What Next for India?

The Reserve Bank of India suddenly reacted to the continuing liquidity problems in Indian credit markets, by cutting the repo rate, the cash reserve ratio, and even the statutory liquidity ratio. This was a welcome reversal from last week, when the RBI governor was still musing about inflation dangers. Month-to-month WPI inflation is now basically zero, and with the global recession already under way, the year-to-year figures, which are very backward looking, will start coming down quickly.

The RBI governor was worried about the decline of the rupee contributing to domestic inflation through imports and pass-through. I really don’t see that as a big problem. Admittedly, the rupee has fallen dramatically against the dollar, but its rate vis-à-vis the euro is relatively stable, and I would guess that the trade-weighted exchange rate decline would look much less. I only hope that the RBI does not accompany its interest rate cuts with stepped up, or even continuing efforts to support the level of the rupee. Far better to let the rupee float, and give Indian firms more scope to hedge as they see fit, including through use of currency futures markets. India’s foreign exchange reserves should be saved for a crisis, rather than being used to subsidize currency bets. One can also add that the outflow of foreign funds has probably stabilized, so that source of pressure on the rupee should also diminish.

Ultimately, the financial sector’s job is to promote efficient investment and risk management, i.e., to put the economy on the risk-reward frontier. The RBI’s job is monetary management, including prudential regulation of parts of the financial sector. Ideally, one would like to see it simplify and clarify both its role and its regulatory approach and instruments. The real onus could then shift to the government, which has an enormous set of possibilities before it.

One issue is short-run growth. With a global recession, India will not stay insulated, and will see some slowdown. That slowdown would be exacerbated by a failure to deal with a lingering credit crunch. The RBI is addressing that threat with its latest policy moves. There has also been some discussion of fiscal stimulus through infrastructure investment. That may not be needed, and may be unwise when the government’s finances are already deteriorating. Spending on redistributive schemes has gone up, and the Sixth Pay Commission’s award will also increase government spending (though not in the most productive manner). In general, the government’s spending remains relatively inefficient. The best short-term moves may be further monetary loosening by the RBI – far better to be proactive than forever be fighting yesterday’s battle.

The big issue is India’s long-run growth. The RBI’s monetary management has to keep inflation in check and ensure financial stability (including sufficient liquidity, and monitoring capital adequacy). Monetary policy is not the determinant of long-run growth. It is the government that has to set the strategic direction and implement policies for sustaining growth. Suppose that India’s long-run growth potential is 8.5 percent per annum (based on current savings and investment rates and the recent record in terms of converting that investment to output). This year (2008-09), growth may slip to 7 percent. The next two years could be worse. So there is a challenge of even achieving potential growth in the short run. One can add the challenge of increasing the potential growth rate to 10 percent, which has been the recent policy target. How is it to be done?

Laveesh Bhandari has a nice article about India’s growth potential and sectoral opportunities. In particular, he mentions low-income housing as a huge need and opportunity. Interestingly, much of the recent real estate boom in India was at the high end. The RBI tried to control real estate speculation through the sectoral constraints it puts on the banking sector’s lending practices, but that is a blunt instrument. It is only the government that can really nudge investment toward low income housing, through tax policy, for example (but not through quotas or quantitative targets, which tend to be less efficient).

Bhandari also identifies information technology spending. He emphasizes the need for government to upgrade (in some cases, create from scratch) its backend IT infrastructure, with the payoff being improved efficiency and effectiveness of government. That is true, but there is also a huge opportunity for improving productivity in the private sector, by encouraging investment in IT. An empirical study I co-authored with Shubhashis Gangopadhyay and Manisha G. Singh unearths large productivity gains that can be achieved through the diffusion of IT among Indian manufacturing firms.

Bhandari also notes the huge potential in the education sector in India. His numbers focus on primary and secondary education, the current shortcomings of which are ultimately one of the largest constraints on Indian growth. But the political problems that need to be overcome will take time. In tertiary education, including vocational training, the fix is relatively easy, since the private returns are very large – open up higher education completely to private (including foreign) participation. I think the political problems here are overstated, and any politician who can take this forward will be an easy hero. Just as an education cess is being used as a surcharge on corporate taxes to fund government education spending, it should be easy to design a scheme whereby private entrants into higher education pay a tax that is used to shore up public higher education institutions, so that they are not victims of cherry picking. I would predict that a very large expansion of private sector higher education would take place, making it easy to cross-subsidize India’s puny effort in public sector higher education.

Finally, the Raghuram Rajan report has laid out a detailed blueprint for financial sector reform that will serve India’s masses. Even though the earlier Mistry committee report was focused on serving international finance needs, it has some great analysis of specific niches that would also be important for domestic financial services. From my perspective, there are all these policy no-brainers waiting for government to act.

The fact that this government only has a few months of life left suggests to me that it is in fact the perfect time to act boldly. Indian voters are not stupid. If the government just makes the usual giveaways, it is still likely to get voted out. An active agenda for stimulating private sector investment in areas where there are mass needs might just capture the electorate’s imagination. I realize that sounds a lot like the failed “India Shining” BJP campaign of 2004, so getting across the message that access to credit, education and housing can actually help the masses won’t be easy. Ultimately, though, the policy reforms are going to have to be made. As Bhandari points out, India’s domestic economic potential is great. He emphasizes the need for confidence. Confidence will flow from good policies and an effective political message.