From Financial Express, September 12, 2012

Virtuous growth for India

India’s ruling coalition has promoted the idea of inclusive growth. What this means operationally is something that can be debated. One idea is that a broad cross-section of society should enjoy the fruits of growth. For example, Kaushik Basu has suggested measuring the income gains of the bottom quintile of the population as a concrete, specific indicator of growth. One can also interpret inclusiveness to mean going beyond income. Amartya Sen has emphasised that there are other measures of development and well-being—literacy rates and life expectancy can also grow, for example. For others of Sen’s suggested dimensions of development, such as rights and capabilities, quantitative measures of growth may be difficult, but one can still speak of more inclusive development in a qualitative sense.

Material welfare and rights are reasonably well understood, though agreeing on how to measure gains, or manage tradeoffs between them, still can be a challenge. But there is a third dimension that has been stressed by philosopher Michael Sandel, who discusses the importance of virtue, in his books, Justice: What’s the Right Thing to Do? and What Money Can’t Buy: The Moral Limits of Markets. Sandel’s examples are mostly from the US, and are germane to the current political debate in that country’s presidential race. But they also have relevance for India.

Basically, Sandel argues that welfare and rights (especially freedom of choice) are insufficient to guide us to just social outcomes. There has to be a consideration of morality that goes beyond these. He favours “cultivating virtue and reasoning about the common good”. What this means in practice is hard to generalise, but he argues through examples, and he gets at the heart of some of the issues that trouble ordinary people when they consider the role of market forces. In particular, a key idea that he advances is that market exchange based on commoditisation can crowd out moral considerations and make us worse off as a society. For example, market exchange can destroy the good itself—friendship cannot be bought and sold. But even if the good is tradeable without being degraded (babies are an example he discusses), there is a loss to us individually and socially from such marketisation: the participants in the exchange are corrupted or degraded, rather than the object of exchange. A complementary possibility is that pure market-based allocation is undesirable because it is unfair, pricing all but the rich out of some goods (such as a visitor’s seat to watch Parliament in session)—this relates to more conventional notions of equity or egalitarianism, and the basic idea of inclusiveness.

Sandel uses his framework to discuss more concrete notions of citizenship, sacrifice, honour and responsibility. If markets intrude too much on social norms, then there is a loss of virtue. On the other hand, virtue is strengthened by its application—we learn to be good citizens through how we go about our civic duties. In particular, allowing the market to dominate the government will be problematic. Note that this does not constitute an argument against economic reform in India. In fact, the problem with the old system was precisely that it created opportunities for buying and selling government favours, in situations where open and transparent market allocation could have been more effective. My guess is that Sandel would have concerns about Kaushik Basu’s suggestion to decriminalise bribe-giving where the bribe is demanded for a service to which the recipient of the service is entitled. This can increase efficiency and material welfare, but can have a corrupting or degrading effect on individuals and society.

Sandel’s idea of virtue as important for individual and social good is not new. There are conceptual links to Gandhianism or even Nehruvian socialism. But like Nehru and unlike Gandhi, there is not a broad-based suspicion of material progress. And unlike Nehru, there is not a broad suspicion of markets. So I do not think that paying attention to virtue means neglecting traditional economic growth. Virtuous growth is not an oxymoron. If fairness is a virtue, then virtuous growth subsumes inclusive growth. But if inclusive growth means that rich and poor alike progress materially while becoming socially less engaged, or more corrupt, or materialistic in ways that are degrading, then even inclusive growth lacks something. It is possible that the sustainability of growth may require inclusion in the medium term, but virtue in the longer run. Virtuousness can align with intrinsic motivation, so that people do their jobs well, not only because they are paid for it, but because it is the right thing to do. It also focuses attention on how those jobs are experienced, so that dignity matters in itself, not just for the bottom line. There are implications for how the private sector chooses to conduct itself, aside from government regulation. The sharpest implications, however, are for the government itself, which in India, often fails to promote virtue or to practice it, while pretending otherwise.

