No escape from freedom

Indian Express, 3rd March 2014

A closed capital account is not a real option. We should focus on sequence and timing.

In his article, 'Against the flows' (IE, February 24), Gulzar Natarajan said capital controls were good and necessary. Liberalising our capital account, he claimed, will not benefit India either through higher growth or investment. It will only result in currency crises and higher risks, which we cannot manage.

India must, therefore, not liberalise its capital account - even the IMF has endorsed this line of reasoning according to Natarajan. But this argument ignores India's de facto capital account openness, the aspirations of a young and ambitious country, which does not want to go back in time, and the enormous body of evidence on the failure of capital controls as a tool of macroeconomic policy.

Economists like to think that there is a debate about capital account openness and that a decision about whether it should be open or closed is yet to be made. But this is not what happens in the real world. In the real world, a maturing country develops a capable financial system and sophisticated firms. It develops a liberal democracy, where the government is unable to interfere in the freedom of citizens. Once a country reaches this state of maturity, the capital account is de facto open.

Whether some economists think it should be open or not, in the eyes of the top 10 per cent of India - which makes decisions for the bulk of the economy - the capital account is open. To close it requires intruding on personal freedoms, inflicting harm on internationalised firms, and damaging the financial system.

When some Indian bureaucrats have argued in favour of a closed capital account at international forums, they have faced amusement from the audience. No country has taken this idea seriously. This so-called "lesson from the global financial crisis" is something no one is interested in learning. There has been no reduction in capital account openness - either among advanced countries or among emerging markets - after the crisis. The free movement of goods, services, ideas, capital and enterprise across national borders is an integral part of modernity.

Capital controls in emerging economies, where they exist, are like tariff or non-tariff barriers that can be switched on and off. They can be price- or quantity-based. Most evidence shows that these controls have little usefulness, both in terms of the time period for which they are actually effective, and in terms of their macroeconomic impact, which is limited and short-lived.

Advocates of capital controls have argued that their failure to deliver results is because they have been temporary. It is contended that permanent controls, which intrude deeply in the functioning of the economy, would work better. India is a rare laboratory that permits restrictions on capital flows.

The present Indian framework is a complex licence-permit raj. It is unlike what is found almost anywhere else in the world. We, in India, know that complex licence-permit systems always work badly, and are almost allergic to the thousands of pages of detailed restrictions.

Have Indian capital controls been effective? The effectiveness of controls is an often-misunderstood concept. We should measure whether they were able to achieve the objective that they were imposed for. If the all-in-cost ceiling for external commercial borrowings (ECB) was reduced from Libor plus 400 basis points to Libor plus 200 basis points, then the question to be asked is not whether borrowing went down. Instead, it should be whether this decision was able to achieve the objective of the restriction - for example, to reduce net inflows. All too often, companies respond to controls by simply changing the garb in which the same capital flows.

If companies moved from pure debt under ECB to foreign currency convertible bonds, the same money would come into India under a different name. One could then wrongly argue that the controls were effective because flows under ECB declined after restrictions were imposed. But the original objective - reducing overall inflows - was not met. Careful analyses of effectiveness have demonstrated that the Indian framework has not delivered on the objectives of macroeconomic policy.

Natarajan's article is about the least interesting end of the capital account openness puzzle. There are two interesting questions to be asked. First, in what order and sequence should controls be removed? Second, what auxiliary actions should India undertake in order to become resilient to the new challenges that an open capital account introduces? If you have air travel, you will have plane crashes, and the country will need to develop the institutional capability to respond to crises. It is interesting and important to understand the regulatory framework required for aircraft and airports. But surely, nobody would propose that we should not have planes.

This takes us to the territory of technical questions that generally do not fit neatly in opinion pieces. What does prudent foreign borrowing mean? Should rupee-denominated debt continue to be more restricted than foreign currency-denominated debt? How can companies be encouraged to hedge their currency risk? How can we help markets for hedging develop? And so on. These are the interesting questions in the field of capital controls - not ideological sloganeering about whether capital account liberalisation is good or bad.

To a significant extent, this is about generational change. One generation ago, it was interesting and fashionable to discuss whether India should liberalise its capital account or not. Things have changed. We are now a $2 trillion economy, with capable global firms, with aspirations for a sophisticated financial system, with a liberal democracy that makes it infeasible for the government to arbitrarily restrict the freedoms of citizens. In such a country, what merits attention is the sequence and timing of capital account liberalisation, and the establishment of institutional capability for fiscal, financial and monetary policy.

