Suman Bery: Looking ahead

Responses to the recent inflation have been clumsy. We should find a more modern approach.

The government's economic team, led by the Prime Minister, is committed to the economic goals of sustained rapid and inclusive growth; low inflation; and increased integration with the global financial system. One has only to look at the recent experience of Thailand, or even South Korea, to see that these are not easy goals to reconcile, even in more industrialised economies than ours.

Over the last decade India has been pretty successful at getting the job done: inflation has been muted, growth has accelerated, the economy has been resilient, inequality has not widened and India has integrated successfully in both the real and financial spheres, without a major accident. The main blemish has been the slow rate of job creation and of poverty reduction.

There is no accepted body of theory or of established practice to guide one in these matters, particularly in matters of international finance: in the fads of the present lie the seeds of future disasters. So any armchair critic has to approach the task with humility and with respect for the practitioners. Former Reserve Bank Governor Bimal Jalan is fond of remarking that India's eclectic approach to monetary matters has itself become a role model for emerging markets. To quote the bard, "There are more things in heaven and earth, Horatio, than are dreamt of in your philosophy." A modern formulation might be: if it ain't broke, don't fix it!

Despite this record of past success, it is worth revisiting the overall framework for macroeconomic management, for several reasons. First, life does not stand still. Through trade and finance the Indian economy is rapidly reintegrating with the world. Economic frameworks need to adapt to these changes, even as global markets themselves evolve.

Second, the recent resurgence of inflation demands both political and economic responses. On the economic side, knee-jerk responses to the revival of inflation can do immense damage to the larger programme of deregulation and liberalisation. Some recent examples include the restrictions on trading in agricultural commodity futures, export bans and hikes in the cash reserve ratio (CRR) applicable to the banks, and the famous cement saga.

Quite apart from the considerable intrinsic economic importance of low inflation for a country wishing to integrate financially with the world, it is clear that the political credibility of the reform effort is seriously undermined if inflation is seen as out of control. Yet, as pointed out by Ajay Shah in a recent column in these pages ("Monetary Policy at the crossroads": Business Standard, March 7, 2007), there are mounting signs of strain in the attempt to curb inflation using monetary tools. Ajay also makes two other points with which I am inclined to agree: that market understanding of the Reserve Bank's monetary framework is less than ideal; and that such lack of clarity carries increasing risks as financial markets integrate further.

These are not the only signs of strain in the framework. As I noted the day following the Budget, lending reserves for infrastructure is back on the agenda, despite the many arguments against it. More broadly, I have long been persuaded by the argument (first advanced by Michael Dooley) that a large stock of international reserves is itself an invitation to a speculative attack, and in this sense can be destabilising rather than stabilising. Such an attack can only be forestalled by maintaining effective capital controls. There is the additional inequity that high domestic interest rates impact very differently on medium versus large firms. Large firms increasingly have assured access to foreign finance and can often gamble on leaving their foreign liabilities unhedged given Reserve Bank intervention in the foreign exchange markets: what Shah calls the defence of the dollar.

What might be a more coherent, and therefore sustainable framework going forward, and how should the fiscal and monetary frameworks support each other? Some theory may be helpful; in addition, more concrete suggestions were given both in the second Tarapore Committee report on fuller capital account convertibility, and in the recent report on the IMF's 2006 Article IV consultation with India (Country Report 07/63 of February 2007), which is now fortunately routinely made available in the public domain.

As I noted in a recent seminar on the Budget (in the company of the heads of three other Delhi research organisations), what India continues to struggle with is the familiar monetary "trilemma": trying to reconcile an open capital account, a targeted nominal exchange rate and independent monetary policy. In the pure case targeting all three magnitudes would be impossible. But, in common with many emerging markets, the RBI attempts to square the circle by operating "intermediate" regimes all round: a semi-open capital account; an exchange rate in an undeclared band; and a "multiple indicators" monetary policy which targets narrow money, broad money, credit growth, prices, economic activity and interest rates at various moments.

Two other bits of economic theory are also relevant in this context. The first is the so-called "monetary theory of the balance of payments", which basically argues that with an open capital account the money stock is endogenous: as the domestic central bank attempts to tighten, local economic agents rebuild their desired money stocks by importing capital from abroad; and real exchange rate analysis, which suggests that the relative price of nontradables tends to rise in response to fast domestic growth and other demand-side shocks. If this real appreciation is not validated by an appreciation of the nominal exchange rate, it is likely to occur through inflation.

What shifts in policy assignment and policy communication are entailed by these bits of open economy theory? First, the Reserve Bank should reduce the scale of its exchange market intervention and move to greater two-way flexibility in the nominal exchange rate. While the Tarapore 2 report recommends targeting the real exchange rate (as has in general been the practice till now), I would agree with the Fund report (para.27) that this is undesirable, and risky.

Reduced intervention would also reduce the need for sterilisation. Reduced sterlisation, which would tend to in due course lower domestic interest rates, in turn reducing the incentives for short-term arbitraging capital inflow. In due course domestic interest rates would broadly reflect international rates plus a country risk premium. The degree of monetary policy autonomy would be of course directly related to the appetite for exchange rate flexibility.

The system would need a nominal anchor to guide inflationary expectations. A common approach is to adopt an inflation target. An alternative could be to target a fiscal magnitude: I would vote for the debt stock rather than the fiscal deficit per se.

To sum up, the old responses to inflation can have perverse consequences in a more open India. The recent spike provides an opportunity to rethink our approach and reduce, not increase, the growth cost of fighting inflation.

The writer is Director-General, NCAER. The views expressed here are personal.

sbery@ncaer.org