V. Anantha Nageswaran
Social media is busy analysing S. Gurumurthy’s speech at the Vivekananda International Foundation on 15 November. He is a government nominee on the board of directors of the Reserve Bank of India (RBI). The board is meeting on 19 November, hence, the extraordinary interest in and reactions to his speech. It was an impressive speech and one that is thoughtful and thought-provoking, as always.
In principle, the idea that a country that faces a twin-balance sheet problem—in the corporate and in the banking sector—should have the option to consider a central bank-funded government expenditure programme is not that outlandish. It is conceptually correct. Problems arise in translating it into reality.
The developed world has always preached one thing to developing countries and done something else under similar circumstances. Faced with a balance sheet squeeze, America, the Eurozone, Japan and the UK engaged in monetization of government debt, even if it was not quite the monetization described in textbooks. But the all-important fact to note here is that financial markets allow them to do so. Financial markets do not extend the same courtesy to developing economies. It is partly unfair and partly with good reason.
It is unfair because financial markets constrict sovereign policy choices for developing economies. It is with good reason because it takes time for emerging economies to win credibility and the trust of investors. Once they are established, countries can and do abuse them and get away with it. However, it takes a long time for financial markets to revisit the risk-premiums they attach to assets of developed and developing countries. For better or worse, India is wired into international financial markets.
Even if India wants to raise walls for capital inflows and outflows, it cannot do so because it runs a current account deficit. It needs to be funded. It is one thing to say that India welcomes foreign direct investment (FDI), but it is another thing to find foreigners willing to supply all the external funding needs as FDI. India also does not want it to be all equity flows because ownership is a sensitive matter, but debt-funded external deficits are not ideal because they are not stable, but fickle flows. So, conceptually, Gurumurthy’s idea is correct, but practically it is impossible.
Hard-currency countries could get away with deficit financing which is what quantitative easing (QE) was about. Emerging economies cannot. There will be a heavy price to pay. That is the market reality. In other words, Gurumurthy ignores the counterfactual—the costs of pursuing such a policy for a developing country. QE was in the context of a Great Recession. But India has been claiming that it is the fastest-growing large economy in the world. Therefore, the government has failed to make the case for such a remedy in India.
Gurumurthy has zeroed in on an important fact of modern exchange rate regimes around the globe when he stated the following: “The Indian rupee gets expanded only when dollar comes in India and when the RBI acquires the dollar, it prints Indian rupees and gives it to the banking system. There is no other way the Indian rupee gets generated today.”
To be clear, India does not run a currency board system with the US. India is free to estimate its money supply needs and print Indian rupees accordingly. But emerging economies, in particular, regardless of whether they are in a fixed exchange rate regime with the US dollar, do expand their money supply when US money supply expands and contracts their money supply when US money shrinks. It is because the US consumer is the market for many economies.
Second, when US monetary policy is expansive, the US dollar tends to weaken and emerging economies experience foreign capital inflows. Global confidence and risk appetite are usually high when the US dollar is weakening. So central banks in developing economies tend to run expansive monetary policy then, to prevent their currencies from strengthening excessively against the US dollar as capital floods in. When the US runs a restrictive money supply, risk appetite turns south, dollar borrowing obligations begin to bite and emerging economies raise rates to prevent their currencies depreciating too much, too fast. Sometimes they succeed and sometimes they don’t.
So, the developing world, in particular, is still operating as though it is in a fixed exchange rate regime with the US dollar. It is partially true for India despite the fact that it has a large domestic consumption share of gross domestic product. It is hard to get away from this reality as long as the US is the world’s dominant consumer market, as long as India runs current account deficits and as long as India has to keep an eye on its external debt repayment obligations in any given year.
In short, while there is much conceptual merit in Gurumurthy’s speech, India is not in a position to embrace his ideas in practice because its economy is far from being strong. It has to raise its head slowly before striking out on its own. There might have been a time when India and China dominated the world, but that was when economies were labour-intensive and not capital-intensive. The Great Plague came and the world became capital-intensive. Economies rich in labour endowment have not figured out since then as to how to grow and regain their lost glories, Gurumurthy’s latest speech notwithstanding.
V. Anantha Nageswaran is the dean of the IFMR Business School. These are his personal views. Read Anantha’s Mint columns at www.livemint.com/baretalk.
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