No Cecily, do not omit the chapter on the rupee

In the "importance of Being Earnest" by Oscar Wilde, Miss Prism assigns her ward Cecily a book on Political Economy, but advises her that she may omit the chapter on the rupee, which Miss Prism finds "somewhat too sensational." In his latest column, Arvind Subramanian tells us it would be a mistake if we did the same today. For the recent travails of the Indian currency present a wonderful illustration of how democracy can generate the correct policy outcomes. 

Economic outcomes in pluralist societies arise from the interaction of different interest groups and institutions. Take the actors in this saga of the rupee each with distinct but legitimate objectives: the RBI, which is concerned with preserving monetary autonomy; the Commerce Ministry, which has to be mindful of the interests of exporters; the Finance Ministry, which is keen to promote financial efficiency and integration but is also acutely sensitive to safeguarding the public finances; and finally, the Economic Advisory Council to the Prime Minister, which presumably takes a broader view, aggregating and weighting the interests of each of these actors.

How did the process play itself out? The saga unfolds in three acts.

In act one, we had the RBI that, partly out of policy decisions to liberalise the capital account, especially for external commercial borrowings (ECBs), found itself in the unenviable situation of struggling to preserve monetary autonomy; the autonomy it needed to combat what seemed then (around April) like incipient but potentially damaging inflationary pressures. It responded by letting the exchange rate go, and the rupee quickly appreciated by about 10 per cent.

The consequences were predictable and predicted. The resulting appreciation led to a clamour for help from exporters. A spate of studies also started to suggest that the Indian growth machine would slow down because of the appreciation. So, in act two, the Commerce Ministry, announced a package of financial assistance—comprising duty drawbacks and cheap credit—amounting to Rs 1,400 crore.

While the budgetary consequences of this package are not immediately large or fiscally fatal (less than 0.1 per cent of GDP), it must nevertheless have been discomforting to the finance ministry—especially if the package were to set a precedent for future episodes of appreciation—which is justifiably keen to reassure a sceptical world that its stated fiscal targets will be met. The finance ministry has probably also come to recognise the tension between its objectives of furthering financial integration and maintaining fiscal prudence: increased capital inflows inevitably entail additional fiscal costs either in the form of sterilisation (to prevent appreciation) or explicit assistance to exporters (to address appreciation). Thus, in act three, the EAC recommended that the government should clamp down on ECBs, thereby trying to head off some of the future pressures for rupee appreciation.

The EAC’s intervention has been especially noteworthy as a contrast to the recent Mistry Report, which made a strong ideological case, with little empirical substantiation, for faster capital account convertibility. The EAC’s advice, on the other hand, seems to have been sensitive to the experience of the last few months, demonstrating the system’s capacity for learning by doing and, indeed, learning from over-doing.

Exemplary indeed. Something for central banks and treasuries elsewhere to ponder upon, and for all those democracy pessimists in the blogosphere to take note.

Comments

[hari]

From my experince with Indian Centre-State relationship (ie. federalism) externalities
of state borrowing has always been a serious constraint on RBI ability to manage monetary policy.
One, because given the federal nature of governance, opposition parties ruling in states can create problems for union govt at centre. I don't know exactly what's the percentage of state indebtedness today compared to centre's.

Politics is messy in India - like in any democracy with left-right pluralism - yet on balance RBI is able to impose its will on externalities as it affects monetary policy.

Current PM ( 1991, as finance minister, he initiated India's opening of domestic market or ending "license raj") and is also former chairman of national planning commission. And,as a professional economist, he's more than aware of India's weakest link,ie. the still subtantial rural population whose share of the national wealth is negligible. Political economy of India, in my view, demands still more unbalanced planned growth of the rural sector in order to overcome abject poverty. This remains the most serious political constraint for the ruling classes.

Compared to China, India cannot impose policies at the centre irrespective of democratic governance. This political constraint is magnified, as the country moves up the economic ladder....

[paine]

"all those democracy pessimists in the blogosphere to take note"

i want to know who's behind the open ECB flow
= domestic "real" sustainable bonanza claims
in an open society the struggle among interests
is also open
but it must be fought
by loud persistent ways
having the facts on your side
in policy debates
like innocence in court
are not enough

your agitprop
is the only effective counter to their agitprop

[Krishna]

That's way too effusive and congratulatory, in my opinion. Here's a broader view/perception of the Indian government from a respected domestic business journalist:

"Have you noticed something? The government has nodded off.

Policy debates, say, in economics, which matters more than foreign policy, have all but ceased. Except for the angry fuss around the rural employment guarantee programme two years ago, no one talks very much about anything relating to economic policy.

True, there is the odd quibble about the pace of this or the details of that. But no one, not even those darling pussycats, the Communists, who seem to have gone into quietus, is getting really anxious and jumpy any more about anything on the economic side.

This is the UPA Effect, because this coalition is the greatest pacifier ever, led by a man who can soothe frayed nerves as no one else can.

The technique is simple. You don't like something? There there, says the government, we will not do it, calm down, go and see a movie or something. When you come back you will find nothing has changed, promise.

Thus: Let's cut subsidies. No? OK. Let's privatise. No? OK. Give market access to someone other than you-know-who. No? OK. Reduce the EPF rate. No? OK. Do something about participatory notes. No? OK. Power sector reform? No? OK. Don't want us to keep saying OK to every no? OK.

And so it goes on. If even three ordinary people (let alone ministers) don't like something and shout their protest loudly enough, the idea is dropped. Nothing moves forward so as the world moves ahead, we get left behind.

This approach to consensual governance has had three effects, at the very least. First, the undeserving continue to get what they want. You can apply this test yourself and make a list.

Second, conversely, the deserving are being denied what they need. It doesn't matter which group. If you are deserving of something, you won't get it. Go on, make a list and see.

And, third, as a result, the majority is getting mighty peeved with a government that does absolutely nothing at all, good or bad. Indeed, this must be the only government--if one can dignify it by that name--of this kind in the world. It just floats along smilingly..."

http://www.rediff.com/money/2007/jul/28guest.htm

[jonfernquest]

Thank you. This is wonderful stuff to supplement any discussion of the currency appreciation problems many countries are currently experiencing.