What 2014 won't change

Indian Express, 26th November 2013

There are no more stroke-of-the-pen economic reforms, no shortcuts

That a change in government in 2014 will bring back the higher rate of GDP growth that we experienced a few years ago is an increasingly popular view. While there may be an upturn in exports, due to the recent depreciation of the rupee and the pick up in the US economy, and some improvement in domestic investment, sustaining a high rate of growth requires longer-term solutions. These solutions are not difficult, but could take some time to put in place. In the meanwhile, GDP growth may still pick up a little in 2014-15. There are two components of the slowdown: the trend growth rate and business cycle conditions. While the business cycle conditions may improve in the coming months, the trend growth rate remains a problem.

Has India's trend growth rate slowed down? Long-term trend growth rates of economies, such as a 30-year average growth rate, have been one of the least understood and most unpredictable variables in the field of economics. The accumulation of capital, human capital, institutions, rule of law, infrastructure, political systems, and productivity growth change in ways little understood by economists even today. Their impact on long-term growth remains even less understood.

Scandals in the allocation of spectrum, coal blocks and land, and projects that have been stalled due to environmental clearances have certainly worsened the medium-term growth rate. But if these factors affect the long-term trend it implies that India does not have the institutions it needs to solve these problems. Despite all the gloom and doom, this is a view that is hard to find. One of the characteristics of Indian democracy is that even though it takes time to build the state's capacity, which is one of the biggest challenges that needs to be surmounted in order to deal with the issues of the day, it is not impossible to do so.

Recent problems have highlighted the limitations of the Indian state's capacity. For example, stalled projects are a major reason for the slowdown in investment today, which is in turn responsible for slower growth. But the growth in investment can only become smooth if there is a serious change in the way in which firms interact with the government. The state's capacity needs to be enhanced and it needs to move away from the old systems that were designed to function under the licence-permit raj.

For example, had proper legal, regulatory and policy frameworks been in place for the protection of the environment, so many projects would not have been stalled. The fast pace of GDP growth meant that there were suddenly several projects where the trade-offs between growth and environmental protection became pressing. Due to the lack of set standards and regulatory mechanisms, each project had to, on a case-by-case basis, be cleared by local, state and Central bureaucrats, many of whom did not understand the basis on which a clearance was to either be given or withheld. The number of projects stuck in the pipeline became greater. It is the lack of a policy framework that scares bureaucrats from clearing projects today.

With the right institutions, there would have been no need for a Central body to clear stalled projects. Many clearances have been given by the Cabinet Committee on Investment. Others will also be given. But does this mean that the problem is solved? That in the future, projects will not get stuck? Unlikely. Without a change in the legal and regulatory framework, India cannot thunder ahead at a 10 per cent growth rate for 30 years like China has done. The demands for transparent and non-discretionary systems for the allocation of resources like land, spectrum, mines and contracts, for well-designed regulatory frameworks, and for clearly defined policies are likely to increase in the coming years. But building the state's capacity is unlikely to be a quick process. Indeed, if it were, then it is less likely to provide us with frameworks that can pass the test of time.

What is this process of change and why might it take so long? The process of financial sector reform is an illustrative example. First, we faced a problem. Slowly evidence started to build up that the problem was not an isolated incident. Then the media, think tanks and academics analysed the data and identified deeper problems. This was followed by committee reports, which involved broad consultations and offered recommendations. In the case of the financial sector, committees such as the Raghuram Rajan committee, the Percy Mistry committee and the U.K. Sinha committee helped form the consensus on the reforms needed. Many changes were made and often legal hurdles came in the way. The government then set up the Financial Sector Legislative Reforms Commission (FSLRC) to review the existing laws. The process of writing a draft law involved studying all the existing laws relating to finance. A full-time 30-person research team of economists and lawyers at the NIPFP supported the commission. After consulting more than 170 people, creating various working groups that analysed specific problems and many long meetings of the commission, a broad consensus was formed on most issues.

The FSLRC submitted its report after the designated two years. The process of legal change will take at least another two to three years. The setting up of the new regulators and the framing of the relevant rules under the new laws are likely to take even longer. Hundreds of regulators, lawyers and judges will need to familiarise themselves with the new legal framework. Companies will need to reinvent themselves.

In the case of financial reform, one can argue that there is at least some consensus. In other areas, the problems are more recent and there is no clarity on what needs to be done. The process of change will therefore take longer. As it should.

India has seen the slow and gradual build-up of the state's capacity. There are no more stroke-of-the-pen reforms left, there are no shortcuts. Hopefully, we will be lifted out of the present downturn thanks to an upturn in the global economy. But we will need to build frameworks to create a healthy interaction between firms and the state. Today's system was designed for a command and control economy. That will hopefully change over the next few years and keep India's trend growth rate high.

