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Crisis: Isn't our government to blame?

By Rajeev Malik
November 22, 2008 14:18 IST
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An economy is like a living human being. All is almost never perfect, but the key is the ability to pass different stress tests, and to have agility (i.e. policy flexibility) to withstand different shocks.

Few policymakers plan for Black Swan events, but the focus is always on whether the deleterious effects of a potential economic shock can be mitigated, or will the shock fuel more problems. In India's case, the current global crisis exposes chinks in the policy armour.

They leave a lot to be desired from a country that harbours global ambitions but has a macro policy framework that is often held hostage to the disparate assortment of micro-level responses with their macro implications largely ignored.

Three fatal policy oversights were committed in the run-up to the current problems.

One, the government reportedly chose to ignore the build-up in the global capital flow cycle and its implications for India, despite the uncanny precision of such a diagnosis and warnings by the former RBI governor, Y V Reddy.

Consequently, India today is also experiencing a crisis that is a milder version of what the rest of Asia experienced in 1997: An unanticipated and sudden reversal in the multi-year surge in global capital inflows that causes currency collapse and depresses domestic demand, especially by hitting investment spending.

The government, like those of the Asian countries that were seriously affected by the Asian financial crisis, appeared to have become too obsessed with unsustainably high growth rates, which were partly fuelled by a surge in capital inflows.

Other countries also witnessed a surge in capital inflows in recent years, but the exuberance cycle in India was far more pronounced.

If not for some sensible policies (which were criticised at the time) that were undertaken by Reddy, India would be currently embroiled in a far deeper and more protracted crisis.

Two, there was a dearth of basic macroeconomic understanding that a continuous boost to investment spending in a supply-constrained economy like India will likely cause inflation to become problematic in the near term, even if the increased capacity softens inflation in the subsequent years.

In such a setting, a government can: (1) slow the pace of investment growth to ensure inflation does not become a problem; (2) live with higher inflation; or (3) move quickly to ease the supply constraints. In India's case the government chose to do nothing! Monetary policy can only achieve limited success -- if at all -- in such a setting.

Three, the government remains unprepared for our broader global integration, and its related impact on the rupee, and the subsequent effect of the currency movements on the real economy.

Liberal fanatics told us that the surge in capital inflows was sustainable, that India's time had come, that rupee should be fully floating, that corporate India should borrow as much as it needs from overseas, and that the opening up of the capital account should be accelerated!

Unfortunately, they were clueless that India was just at the receiving end of a global bubble. Several of these suggestions need to be adopted over time, but putting them into effect in the last couple of years would have caused a more serious crisis.

India's response to the current crisis is vastly different from that of its Asian neighbours to the same imported crisis. The panic is far more palpable in India.

Interestingly, no other Asian country felt that it was necessary to appoint an honorary foreign-based advisor to its prime minister.

The strong credentials of the well-known advisor notwithstanding, it appears that the government itself is unsure about the trajectory of its march toward globalisation, and its consequences for domestic politics.

Much of emerging Asia is geared meaningfully into the global trade cycle, and, in recent years, has developed -- and benefited from -- new supply chains with China, the factory to the world.

Consequently, the evolving global recession will extract a high cost in terms of collapse in growth, with some economies such as Taiwan, Singapore and Hong Kong poised to post contractions in their calendar 2009 GDP. Growth will rebound in these economies as the global economy recovers.

But in the meantime, there is concern, but no panic in these countries; there is anxiety but no despair. And, guess what? No foreign advisor.

Other countries appear self-assured about their place in the world, and of the pros and cons of being integrated with the rest of the world. However, in India, there appears to be a wide gulf between the frequent sound bites and the infrequent actions.

All is not lost, and policymakers have an opportunity to make amends. There are two key differences between what India is experiencing now compared to the Asian financial crisis (India was largely unaffected by that crisis as it lived in a cocoon).

One, India's dependence on foreign short-term debt is less than what was the case with several Asian countries in1997, despite the fact that corporate India's reliance on foreign financing has increased in recent years.

Two, India remains a supply-constrained economy, unlike the countries involved in the Asian financial crisis that were demand-constrained (China today is demand-constrained as well) -- they never returned to the pre-crisis growth rates on a sustained basis.

This difference is important as it suggests that there is scope for India to return to the elevated pace of growth for multiple years.

India was essentially flirting with increased linkages with global capital flows without having prepared itself and its policy framework for the positive and the sometimes potentially negative consequences of doing so.

To be sure, Reddy's unpopular approach prevented greater imbalances that in turn could have resulted in a far more serious financial crisis.

For example, the most important safeguard India currently has is its stock of foreign exchange reserves, which ballooned under Reddy owing to the RBI's intervention in the foreign exchange market to prevent excessive rupee appreciation.

Minus that, and we would have seen a far more violent swing in the rupee, and India could have been the next Iceland.

Let the current crisis be a wakening call to our accidental reformers who have squandered the good years by doing precious little to strengthen India's economic rise.

Whether they like it or not, India will become more integrated with the rest of the world. It is best to undertake reforms that will make that integration smoother, beneficial, and long-lasting. In the absence of reforms, we'll probably be condemned to unanticipated boom-bust cycles, and there is not guarantee that the economic and political costs will manageable the next time around.

The author is head of India and ASEAN economics at Macquarie Capital Securities, Singapore. The views expressed are personal

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