My macroeconomic catechism

Growing up in Delhi, like many of my middle-class contemporaries, I went to a Catholic school. There, we had classes in “Moral Science”, which I later realized was based on the Catholic catechism. I only recall that it began with “Who made all things? God made all things.” I did not care for the subsequent parts about all the types of sin and punishment, but the simplicity and certainty of the formula was appealing. If only we could have the same for macroeconomic policy in developing economies. It might go something like this, for India.

Can India have an open capital account, a fixed exchange rate, and control of domestic inflation?

No, it cannot. Nor can any economy.

How does China do it?

China relies on domestic financial repression, artificially controlled interest rates and quantitative controls, something India has moved away from. As a result, India’s banking sector is probably much stronger than China’s.

Then what should India choose?

If inflation control is a political imperative, India would have to choose between capital controls and exchange rate flexibility.

Why not a bit of both?

In practice, that is what many economies do. Certainly, managing short-term volatility and possible speculative bubbles are important. But ideally, controls must be simple, transparent and not destructive of investor confidence. The hardest part is sticking to any fixed band for the exchange rate, if the market has other ideas. It can be like walking a tightrope.

Since there is no strong evidence that foreign capital enhances growth in developing countries, why bother with it?

Foreign direct investment (FDI) is the exception to that negative picture, and seems to have positive growth effects. Perhaps this is because FDI is accompanied by inflows of technical and managerial knowhow, and is less likely to be wasted, stolen or otherwise directed to unproductive uses.

But can’t FDI go into areas such as real estate speculation?

That is a general macroeconomic issue, and not specific to foreign capital. Foreign capital can amplify speculative asset bubbles. Controlling such bubbles is probably best done through managing overall credit conditions with monetary policy, backed by sound financial regulation. (Note: even advanced economies can mess up—the US housing bubble was exacerbated by poor regulation of mortgage lending practices.)

So, aren’t you saying that domestic financial institutions matter the most?

Yes, that is exactly what the evidence suggests. The tough question is whether openness to foreign capital inhibits, supports or is neutral with respect to the development of domestic financial institutions. Even in the first case, forward-looking policy can rectify the negative impact. The growth benefit of developing the domestic financial sector is another reason India should not go back to financial repression.

Going back to the exchange rate, didn’t the rupee’s appreciation last year hurt exporters?

Yes, it did, especially those who export to the US—remember, though, that the dollar has been depreciating against most major currencies. Part of exporters’ problem was the suddenness of the fall.

But if the rupee stays high, will this not hurt growth—after all, wasn’t the East Asian miracle helped by undervalued exchange rates?

Recently, Dani Rodrik, at Harvard, has marshaled empirical evidence for this view, and tried to explain the growth benefits of an undervalued real (that is, the market rate adjusted for differences in purchasing power) exchange rate. The explanation relies on the idea that market or institutional failures may affect sectors producing tradable goods mo re severely, so that the tradable goods sectors are too small to maximize growth. An undervalued real exchange rate may correct the problem. But, as Rodrik recognizes, the exchange rate is a blunt instrument, and manipulating it is an inferior policy to fixing distortions directly. Furthermore, India’s situation, and the global environment, may not be comparable to what characterized East Asia decades ago.

What about China’s current success?

China uses capital inefficiently, and has a different political system within which to pursue its growth strategy.

But don’t political constraints in India leave the ‘undervalued exchange rate’ approach as the best feasible option?

If they do, India’s policymakers need to acknowledge this explicitly. Is the RBI able to say that it is being forced to follow suboptimal monetary and exchange rate policies because the Centre cannot fix the economy’s real problems? Not likely. The RBI should not be forced to walk a tightrope with the politicians’ burden of generating sustained growth in output and employment.

So what should the government do?

Let the RBI serve its proper role—managing price levels and the banking system’s health. Encourage the RBI to let go of some of its unnecessary controls, and work with it to continue reforming the financial sector, trying to bring down transaction costs so that credit starts reaching the rural economy more deeply. Take its own policy actions to stimulate private sector job creation.

Are there any dangers?

The political dangers of acting are probably overrated. The danger of not acting sensibly is that the RBI, and the economy, could fall off the tightrope. That would not be as bad as eternal damnation, but painful nevertheless.