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Avoiding Handicaps: Assessing Global Policy Advice for India

Aaditya Mattoo and Arvind Subramanian ("India and Bretton Woods II", EPW, 8 November 2008) offer useful suggestions for India's stance in global groups such as at the g-20. Subramanian ("Preventing and Responding to the Crisis of 2018", EPW, 10 January 2009) does the same for India's macro-policy responses following the financial crisis. But the arguments of the two sets of proposals are inconsistent. Mattoo and Subramanian want India to support a proposal to give the World Trade Organisation enforcement powers against undervalued exchange rates, but Subramanian wants India to follow self-insurance as China did. The reason for the inconsistency may be the authors' preference for India to follow the United States' interests in international negotiations, but to follow its own interests when domestic policy is involved.


Avoiding Handicaps: Assessing Global Policy Advice for India

Ashima Goyal

Aaditya Mattoo and Arvind Subramanian (“India and Bretton Woods II”, EPW, 8 November 2008) offer useful suggestions for India’s stance in global groups such as at the G-20. Subramanian (“Preventing and Responding to the Crisis of 2018”, EPW, 10 January 2009) does the same for India’s macro-policy responses following the financial crisis. But the arguments of the two sets of proposals are inconsistent. Mattoo and Subramanian want India to support a proposal to give the World Trade Organisation enforcement powers against undervalued exchange rates, but Subramanian wants India to follow self-insurance as China did. The reason for the inconsistency may be the authors’ preference for India to follow the United States’ interests in international negotiations, but to follow its own interests when domestic policy is involved.

Ashima Goyal ( is with the Indira Gandhi Institute of Development Research, Mumbai.

aditya Mattoo and Arvind S ubramanian (“India and Bretton Woods II”, EPW, 8 November 2008) offer useful suggestions for India’s stance in global groups such as at the G-20. Subramanian (“Preventing and Responding to the Crisis of 2018”, EPW, 10 January 2009) does the same for India’s macro-policy r esponses following the financial crisis. I shall call the first S1 and the second S2.

S1 want India to support a proposal to give the World Trade Organisation (WTO) enforcement powers against undervalued exchange rates, but S2 wants India to follow self-insurance as China did: keep a severely undervalued exchange rate to collect above $1 trillion in reserves. But following S1 will make it difficult to do what S2 wants! India is being asked to run a race with a handicap.

The reason for the inconsistency may be the authors’ preference is for India to f ollow the United States’ (US) interests in international nego tiations, but to follow its own interests when domestic policy is involved. What S1 want India to stand up for is almost never against the interests of the US. Thus, they seek to convince us that it is in our interest to call for coordinated currency intervention “to prevent any strong and sustained rise in the US dollar” (p 64), to “not merely give up the right to increase protection but to significantly open up its (our) markets to foreign trade and investment” (p 66).

Managing Exchange Rates

The US as the most developed and mature foreign exchange (FX) market has a free float. It wants to find more pressure points especially against the Chinese exchange rate. The latter’s close link to the dollar prevents a bilateral price adjustment that could help improve the large US trade d eficit with China. But emerging market economies (EMEs) need to manage their exchange rates. They cannot go for full floats since their narrow markets would otherwise be subject to excess volatility aggravated by capital movements. Moreover, the real exchange rate has to be relatively depreciated to the extent the average real wage is lower in an EME.

After the 1970s collapse of the Bretton Woods agreement on fixed exchange rates, countries are free to follow what exchange rate regime they choose; there is no enforceable agreement with the International Monetary Fund (IMF). According to S1, the WTO has a credible and effective enforcement mechanism, which could be used to force a revaluation. Since there are trade and distributional implications of undervalued exchange rates, which are equivalent to export subsidies and tariffs, the issue is relevant for the WTO. The IMF would continue to play the technical role of a ssessing whether or not an exchange rate is undervalued. But signing an agreement with the WTO seriously reduces flexi bility. Change at the WTO tends to get mired in endless negotiations. For example, an agreement signed against more regulation of financial services is a block now that the requirement for regulatory overhaul of the financial sector has b ecome obvious.