Inflation-targetting is critical

Financial Express, 25th November 2013

After some months of a falling WPI-based inflation, the numbers have picked up again. Food inflation has risen, but the full pass-through of a depreciated exchange rate is yet to be seen and may push up non-food WPI inflation as well in the coming months. The Indian inflation story can, at best, be summarised as one where the monetary policy stance has failed to anchor inflation expectations in the economy. Among the main problems have been Reserve Bank of India's multiplicity of goals, instruments, lack of transparency in monetary policy strategy, and poor communication efforts. Looking forward, an effective strategy to combat inflation depends on a public announcement of the medium-term numerical inflation target, a clearly articulated commitment to price stability as the sole target of monetary policy, a well-espoused instrument of monetary policy, and an accountability (to the Indian public) mechanism.

One way to move ahead is to keep the framework informal, where RBI chooses to do the above depending on the willingness and the political clout of its Governor, which Raghuram Rajan is, no doubt, well-placed to do. The other is to enact it as law. Most inflation targeting countries include the objectives of monetary policy in the law. This helps to build credibility of the framework and create channels of accountability. Despite similar monetary and fiscal environments, evidence suggests that those who have clear inflation-targeting regimes are better able to achieve low and stable inflation than those who do not have an explicit inflation-targeting framework in place.

February 2006 onwards, inflation breached the upper bound of 5%. It has never come back to the below-5% levels. If our informal goal was to get inflation between 4% and 5%, we have failed to do this as measured by average inflation from 1999 onwards.

Undoing the benign inflationary environment till December 2007, the global commodity prices environment drove prices upwards across all emerging market economies, including India. However, India has been singled out for the speed with which present inflation feeds into its inflation expectations. In other words, it is likely that economic activity will incorporate present inflation as one that will persist into the future, thereby delivering high inflation in the future as well.

The question of anchoring inflationary expectations depends on two critical factors: the magnitude and timeliness of response to prevailing inflationary conditions. Has RBI done enough to anchor inflation expectations? To explain this, Riccardo Christadoro and Giovanni Veronese of the Banca d'Italia compared the present short-term interest rate with what would be obtained by the Taylor Rule since January 2008. Except for the third and fourth quarter of FY09, where the interest rate set by RBI was much lower than prescribed by the Taylor Rule, on all occasions, interest rate changes by RBI were at least two percentage points lower than what one would expect to combat inflation. On the one hand, interest rates were not high enough in India during inflationary conditions and on the other, lower than required during the two quarters of extreme global conditions.

It is important to note that this analysis does not exclude growth concerns as the Taylor Rule responds to output gap as well. Some studies have also suggested that the output gap dominates inflation in determining movements in policy rates in India. It may now well be the occasion to rebalance this prevailing bias in the monetary policy rule of RBI.

What can be done? Whether inflation is initiated by higher food prices or otherwise, monetary policy has a role to play if general inflation fears get embedded in expectations. The world adopts several approaches to combat this problem. Several peer economies have adopted a clearly articulated monetary policy strategy to combat inflation. Brazil, for example, has had a long history with inflation and inflationary expectations. Brazil and more than half of the emerging market economies, at various points in time, have adopted similar strategies to combat this problem. Detailed studies generally suggest that when otherwise similar emerging market economies are compared over same time periods, key macroeconomic variables such as inflation and output performed better in countries that adopted this framework compared with those that did not. Taking a leaf out of its peer central banks across the world, RBI could pursue price-stability through a multi-pronged strategy:

*Public announcement of a medium-term target: The first step towards clarifying the intent of monetary policy is the public announcement of a medium-term inflation target. This acts both as an information to the market and as one that holds the central bank accountable. There has been some progress on this. Rajan has recently announced a 5%-WPI target. At some point he will need to move to a CPI target, but for the time being, this is better than the RBI policy before his announcement.

*Defined instrument of monetary policy: The second step in the process of anchoring inflation expectations is laying emphasis on a short-term interest rate as the tool. RBI is expected to move to the repo rate as the tool. But today, this is not solidly in place. Hopefully, the Urjit Patel committee will be able to clarify this.

*Articulated commitment to price stability: A well-articulated commitment to price stability will not have the RBI Governor opposing the idea of price-stability being central to the functioning of RBI. This has been witnessed repeatedly since 2008, and is now being reversed by Governor Rajan. RBI needs a shift in emphasis away from the exchange rate to price-stability in all its communications. The market will need to understand that what drives RBI policy is not keeping the rupee stable in the short run, but ensuring low inflation (which will keep the rupee stable in the long run).

*Accountability mechanism: This requires a clear monetary policy law where the central bank is given the responsibility of achieving price stability while not being burdened with conflicting objectives. This is the way forward.

