---the standard size based classification. Some low level democracy, public accountability and transparency are being introduced. The leaders are open to suggestions and listen to reasonable arguments. But once they decide, the people accept.

Apart from learning from each other, the two fastest growing countries have natural economic complementarities. Institutions should be set up to find these, leverage them, improve communication and reduce transaction costs. Rapid growth in trade and intertwining interests are the best way to increase cooperation and understanding. If the two countries can also reach similar positions in international fora such as the WTO, environmental agreements, and hammering out a new international financial architecture, it would make these bodies more responsive to developmental issues.

Woo Technology by Outsourcing

British mill workers had revolted against new technology. If they had been successful, and the industrial revolution had bypassed Britain, where would British workers be now? Technology, over time, has raised productivity, wages and living standards for workers. While automation does decrease labour requirement per unit output, the new feature of Internet and communication technologies (ICT) is that they enable a much smaller scale of efficient production, compared to the earlier factory technologies. Therefore it is easier for new firms to enter, which, over time, tends to raise wages and employment more than profits, thus benefiting workers.

Taking an example nearer home, workers in Bihar earn the lowest wages in India, and it is a state that has stoutly resisted the new technologies. Although Lalloo is now reported to be saying “sabh karte hai to hum bhe karege”, and has married his daughter to a computer engineer.