The asymmetry in S1 is revealing. They do not mention WTO action against overvalued exchange rates. The EMEs often struggle with overvaluation due to large temporary foreign inflows. If the WTO is to take action against undervaluation it must also be authorised to take action against overvaluation. But this would require regulatory action against volatile flows.

The authors encourage India to speak up, and participate in the debate on redesigning the international financial architecture and institutions after the financial crisis. Emerging markets had spoken after the east Asian crisis; a lot was said but it did not influence policymaking. The chief priority must be to realign the power and governance structures that make it possible to ignore diversity of views. Priorities are required for progress on the long todo-lists S1 and S2 produce.

After the east Asian crisis, while the a ffected countries largely accepted reform prescriptions for their own markets, they

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wanted more transparency and regulation for hedge funds, which were implicated in huge capital outflows during the crises (Goyal 2002). Outflows unrelated to the fundamentals of an emerging economy can follow inflows driven by excessive l everage. This sudden stop (Calvo 2005) can occur due to deleveraging, or just b ecause of a rise in emerging market risk premium, as a consequence of a crisis that originated elsewhere.

But the US Securities and Exchange Commission (SEC) actually moved in the opposite direction to the Asian requests. A 2004 bargain with investment banks gave them higher leverage. The net capital rule or the ceiling of 12 times capital placed on borrowing limits was removed, and investment banks allowed to self-regulate based on their own risk models. In return the SEC got regulatory oversight over the parent holding companies, but the oversight window was never used even as debt to asset ratios rose to above 30:1. The oversight was voluntary, at the institution’s choice. They had negotiated the bargain only in order to escape threatened regulation in the European Union, by closing a loophole in the modernising US GrammLeach-Bliley Act of 1999 that had left some entities unregulated.

The Bank of International Settlements (2008) estimates that notional amounts outstanding in derivatives grew from $100 trillion in 2002 to $516 trillion in April 2007 – an annual compound rate of growth of 33%. The US monetary accommodation has been blamed for excess global liquidity, but the broadest measure of US money supply for the period is about $15 trillion with an annual growth rate of about 6%. The growth in derivative securities was so rapid that since 2000, the market for mortgage-backed securities e xceeded that for US treasury notes and bonds. Comparing other sources of liquidity expansion, the net ownership of US assets by foreigners grew by about $1.5 trillion in the period, while the US current account deficit grew from $200 billion to $700 billion (Goyal 2009). Thus, leverage was partly responsible for massive volatile inflows affecting emerging markets.

In the absence of the required reform in the international financial architecture, major emerging markets had no choice but to accumulate large reserves of foreign currency, which have helped them in the crisis, but contributed to global imbalances. Even so, at less than $3 trillion, these were only a minor fraction of the financial leverage lax regulation created.

Sharing of Power

The not listening was partly a function of the dominant pro-market ideology, which caused a failure of regulatory will, so that Wall Street was able to successfully sell self-regulation. The few voices that raised concerns were ignored. But not listening has proved to be a severe loss for Wall Street, for the US, and for the world as a whole. Therefore, it is necessary to heed advice from diverse sources, but for this to happen power must be shared.

The way out of the inconsistency b etween S1 and S2, is for S1 to put more emphasis on reform in the international financial architecture. Then neither S2’s massive self-insurance, nor the seriously undervalued exchange rates to collect the reserves for the insurance and therefore S1’s WTO intervention are required. Examples of such reform are improved regulation that reduces excessive leverage and pro-cyclicality of capital flows, and creation of a special fund to compensate emerging markets for a sudden stop.

S1 discuss the meta-processes that drive global governance, and approve of the expansion of the G-7, but they want expansion based on the principles of regional representation and effectiveness. But inclusion must not be so broad as to make the group ineffective. The G-7 worked on the basis of economic power, even keeping that as the criterion sufficient diversity and countervailing economic power would be added. Expansion must be slow, with the effectiveness principle paramount. Adding the BRIC (Brazil, Russia India and China) countries is a sufficient beginning. Western domination of WTO, despite the one nation one vote, meant it reached decisions, but they were largely favourable to the dominating block. After serious countervailing power has developed there is no progress on decisions.