Hold on to interest rates

Financial Express, 1st April 2014

The impact of tighter fiscal and monetary policy on inflation is now visible in the recent price data. Inflation, measured both by the wholesale price index and by the consumer price index, has come down. It may still be too early to cut rates, but RBI Governor Raghuram Rajan can now afford to hold rates unchanged in today's monetary policy announcement. His strategy of an aggressive attack on inflation, despite the scepticism often voiced in the Indian monetary policy debate about the effectiveness of monetary policy, was the right strategy and is yielding results.

Considering that inflationary expectations in India are high and persistent, and could take a while to come down, Rajan should not cut the repo rate as yet. If the WPI inflation measure is the target, there is a case for cutting rates since this has come down sharply. However, the CPI, the target towards which the RBI sensibly appears to be moving, is still above 8% and there is fear that it may go up due to unseasonal rains. Also, CPI based inflation has not remained low long enough for inflationary expectations to fall.

The fiscal and monetary contraction of the last 9 months, as well as the slowdown in the economy, have contributed to the reduction in inflation. In this environment, effective communication by RBI that its focus will be on inflation control, has played an important role. In addition, the setting up of the Urjit Patel committee and its view that RBI should adopt inflation targeting has helped counter some of the traditional RBI view that monetary policy has no impact on inflation, that India has a weak monetary policy transmission mechanism so there is no point in trying to raise rates, that inflation in India cannot be measured properly and so on.

The war on inflation is still not won. The present dip in inflation must be sustained for many months before RBI can relax. Despite the fall in GDP growth, the consequent slowdown in demand, and the fall in commodity prices, Indian inflation is higher than what is seen elsewhere in the world. Inflation in food has contributed most, but inflation in non-food has also been sticky.

Looking forward, there is a contradiction between RBI's aggressive stance on inflation and its intervention in the foreign exchange market. RBI's stance on monetary policy could be undermined by its intervention in the foreign exchange market. In recent weeks, RBI appears to be intervening in the foreign exchange market to prevent the rupee from appreciating. The extent of intervention and its sterilisation is not known yet. If the intervention is unsterilised, then it would lead to an increase in liquidity and would pull down interest rates even without a monetary policy announcement. Indeed since RBI's monetary policy is not conducted only through the interest rate instrument, but also through its intervention and sterilisation, something that the Governor does not announce with the policy stance, it has been seen in the past that while actions on the policy rate move in one direction, the liquidity conditions in the market can move in quite the opposite direction. This was the story of the mid-2000s, when RBI was intervening in the foreign exchange market to combat rupee appreciation and raising the repo rate at the same time to fight inflation. Its intervention was only partly sterilised and was pumping liquidity into the system pushing up inflation. As a consequence, the policy rate hikes were ineffective.

Inflation targeting countries usually solve this problem by adopting a flexible exchange rate. In other words, the exchange rate is allowed to move, while inflation is stabilised. Sometimes there may be occasional sterilised intervention by the central bank. However, central banks that target inflation do not pursue pegged exchange rates for long periods. This means that they do not require resources for sustained sterilisation. While the Urjit Patel committee has proposed that RBI target inflation, it has also proposed that the central bank should get unlimited sterilisation powers. Occasional foreign exchange intervention and sterilisation to contain volatility do not require unlimited sterilisation capacity. If RBI is move to an inflation targeting framework, it cannot plan to do unlimited sterilisation. The People's Bank of China, the Chinese central bank, which targets the exchange rate, has such powers. Other central banks do not have such powers as these are inconsistent with the mandate of inflation targeting. In other words, if RBI is to seriously adopt inflation targeting, it must give up on pegging the exchange rate. Trying to target inflation and exchange rate simultaneously on a sustained basis is inconsistent.

A further consideration in the decision about the stance of monetary policy would be global liquidity considerations. Janet Yellen's recent comments suggest that the US Fed could start raising rates next year. As long as the US monetary policy remains unconventional, i.e., until the time comes when the FOMC discusses and decides policy interest rates rather than the purchase of bonds, it remains in uncharted territory. Low inflation, along with a low current account and fiscal deficit, would be a more prudent policy, as there could be sharp and sudden changes in US and global liquidity conditions. This may prompt RBI to keep interest rates unchanged.

