Suman Bery: Too sensational

In last month's column ("Looking Ahead"), I felt I had said my piece on inflation, monetary policy, exchange rates and the like. Returning at the weekend from a brief trip to Australia I find that the debate has become even more hectic, with contributions in these pages by T N Ninan, Jamal Mecklai, Ajay Shah, Surjit Bhalla, A V Rajwade and Subir Gokarn, among others.

This most recent flurry of interest has been provoked by the policy actions taken by the Reserve Bank after the markets closed on March 30. As this was the last trading day of the fiscal year, the measures could have been timed to have minimal effect on annual measures of stock-market performance. (I have no idea whether Mumbai bonuses are paid on a fiscal year basis: I rather suspect so.)

The measures followed the well-established drill: increases in the cost of collateralised borrowing by 25 basis points (to 7.75 per cent) (the so-called fixed repo rate), and a range of sterilisation measures designed to offset Reserve Bank interventions in the foreign exchange market.

The press release announcing the measures highlighted the Reserve Bank's concern for inflation as far back as September 2004, while citing recent data to demonstrate the need for additional action. Prominent among these were of continued fast credit growth (of around 30 per cent) and various twelve-month measures of inflation, all above the RBI's declared comfort range of around 5 per cent.

The RBI has acquired considerable experience in dealing with both capital surges and speculative attacks, and is skilled in using a broad range of heterodox instruments to deal with these episodes. Its recent policies have however provoked an extremely diverse range of reactions, illustrating the dilemmas and choices it faces.

Thus Mr Rajwade is deeply concerned by the appreciation of the nominal (and real effective) exchange rate that has occurred. And its impact on export competitiveness. On the other hand, Ajay Shah is extremely critical of the RBI's massive intervention in the foreign exchange markets and its impact on the growth in reserve money. In my own piece last month I expressed concern that attempts to sterilise its foreign exchange intervention through sale of securities raised interest rates and provided a further stimulus to short-term flows.

While virtually all commentators agree that low inflation is important for both political and economic reasons, there are divergent views on how effective monetary policy can be in addressing "supply-side shocks" in the Indian context, or even what is meant by "overheating" given the massive underemployment in our labour markets. One polar position is that taken by Surjit Bhalla, who points out, correctly, that the great disinflation of the 1990s was a worldwide phenomenon (from which India also benefited) and that real factors connected with technology, transportation and globalisation were much more influential than monetary policies. At the other extreme there is the monetarist view that while there are relative price shocks galore, "inflation is everywhere and always a monetary phenomenon", even if the focus is now less on money stock measures and more on interest rates.

What does Australia have to do with all this and with the title of this column? More than one might imagine, as was pointed out by Prof. Ross Garnaut of the Australian National University (ANU), Canberra. In delivering the third Sir John Crawford Lecture at NCAER in September 2004*, he remarked: "India, China and Australia are three countries of continental size in Asia and the Western Pacific. This geographic extent and diversity encouraged the view in each that it could achieve economic success mainly through utilising resources and opportunities within its own borders."

Each country reacted to imperial domination with a long flirtation with autarky, particularly in the middle years of the 20th century. This led in time to a visible retrogression in the relative economic standing of each. China was first in reversing policies, in 1979, followed by Australia in 1983, and India in 1991. Garnaut remarks, "The decisive initial reforms were implemented by a political party that had been closely associated with the introduction of the inward-looking policies", while noting the continuing unease in all three societies about reconciling the expanded role of markets in allocation with equitable income distribution.

Australia was particularly daring with its financial sector reforms, abolishing all exchange controls and floating the dollar in 1983; trade and investment reform was more gradual but by now is fairly complete. China has been aggressive in trade and investment reform, but cautious on financial reform because of the parlous condition of its banks. India is more like Australia in having to undertake its reforms within a democratic, federal structure, and is clearly less well advanced on both trade and financial liberalisation. As Mecklai (and others, such as S S Tarapore and Percy Mistry, point out) public ownership of the banking system is a huge complication.

This finally brings me to the title of the article. For my generation, Prof. Max Corden, now at the University of Melbourne, has been one of the clearest thinkers on international trade and financial policies as they affect small open economies.

A recent book by him draws its title from a passage in Oscar Wilde's The Importance of Being Earnest, where Miss Prism observes: "The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational. Even these metallic problems have their melodramatic side"!

In conversation on this recent visit Prof. Corden was clear that a flexible exchange rate had been a huge success in insulating the Australian economy from a series of shocks, both negative and positive. Large fluctuations in the nominal exchange rate have been easily absorbed by both public opinion and the corporate sector, and have been part of the great economic success of Australia over the last decade. For a large continental economy, flexible exchange rates and monetary policy oriented to the domestic value of the currency are clearly the way to go.

* "Lessons from Different Reform Paths: Australia, India and China," NCAER , New Delhi and Australia-India Council, Canberra

The writer is Director-General NCAER. The views expressed here are personal. sbery@ncaer.org