The lesson S2 draws from the crisis is that other crises are inevitable. And the lower impact on Chinese exchange rate and stock markets suggests Chinese levels

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of FX reserves are required as insurance. But the Chinese fixed exchange rate and trade dependence has meant a relatively greater fall in Chinese growth rates and employment.

S2 is right to recommend a rethink on the path to full capital account convertibility, and to point out the huge exchange rate volatility that would have resulted on following the recommendations of the R aghuram Rajan Committee and going for a full float. S2 is also right that some e xchange rate management will continue to be required, but not the undervalued fix and trillion dollar reserves that he r ecommends.

Fiscal Responses

S2 suggests that India halve its current d omestic debt/gross domestic product (GDP) ratio to give it the fiscal space to respond to future crises – the implication is that currently this space is lacking. The issue is important because of the widespread external perception that India’s limited room for fiscal response makes it among the more vulnerable eco nomies. Such a perception can raise risk premiums for Indian firms borrowing abroad and reduce fund inflow into India. This is ironic since India continues to have one of the highest growth rates in the world.

The debt/GDP ratio is currently 80% of GDP. It is not clear that this level of debt or the current rise in deficits is threatening. The rise in the fiscal deficit/GDP ratio by about 4% above the budget estimates for 2008-09 implies the fiscal stimulus of this magnitude is being given. A distinction should be made between the structural and cyclical deficits. At the present juncture, with private demand slowing, a c yclical deficit is needed. A high debt ratio does not preclude a fiscal boost. Since spending is required to remove bottlenecks and develop infrastructure, a structural deficit is required, but it should be reduced in good times, and the level of debt should be sustainable.

To associate high Indian deficit/debt r atios with higher risk is to extrapolate unconditionally from past crises in Latin American countries where these features were found together. These countries had low savings rates and low population d ensities. In India higher private savings

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compensates for government dissaving. In high population density emerging markets in a catch-up phase, such as India and C hina, labour share in productive occupations rises, and debt ratios fall.

In Asia a rise in income tends to raise savings more than consumption. In boom times investment may exceed savings but only marginally. So the current account deficit, which finances the difference between investment and domestic savings, remained around 1% of GDP in India. Capital flows much larger than the current a ccount deficit were accumulated as reserves. With these cushions of domestic and foreign resources available, temporary government dissaving is not threatening.

The more interesting question is what is the best way to bring down or at least stabilise the Indian debt/GDP ratio. The a nswer is, first, more efficient systems of tax collection, second, restraints on the composition of government expenditure, and third, maintaining growth rates and lowering the real interest rate. India does have improved technology-based tax systems, independent of government, that have delivered on the first, and more improvements such as goods and services tax (GST) are on the way.

The Fiscal Responsibility and Budget Management (FRBM) Act contributed to an improvement in government finances, which were on track to meet announced targets before the oil shock hit. But the episode exposed the inadequate attention paid to incentives and escape clauses in formulating the Act. Loopholes were found to maintain the letter of the law even while violating its spirit. Off-balance sheet items such as oil bonds were used to subsidise some petroleum products. Targets were mechanically achieved, compressing essential expenditure on infrastructure, health and education, while maintaining populist subsidies. The Act should be reframed to improve incentives for compliance. Expenditure caps that bite especially on transfers, while protecting productive expenditure, will create automatic counter-cyclical stabilisation as tax revenue falls and deficits rise in a slowdown. Induced change in the composition of government expenditure together with escape clauses will make the Act more credible.