Open up the capital account

Financial Express, 15th March 2014

India's path to capital account convertibility will be an important question for the new government. Left thinkers have attacked financial globalisation, pointing to the risks it brings to emerging economies, especially after the financial crisis. For the new India with world class multinationals, with a skilled labour force and the potential for becoming an international financial centre, the Left arguments perpetuate backwardness. The next government needs to move forward with rationalisation, liberalisation, removal of bureaucratic overhead, and establishing the rule of law so that Indian companies and citizens have greater freedom to manage their finances and access to world-class products and lowest prices. Missteps on this process will generate shocks to the exchange rate and to the economy.

India has a large and complex system of permanent and pervasive capital controls. Numerous agencies have been given powers to interfere with cross-border transactions. It is often not clear why certain controls are in place. For India to succeed, the relevant question is: How to open up sensibly?

The first element for policy is the hygiene of good governance. The principles of transparency, accountability and rule of law, which have gained prominence across all parts of the working of the state, are equally relevant here. Across the landscape, there is unhappiness about the bureaucratic overhead faced in doing simple things-it is time to slash the red tape and simplify procedures. This is just the hygiene of sound public administration. The government is in the process of voluntarily implementing the governance-enhancing features of the Indian Financial Code that was drafted by Financial Sector Legislative Reforms Commission (FSLRC). These will yield major gains when applied to the working of capital controls.

Percy Mistry, whose report argued for making Mumbai an international financial centre, has long reminded us that there are no accidents on a village road not because the traffic police is effective, but because there is no traffic. Whether we should have financial globalisation is no longer a question for India. The question now is: How can we open up to the world and, at the same time, undertake measures to become strong and

resilient? For example, steps to increase the liquidity of derivatives markets, removing caps on rupee-denominated debt and enabling firms to hedge their foreign currency exposure will make the economy more

resilient. Engagement with the world introduces new risks-and the best way to deal with those risks is to have deep and liquid markets as shock absorbers. So far, RBI has prevented the emergence of a deep and liquid market for the exchange rate and for bonds. This needs to be reversed.

In the minds of some policy makers, there is the idea that capital controls can be switched off and on at will, based on the movement of the exchange rate that is desired. This idea is flawed at numerous levels.

First, the existing evidence shows that these attempts at tinkering with capital controls do not yield the desired impact on the exchange rate. The hoped-for outcome is not realised.

Second, there are important costs. To make an analogy, consider the export of onions. If India repeatedly switches off and on the export of onions, this frustrates the development of sophisticated firms with long-range contracts and a deep understanding of the international onion trade. In fact, the very possibility that a government might shut off a business hinders firms from investing in developing those capabilities. If the government threatened that they would shut down barber shops in the future at whim, there would be fewer and inferior barber shops.

Participation in the global onion trade requires complex firms with a rich network of human networks and long-term contracts. So it is with international financial activity. For Indian firms to grow roots in global finance, and for global firms to grow roots in India, both sides have to invest considerable amounts in the long-term objective of building organisational capability. When India indulges in a ban, this kills off organisational capability. When India even threatens to impose a ban in the future, investments in building this capability are reduced.

The defining problem in a safe and sound engagement with financial globalisation is that of overcoming asymmetric information. When the global financial system does not have a deep understanding of India, it is more likely to make mistakes, with capital surges, sudden stops, mistakes in investment flows, knee-jerk responses to events, etc. To avoid these maladies, we require that global financial firms have a deep knowledge of India. This deep knowledge is impounded in the organisational capital of global financial firms: in their staff, in their processes, in their long-term investments in learning India. But for this to happen, we have to stop banning cross-border activity and change laws so that there is no possibility of bans in the future.

To simplify the complex system we have, we need to ask what is the objective of each and every control in place and to undertake the task of steadily dismantling unnecessary restrictions. Some controls were put in place to prevent capital from flowing in and while others were imposed to prevent capital from flowing out. These channels of flows get circumvented by investors and overall inflows and outflow occur based on economic conditions, but the restrictions create distortions. The task is challenging, but necessary for India to become globally competitive.

With an eye on inflation

Indian Express, 14th February 2014

Flexible inflation targeting is the best way to dent price rise.

India is the only large emerging market (EM) that doesn't currently have a monetary policy framework. Other than China, which targets the exchange rate, all large EMs target inflation. This is one of the main reasons why India saw a rise in inflation after the global financial crisis, while other EMs experienced a downward pressure on prices. It is clear to students of monetary economics that an inflation-targeting framework is the way forward for India, which is opening up its capital account and moving towards a flexible exchange rate regime.

