Financial Express, August 22, 2013

An Indian Spring?

In my last column, I ended by suggesting that India can either have a true Indian Spring, with its economy and society blossoming, or instead something that veers toward what has happened in Egypt. What are the factors that will determine where the country goes? First, I want to emphasise that the current economic debate (now and perhaps forever labelled as “Sen vs Bhagwati”) has tended to miss the interaction of economics and politics. Prescriptions are sometimes offered as if by wise philosophers or technocrats, with the only issue being a sorting out of the facts of the growth process, or agreeing on the relative weighting of the welfare of different segments of society. How does politics enter into the evaluation of different policy options? 

The most obvious political process is the use of government transfers to buy votes. Empathy for the poor may matter for many of those involved in the intellectual debates, but a good first approximation to reality is that India’s politicians care most about getting re-elected. The policies that get implemented, in this case, are the ones that maximise the chance of winning the next election. India’s voters have to keep making it clear to politicians that subsidies and transfers are not going to be enough to secure their votes. There have been signs of this shift (rewarding performance over populism) in how Indians vote, and one has to hope this trend will continue.

But politics is also more complicated than that. Take Egypt, where democratic elections failed to lead to a stable, popular government, and the country is close to descending into chaos or repression. The winners of the election lost support not just, or even mainly, because they failed to deliver economic betterment. Instead, they were criticised for undermining the people’s recently-won freedoms. Basically, people want dignity and freedom as well as material improvement.

Economic reform in India has delivered an uneven mix of material and non-material benefits. For example, Dalit entrepreneurs seem to have gained on both fronts. Some of the middle classes have seen material gains, but erosion of their status and of traditional certainties. The upper crust of society has benefited disproportionately. And at the other extreme, many people in rural areas, especially in tribal regions, have seen their exploitation increase. This is a complicated story, with perhaps a couple of clear lessons. First, a majority of the population is frustrated with the corruption of, and exploitation by, those with political and economic power. Second, doling out money to win votes will not work as well as it used to, and will not stop the pot from boiling over. Social conflict in India will increase unless there is a quantum improvement in the quality of governance.

There is also another danger lurking. The growth-redistribution debate has only tangentially addressed India’s macroeconomic and financial sector policies. Here, the spectre of corruption also raises its head in the form of the government’s push to give new banking licences to powerful industrialists. But many of the problems have arisen from failure to execute the basics of macroeconomic management. The central government has not done a good job of managing its fiscal deficit, while the Reserve Bank of India (RBI) has gone backwards in managing inflation and the currency. RBI has failed to control inflation effectively, even as economic growth has not been protected. Government mismanagement of food and oil policies has contributed to the problem. Most recently, RBI’s attempts to control the exchange rate have ranged from pointless to damaging, undoing a longer-term program of creating a deeper and more robust financial system. The danger is that macroeconomic conditions will deteriorate rapidly, dealing a severe blow to the economy that will further increase social conflict.

RBI could have used earlier benign economic circumstances to push financial sector reforms that would have improved the functioning of a range of financial markets, improved financial access, and helped capital to flow to more productive uses. It did a little, but not enough, and the futile attempt to defend the rupee has undone some of the certainties of financial sector policy that should have been maintained. Confidence—a valuable commodity itself—has been eroded.

The incoming governor of RBI has a track record of speaking up for the right policies. Not long ago, he authored a vital report on financial sector reform, covering the issues from top (macroeconomic management) to bottom (financial access at the grassroots of the economy). He does not have to stand for re-election, and he does not have to rely on reappointment for his livelihood or prestige.

Raghuram Rajan has an opportunity to determine the nature of an Indian Spring, both through his immediate decisions on macroeconomic management, and through his shaping of financial sector reform over the next two or three years. What he says and does is what will matter much more for India than the shadings of the Sen-Bhagwati debate. He even has the potential to overcome the economic policy missteps of India’s politicians. Let us see what happens.

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.