Trial by taper

Indian Express, 13th November 2013

We need to prepare for the end of QE. Keeping inflation low is our best bet.

US job data for October showed higher employment growth than was earlier expected. This good news sets the stage for the US Fed to reduce quantitative easing. However, the uncertainty over the US debt deal means that this may not happen until March 2014. Still, sooner or later, the tapering will start and emerging economies like India have to be prepared for it. The tapering is likely to take a while to complete - it may be a few years before the Fed gets back to a normal monetary policy. For India, this means that the preparation to deal with it must be in the form of a framework of sustainable policies, rather than temporary measures. Low inflation, fiscal consolidation and addressing the structural problems of growth offer sustainable solutions. While quantitative measures and restrictions to control the current account deficit only offer temporary quick fixes.

The market's reaction to the May 22 "tapering speech" by the Fed chairman, Ben Bernanke, was more extreme than anyone had expected. One, long-term interest rates in the US went up immediately and two, capital flowed out of emerging economies (EMs), resulting in the sharp depreciation of their currencies. This was especially the case among those economies that were more vulnerable due to large current account deficits. Many EMs resisted the depreciation, either with an interest rate defence or, as in India's case, with a series of capital controls and other restrictions on foreign exchange markets.

These knee-jerk reactions were often ineffective and in some cases made the depreciation even sharper. Exchange rates overshot and sentiments worsened. It is inevitable that the US Fed will, sooner or later, have to reduce the purchase of government and agency bonds, which it is currently undertaking. Currently, the Fed is purchasing bonds worth $ 85 billion per month. Any signal or action from the Fed - including about whether its bond purchase programme will be reduced gradually or sharply - is bound to affect global financial markets.

There is a strong possibility that the inevitable tapering has already been factored in by financial markets. There is no doubt that the Fed's communication will be far more careful now, so as not to generate expectations that it's going to suddenly end all purchases. US long-term rates have already risen and may remain stable. EM currencies have also depreciated in comparison to their mid-May exchange rates and may not depreciate any further. However, there is, say, a 20 per cent probability that when the tapering actually begins, financial markets will once again see high volatility, US long-term rates will increase and EM currencies will depreciate further.

This time, EMs must not be caught unawares. The question is: how can they prepare for this event? Countries with high inflation, such as India, were the most affected this summer. They also tended to have high current account deficits, as rising inflation with stable nominal exchange rates had rendered their exports uncompetitive, while imports became more attractive. The real appreciation in the exchange rates needed correction, which happened rapidly when there was a sudden reduction in the inflow and increase in the outflow of capital. The depreciation of the nominal exchange rate was, therefore, an adjustment that was on the cards to the extent that it would help correct the current account deficit.

High current account deficits and inflation are, in many cases, the consequences of the expansionary fiscal and monetary policies that were followed by many EMs in the years after the 2008 crisis. In 2009 and 2010, many EMs, including India, in an effort to offset the demand contraction arising from the decline in exports and private investment, implemented expansionary fiscal policies. For example, India cut tax rates and raised spending. This fiscal expansion was accompanied by a loose monetary policy - interest rates stayed too low for too long. Though the RBI raised nominal interest rates, the 13 hikes of 25 basis points each were too little to push up real interest rates, as inflation was rising faster than the nominal rate. This resulted in a further rise in inflation.

In order to prepare for the beginning of the end of quantitative easing, inflation must be brought under control. Global inflation is low. If inflation in India continues to be higher than our partner and competitor countries, as it has been in the years since 2008, there is a high probability that Indian exports will become uncompetitive, imports will become more attractive and the trade deficit will rise. When the tapering begins, the rupee could depreciate suddenly, create balance sheet mismatches for firms that have borrowed abroad, push up oil prices or subsidies and raise inflationary expectations. Countries that have kept inflation under control have less to worry about, due to a smaller impact on their exchange rate and a less adverse effect of a depreciation, were it to occur, on inflationary expectations.

Reducing inflation, in what might be a short window before the tapering starts, is not easy. Inflation has been high and persistent for nearly four years now, and inflationary expectations are heavily entrenched. The RBI governor, Raghuram Rajan, is moving in the right direction by focusing on inflation. This is the sustainable path to reducing the current account deficit and India's vulnerability to a sudden stop in capital inflows. Consumer price inflation in India has been above the RBI's target levels of 5 per cent since 2006. It has been rising ever since, and not enough tightening was done in 2008-09 to pull it back on track. Bringing inflation down will be a slow and painful process. It will be helped by the slowdown in demand because investment has slowed down sharply. The need to raise rates may not be as pressing as it otherwise might have been. However, if savings are to be raised, gold imports to be genuinely reduced (rather than simply re-routed through smuggling) and investment activity revived, low and stable inflation is a necessary condition.