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May 29, 2007



Your quote from Arvind Subramanian is incomplete. The whole right side of the quote is cut off.


It's about which corner of the trilemma you want to pick. The one with fixed exchange rates and free capital flows probably isn't the best one for India right now, or for most developing countries.

As an aside, usually the worst you can do is to ignore the trilemma and pretend it doesn't exist.


Given the joys of both floating and fixed exchange rates, does anyone have something to say about approaches like Keynes's proposed Bancor / International Clearing Union?

I always thought that the idea was intriguing, but don't really know how well it would work.

Michael Sullivan

I'm not sure I understand the problem with a high exchange rate, at least in the long run. A high exchange rate must mean that *someone* in the economy is doing very well, which should have spillover effects, unless they are reinvesting all their money elsewhere. But if the people with the most capital are investing money elsewhere, how does the exchange rate remain high? Only through foreign inflows which should have a similar effect on investment and demand, no?

Unless one's currency is being propped up by people who are holding it indefinitely as a hedge or for certain international market transactions (like people hold [$|E|Y]), it seems like the capital that props it up has to end up in that nation's economy. Since nobody of any significance is holding rupees for use outside India, for example, it strikes me that a market clearing exchange rate should generally be reflective of the underlying economy. IOW, capital that is propping up the exchange rate is also capital that is being invested or spent on consumption in India.

So the only danger is risk of devaluation should the capital inflows slow or stop. That's certainly a significant worry, but I'm not sure that artificially depressing the exchange rate is the best response, except in a world where other options are much too limited (say by TPTB at IMF/WB/etc.)

It seems to me that the chinese government, for instance is making a strategic mistake by holding dollars in an attempt to artificially deflate the currency. China's overall savings rate is already phenomenal, and they would run a huge surplus even without this. Individual savers would invest most of their capital (or consume more) within China and this seems like it provides essentially the same hedge (by creating more internal demand) but with no deadweight loss and no subsidy of relatively rich foreigners.

I don't see where the last 20 years have demonstrated floating exchange rates to be a problem which causes collateral damage. It seems to me that they merely reflect the underlying market realities, and it is those fundamentals that are good or bad for the economy.

Keeping the exchange rate artificially low essentially provides a subsidy to foreign consumers at the expense of domestic ones. In an emerging market economy where foreign consumers are generally much wealthier than domestic ones that doesn't seem to make much sense even from a whole world perspective, let alone a nationalist one.


I think it might be unfair to compare India and China currently. The IT-sector is much different from the mass-production sector we saw outsourced to China in the past. India is a hub for many different western companies looking to cut costs and they have proven themselves as a valuable tool for investors. Read this article and then get back to me.


Randy Kirk

Is financial liberation the cause of developing countries lending capital to the rest of the world or is liberalization correlated with this phenomenon?

The thesis here is the real economy is driving the situation in the financial markets. It follows, then the question: why are the real economies of developing countries growing currently? If we use the measure gdp = productivity * aggregrate hours worked, productivity is going up because of the importation of technology and the building of modern factories and service centers, and as people are moving in from the countryside to work in urban areas-- as was argued by Paul Krugman in his "Myth of the Asian Miracle." (1996)

According to the Dr. Rakesh Mohan, Deputy Governor, of the Reserve Bank of India: "The primary role of financial markets, broadly interpreted, is to intermediate resources from savers to investors, and allocate them in an efficient manner among competing uses in the economy"

There has been adequate capital in India for this purpose, as real growth rates have increased from the "Hindu" rate of growth (0.9%) in the 50's to 80's to 6% in the 1990's to near 9% currently.

Interestingly, according to the RBI,:
"It may also be noted that over 90 per cent of investment during this period was financed by domestic savings." So here we have the conundrum, noted by Larry Summers, Ben Berdanke, ("Global Savings Glut") among others.

I would argue that a very high percentage of the industrialization in India is for exportation of products and services to developed countries -- that is, India is "learning" productivity and technology from developed countries and are suppliers of developed technology back to developed countries. India is not inventing new technology on its own for the main part, for example, take Wipro -- well Wipro is a congrolmerate but software is its fastest growing business -- but none of Wipro's technologies are ahead of the leading US firms (yet). But Wipro is cheaper and that is its business model.

With many western style technological and manufacturing firms, it makes sense that these firms would export first abroad because, only 20-30 years ago India was 3rd world -- it still is to a large degree -- but who in a massively third world country is going to buy a "4th generation wireless adapter" when most people live without electricity?

So we have a situation in the real economy that demands technology importation, then export orientation at first -- over time a domestic consumer base should develop in India but it is still a bit too soon. The export orientation results in the trade deficit and therefore developing countries "lending" to the developed world.

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