The financial globalization debate, played out in India

Financial globalization was supposed to be a boon for developing countries: it would spur growth by providing much needed foreign capital, and it would help smooth consumption. Neither has happened. So proponents are taking a new tack, arguing that the benefits come indirectly, in the form of improved institutions and enhanced competition, which financial capital is supposed to stimulate. In today's WSJ, this argument is made by Eswar Prasad in the context of India:

The real benefits of financial globalization to an emerging market economy have less to do with the raw financing provided by foreign capital. Instead, the indirect "collateral" benefits associated with such capital are far more important. These indirect benefits may be crucial for India's development.

One of the key benefits is that openness to foreign capital catalyzes financial market development. Foreign investment in the financial sector tends to enhance competition, raise efficiency, improve corporate governance standards and stimulate the development of new financial products. For instance, in India, even the limited entry of foreign banks has already given domestic banks a much-needed kick in the rearside and forced them to improve their efficiency in order to compete and stay viable.

Liberalizing outflows has the salutary effect of giving domestic investors an opportunity to diversify their portfolios internationally. This means greater competition for domestic financial institutions but also an opportunity for them to cultivate the financial savvy to offer products that would help their customers invest abroad.

Other indirect benefits associated with foreign capital include transfers of expertise -- technological and managerial -- from more advanced economies. When supported by liberal trade policies, foreign investment can help boost export growth. Foreign-invested firms also tend to have spillover effects in generating efficiency gains among domestic firms.

I find these arguments not to be compelling, because they overlook what is in effect the most important collateral damage that openness to financial capital inflicts: the tendency for the currency to appreciate, with the usual adverse consequences for investment in tradables and for economic growth. If we should have learned anything from the last two decades, it is that the exchange rate is too important a price to leave to financial markets. Countries that open up to financial capital lock themselves into an inescapable dilemma. Either they let the currency float freely in response to the whims of financial markets, or they have to undertake very costly actions, such as sterilized intervention. Is this what India wants or needs?

No, according to Arvind Subramanian, Prasad's co-author and former IMF colleague, and I agree. For another take on India's policy options, and a much more sensible one, turn to Subramanian:

So, India cannot really follow China [and undertake costly sterilization on an ongoing basis] and yet, India cannot afford to neglect the real exchange rate. Commentators suggest that currency appreciation is less of a problem today either because exports are mostly of IT-services, where profit margins are large enough to absorb adverse currency movements; or because exchange rate changes reflect productivity developments and hence are not a matter for concern. But we have to beware of the “Bangalore Bug,” whereby currency appreciation driven by the productivity of skill-intensive services undermines the competitiveness of low-margin, labour-intensive manufacturing, which is going to be crucial for India’s long-run ability to boost employment creation. Here, we should be thinking of the incentives facing not just existing low-skilled manufacturing firms but also firms that are potential entrants into this sector. We have not yet sorted out the regulatory problems that would allow Indian unskilled manufacturing to come into its own but a necessary condition for that to happen is a competitive exchange rate, and one that is not determined entirely by the performance of skill-intensive services.

What should India do? Three policy responses, one each in the short, medium and long run, might be considered. All of these will make clear that "doing something" about the exchange rate is a call that is easier made than implemented. We should not harbour any illusion of easy, painless solutions.

The first follows from a lesson that is essential to absorb: India’s ability to manage the real exchange rate has been severely undermined by capital flows. There is no need for India to take further policy actions that will lead to greater capital inflow. Indeed, there may even be a case for tightening, especially of external commercial borrowings, which were surprisingly relaxed in the last year, and, if feasible, some tightening of other short-term (hot) flows. It has to be recognised, though, that major restrictions on capital flows will damage market confidence, and minor ones, while helping minimise future problems, cannot fully address current ones.

In the medium run, improving the fiscal position remains one of the key policy tools that can help counter real appreciation. Unlike monetary policy and sterilisation, which largely affect nominal variables, fiscal consolidation can increase domestic savings and hence exert downward pressure on the real interest rate, causing a depreciation of the real exchange rate. Fiscal consolidation is desirable in its own right, but the government should consider making a special effort at improving government finances in response to episodes of sustained appreciation.

In the longer run, the ability to sustain a competitive exchange rate will require strengthening the key factor that underlies value creation in India—its labour. This includes attacking the last bastion of the licence raj—higher education—to augment the supply of skilled labour. Wage increases averaging 12-14 per cent in the last few years signal emerging shortages in the supply of skilled labour. Policy actions also include, crucially, addressing the impediments—labour laws and better basic education—that prevent the utilisation of India’s vast pool of unskilled labour. Perhaps a deeper reason for China’s competitive exchange rate might simply be that it has used—more effectively than India—its vast pool of labour, which has kept a lid on wage growth and inflationary pressures.

India's continued growth will depend in no small measure on playing its exchange-rate card well, and that in turn will require that it take a very cautious attitude towards capital inflows.

UPDATE: Formatting problem with the Subramanian quote has been fixed. Thanks to happyjuggler0 for the pointer. I am beginning to hate Typepad... Truth be told, I picked Typepad because of Brad DeLong's site, but he seems to be able to do things with it that I could never imagine doing....

Comments

[happyjuggler0]

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

[notsneaky]

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.

[alex]

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.

[Dan]

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.

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[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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