India has chosen these two corners of the trinity - and this allows it to have an independent monetary policy. The lack of a monetary policy framework is a recipe for high inflation, low growth and highly volatile business cycles. The Urjit Patel report to revise and strengthen the monetary policy framework has recommended that the RBI adopt flexible inflation targeting.

What are the main elements of inflation targeting? First, a monetary policy framework requires a defined nominal anchor. There are many factors that determine the relative price of any two goods, while the nominal anchor determines the general level of prices. So, for example, if there are only two goods in an economy, and one costs double the other, what determines whether the prices are Rs 10 and 20 or Rs 100 and 200? When economies started using paper money, it became possible to create an unlimited amount of money. But this could cause these prices to rise to Rs 1,000 and 2,000 or any other such combination.

When paper money was anchored to gold or silver, or, in some cases, to the sterling or dollar, this used to determine the general level of prices. However, when these systems ran into trouble, countries chose a general price level as the anchor, with some allowance for changes in relative prices. A small amount of growth in the general price level allows for smooth changes in relative prices. Thus, the price level and a small, specified increase in it became the nominal anchor. This was the inflation target.

Such an anchor incentivises households to save. It allows businesses to plan, knowing how their cost structure will evolve over the years. After 1990, inflation targeting was adopted by 34 countries. The OECD countries were among the first to adopt it and, after 2000, a number of emerging economies such as Brazil, Chile, Colombia, South Africa, Thailand, South Korea, Mexico, Peru, the Philippines, Indonesia, Turkey and many east European countries followed suit.

More recently, after the global financial crisis, even developing countries started adopting this framework. After 2008, we have seen countries like Georgia, Moldova, Albania, Botswana and, in 2011, Uganda adopt inflation targeting. The fruits of the framework have been enjoyed by emerging economies. While all EMs are suffering from a slowdown in demand, India is suffering from stagflation. None of the other large EMs is experiencing such high inflation. None of them has such unanchored inflationary expectations.

Some people suggest that GDP growth should serve as the nominal anchor. But this is not possible. If it were, several countries would have already targeted growth and become rich. Countries with the highest inflation, like Zimbabwe, would also have been the fastest growing ones. An inflation-targeting framework takes into account the effect of various demand and supply shocks on inflation, output and exchange rates, and accordingly forecasts inflation, which the central bank then tries to bring back to the target rate in the medium run. For those interested in the details, Rudrani Bhattacharya and I have a recent paper on how an inflation-targeting framework would work in India.

The paper presents a typical forecasting and policy analysis model, which shows how an inflation-targeting framework takes into account various cyclical factors that impact aggregate demand and supply to forecast inflation. One of the main problems with the public discourse on inflation targeting is that it assumes inflation-targeting central banks only look at past inflation and adjust rates accordingly, rather than figuring out how demand, supply and expectations impact inflation. As the Urjit Patel report argues, while there is a tradeoff between inflation and growth in the short run, there is no tradeoff in the medium run, and cross-country evidence suggests that low and stable inflation is, in fact, better for growth. No country has given up on an inflation forecast in its monetary policy framework.

The proposed flexible inflation-targeting framework also takes into account the difficulties India faces due to high and volatile food prices. In other emerging economies also, food accounts for a high proportion of the consumption basket. The report argues for the consumer price index, of which food is a large component, to be used as the measure of the nominal anchor. A CPI inflation target of 4 per cent, which can be breached by 2 percentage points on either side, will allow the RBI not to respond if inflation is above 4 per cent but within the target band, as long as this is because of supply shocks that will not persist. With the inclusion of food inflation in the target, its spillover into non-food inflation will reduce, keeping overall CPI inflation in check even if there are spikes in food inflation.

However, it should be elected representatives, and not unelected central bankers, who decide what the nominal anchor and monetary policy framework should be. Once decided, the central bank should be given the power to pursue these objectives and it should be made accountable to the democratic representatives of the people. Eventually, in India too, as in most other countries, the monetary policy framework must be enshrined in law. This was also the opinion of the Financial Sector Legislative Reforms Commission. In the meanwhile, the proposed framework is a huge step forward. It is in accordance with the voluntary adoption of governance-enhancing principles that regulators are embracing till the Indian Financial Code is legislated upon.