VIJAY JOSHI

D

I begin by dealing with a minor point. In Joshi (2004), I pointed out an illegitimate step in LBP’s procedures, which biased upwards their estimate of growth sacrificed. The error lay in measuring capital inflows as a proportion of GDP by taking capital inflows at current prices and GDP at constant prices. They have now corrected what they call this “computational error”, without however making any acknowledgement for its discovery. No matter, I am glad the correction has been made. It reduces their estimate of hypothetical annual average growth in the 1990s from 8.5 to 8.2 per cent.

The main point of contention between us is a different one. LBP continue to insist that their estimate of foregone growth of (8.2 – 5.8) = 2.4 per cent per year is correct, since the foregone increase in investment was much higher than the actual reserve accumulation. Their reasoning is that “the change in reserves does not equal the amount of inflows not absorbed as it also reflects the net absorption effects of domestic monetary and fiscal policy, which are also assumed to have changed as compared to the original configuration”.

This is a nonsensical argument. LBP compare an initial position of the economy (in the absence of inflows) with a final position after an exogenous capital inflow plus a fiscal and monetary expansion. But what is actually observed in the data of any year is only the final position. The observed data relate to the current account deficit that is generated by the joint action of the exogenous capital inflow, the expansionary policies and the policy of reserve accumulation. In the observed final position, using their notation, we have,

I – S = M – X = K + R – ΔNFA = B –ΔNFA,

where I is domestic investment, S is domestic saving, M and X are imports and exports respectively, (M – X) is the current account deficit, K is net capital inflows, R is remittances, K + R = B is total net inflows andΔNFA is the increase in foreign exchange reserves.3 The “net absorption effects of fiscal and monetary policy” are already included in the observed I, S, M and X. The only unexploited investment opportunity is represented by ΔNFA. If ΔNFA were absorbed, investment could rise to (I + ΔNFA) and the current account deficit would rise to [(M – X) + ΔNFA], covered by the continuing inflow (K + R). LBP argue instead that investment could rise to [I + (K + R)]. But that would require a wider current account deficit and hence a larger capital inflow than that available in the observed final position.4 It follows that, given their assumptions, LBP’s conclusion that the upper bound of foregone investment is (K + R) is logically invalid.5

The whole novelty of LBP’s claim was that India could have had an annual average growth rate of 8.2 per cent in the 1990s, i e, extra growth of 2.4 per cent per year, merely by absorbing the foreign exchange reserves that were accumulated. That claim was a central plank of their sensational indictment of India’s exchange rate policy during the decade. We see above that their claim is based on faulty logic and rests on assuming capital inflows significantly higher, and by a precise amount, than those actually observed. When that hidden assumption is made explicit, what they turn out to be saying is that growth could have been higher if capital inflows had been higher, a proposition of little interest. Consequently, their policy critique is also negated.

I conclude by reiterating that LBP’s claim that India’s growth could have been as high as 8.2 per cent per year in the 1990s, if foreign exchange reserves had been absorbed, is based on a simple but devastating analytical error. As argued in Joshi (2004) and Joshi and Sanyal (2004), the upper bound of growth was considerably lower. Foreign exchange reserves increased in the 1990s by 1.2 per cent of GDP per year. Hence the upper bound of foregone investment was also 1.2 per cent of GDP per year. On the assumption of an incremental net capital output ratio equal to that actually observed in the 1990s, viz 2.8, the foregone extra growth was 1.2/2.8 = 0.4 (approximately) per year. Thus, the upper bound of India’s growth was (5.8 + 0.4) = 6.2 per cent per year, and even less if we assume diminishing returns to capital accumulation.6,7 LBP have obfuscated the issue in Lal et al (2005). I shall desist from responding to any further obfuscating rejoinders on their part and leave it to discerning readers of this journal to judge who is right.8

EPW

Email: vijay.joshi@merton.ox.ac.uk

Notes

1 The argument in Joshi (2004) was repeated in

one of the sections of Joshi and Sanyal (2004).

In what follows, any references to the former

should be taken to include the latter.

2 There is also a substantive policy disagreement

between LBP and myself as regards India’s

past and future exchange rate policy. I have

nothing to add on this question beyond what is said in Joshi (2003), Joshi (2004) and Joshi and Sanyal (2004). The present article is not concerned with that substantive policy issue, which is a matter of judgment on which reasonable people can disagree. It focuses instead on a logical and conceptual error in LBP’s theoretical model, which invalidates their empirical results, including their startling claims about the consequences of India’s macroeconomic policies in the 1990s.