From Financial Express, July 13, 2012

How not to defend the rupee

As India’s economy has soured, its currency has plummeted. The response of the Reserve Bank of India has been confused and counter-productive. Why do I make that claim? First, the fundamental value of the Indian rupee is determined by economic fundamentals. The rupee will recover when India does two things: put its macroeconomic house in order by controlling the fiscal deficit and inflation, and restoring its growth story through microeconomic and institutional reforms. These have little or nothing to do with RBI’s management of the exchange rate.

There are two counters to this claim. First, in the short run, the exchange rate can overshoot, and this can have harmful impacts on the economy during that period. Second, increased volatility of the exchange rate, which can accompany uncertainty about its level, is also harmful. The harm is that economic agents within India, particularly domestic firms, will suffer losses due to the fluctuations in the exchange rate or sharp movements in its level.

RBI has taken two types of actions to manage the rupee’s recent vulnerability. It has intervened in the foreign exchange market, and it has introduced new restrictions on trading in currency derivatives. Intervention is meant to directly counter private market participants’ views, buying when they are selling, or selling when they are buying. Restrictions on derivatives trading are meant to reduce speculation in movements of the currency. These restrictions can also support the first objective, by raising the cost for private market participants to trade, and give RBI more weight as a trader in the foreign exchange market.

The problem with foreign exchange intervention, as has been shown repeatedly across the globe in the past few decades, is that it has limited power in the face of global capital market sentiment. A large amount of trading of rupee derivatives takes place offshore, and the value of the rupee will be determined by large economic actors in global financial centres. Recently, Kaushik Basu has advanced an ingenious theoretical argument for effectiveness of intervention based on credible commitment by a central bank when other traders are a competitive fringe, but it has yet to be tested empirically. I think instead that RBI has very limited scope to do much beyond managing day-to-day liquidity and unusually sharp short-term falls or spikes in the currency. Even if the rupee is falling below its fundamental long-run value, RBI has to accept the limits of its power to influence the level of India’s currency.

Restrictions on trading in currency derivatives are more problematic. Restrictions include those on who can trade, what can be traded, when trades can take place, and what net positions currency traders may hold. RBI issued circulars in December 2011 and May of this year, substantially tightening existing restrictions. The ostensible goal is to reduce speculation, though a hidden objective may also be to thin out the market and give RBI more clout. But large amounts of trading take place offshore, beyond RBI’s reach. Many of the restrictions simply hurt Indian financial institutions at the expense of foreign players.

The nature of the restrictions also makes it harder for Indian firms to hedge their currency exposures. As India has globalised, the need for managing currency risks of all kinds has increased dramatically. RBI has taken retrograde steps that will make it more difficult for effective hedging opportunities to develop for India firms, especially smaller ones that do not have offshore liquid assets in their treasuries—larger firms with such resources can again operate globally to manage their risks.

The argument that currency derivatives caused problems for Indian firms in the past is like saying that a toddler fell because the parents did not clear the floor of obstacles, so now he should not be allowed out of the crib. RBI’s December 2011 restrictions on cancelling and rebooking forward contracts raise hedging costs for Indian firms, even for the simplest kinds of forward contracts. Such hedging has nothing to do with complex derivatives that were being peddled just before the financial crisis.

Indian firms, and India’s economy, would be better off with an approach to regulation that moves away from piecemeal, ad hoc measures that fragment markets, reduce liquidity and prevent learning. Transparent exchange trading of basic currency derivatives such as plain vanilla forward contracts, without arbitrary restrictions on contracting or net positions, would allow Indian firms to develop effective hedging strategies. The onus of risk management at the firm level would be on corporate boards, which would also learn how to do their job. None of this prevents RBI from regulating to avoid systemic risks, such as dangerously large aggregate currency exposures for the economy. Making sure that the playing field of currency markets is level and visible to all participants is also an important regulatory job. Good regulation is difficult—bad regulation is easy.