Today interest rates are headed downwards and moderate growth should continue. Despite high government borrowing, lower inflows give the Reserve Bank of India (RBI) leeway to increase the share of government securities in the monetary base. Together with cuts in policy rates, open market operations (OMOs) through the term structure can ease pressure on interest rates. Diversified sources sustain Indian growth – domestic demand, agriculture, openness, technology, the demographic profile, the infrastructure cycle, and having crossed a critical threshold. As a net commodity importer India gains from lower global prices. Dependence on external demand is low compared to other Asian countries. So is the dependence on foreign capital. But although aggregate savings are high, about half of the household savings are in physical form, making it difficult to finance high government and reviving private borrowing. Slowdown in foreign funds may force development of the corporate bond market, and require RBI backing of credit to small and medium enterprises (SMEs) to better intermediate savings and raise India’s low credit/GDP ratio. Firms’ large external borrowing as norms were liberalised, began from a cash rich low debt position, so they can sustain higher risk premiums and exchange rate shocks.

Falling real interest rates and rising growth rates effectively reduce government debt. The primary deficit (PD) as a ratio of GDP (PD/GDP), which had, after many years, turned into a surplus in 200607, has increased to 2.5. This must be brought down, since nominal public debt, B, increases in any year by nominal interest payments on debt plus the primary deficit. The PD is defined as the non-interest budget deficit, while the fiscal deficit includes interest payments and is the total government borrowing requirement, or excess of expenditure over taxes. The change in the public debt income ratio b (B/PY) can be shown to be b(r-g) + (PD/GDP), where g is the growth rate of real GDP, and r is the real interest rate (the nominal interest rate minus inflation). Therefore, the public debt ratio rises with the PD ratio, the real interest rate paid on past debt, and falls with the rate of growth of GDP, which is its denominator. The PD ratio directly adds to the debt ratio if the real interest rate equals the rate of growth. For the debt ratio to stay unchanged, at the current PD ratio, the growth rate must exceed the real interest rate by 300 basis points.

Therefore because of improvements in tax collection, restraints from the FRBM Act, and trends in growth and real interest rates, I ndian debt ratios are unlikely to b ecome unsustainable, despite the fiscal boost. Just as I ndian savings rates are rising to Chinese l evels, Indian fiscal health can also approach Chinese levels if growth is sustained.

S2 gives us advice for the crisis of 2018, but India seems to have been well prepared for the crisis of 2008. The financial sector is healthy – free of toxic assets, r eserves adequate for self-insurance, d ependence on foreign capital limited through curbs on debt inflows, and equity outflows have taken out much less than they brought in. Some exchange rate flexibility has developed FX markets but prevented severe undervaluation. Growth rates are healthy and their reduction was driven partly by severe monetary tightening after the oil shock, and fear given the unprecedented global crisis. S2’s warnings on full floats and full c apital account convertibility are timely. Instead of trying to force Indian interests to match those of the US, S1 would do better to e xpand their points on the failings in US regulation, in the international financial architecture, and in global governance in order to allow both countries to gain from safer global engagement without a crisis in 2018.


Bank of International Settlements (2007): “Foreign Exchange and Derivatives Market Activity in 2007”, Triennial Central Bank Survey, December. Available at htm, accessed on 10 November 2008.

Calvo, G (2005): “Crises in Emerging Market Economies: A global Perspective”. Available at http://

Goyal, Ashima (2002): “Reform Proposals from Developing Asia: Finding a Win-win Strategy”, Chapter 7 in Leslie Elliot Armijo (ed.), Debating the Global Financial Architecture, SUNY Press Global Politics Series, under the general editorship of James Rosenau (New York: SUNY Press).

– (2009): “Financial Crises: Reducing Procyclicality”, Macroeconomics and Finance in Emerging Market Economies, Vol 2, No 1, March, pp 213-23.

Mattoo, Aditya and Arvind Subramanian (2008): “ India and Bretton Woods II”, Economic & Political Weekly, Vol XLII, No 45, 8 November, pp 62-70.

Subramanian, Arvind (2009): “Preventing and R esponding to the Crisis of 2018”, Economic & P olitical Weekly, Vol XLIV, No 2, 10 January, pp 32-36.

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