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Macroeconomic Framework and Financial Sector Development: A Commentary

The macroeconomic framework and the policy recommendations for the financial sector in the draft report of the Raghuram Rajan Committee make a case for further capital account liberalisation not because it leads to growth but because of its likely beneficial impact on financial sector development and efficiency gains. There is no evidence that this reverse sequencing works. The draft report also neglects the evidence on market failures, important among them being the pro-cyclicality of capital flows. It recommends using only the interest rate instrument for inflation targeting. This is likely to result in prohibitive interest rates. It also recommends that India follow a non-interventionist exchange rate policy instead of a managed float. This may have been a possibility if there was system-wide coherence in the international exchange rate system, but we know that is not the case.

DRAFT RAGHURAM RAJAN COMMITTEE REPORTEconomic & Political Weekly EPW august 9, 200819Macroeconomic Framework and Financial Sector Development: A Commentary Benu SchneiderThe author has written this article in her personal capacity. The views expressed are those of the author and do not necessarily represent the views of the Department of Economic and Social Affairs, United Nations, New York where she is placed. Email: schneiderb@un.orgThe macroeconomic framework and the policy recommendations for the financial sector in the draft report of the Raghuram Rajan Committee make a case for further capital account liberalisation not because it leads to growth but because of its likely beneficial impact on financial sector development and efficiency gains. There is no evidence that this reverse sequencing works. The draft report also neglects the evidence on market failures, important among them being the pro-cyclicality of capital flows. It recommends using only the interest rate instrument for inflation targeting. This is likely to result in prohibitive interest rates. It also recommends that India follow a non-interventionist exchange rate policy instead of a managed float. This may have been a possibility if there was system-wide coherence in the international exchange rate system, but we know that is not the case.The macroeconomic framework and financial sector development in the draft report(DR)of the Committee on Financial Sector Reforms (CFSR) set up by the Planning Commission recommends further liberalisation of capital flows, an increasingly non-interventionist exchange rate policy such that monetary policy can deal more effectively with an inflation target and demand management via fiscal policy to deal with the open capital account. Other recommendations are within the framework of these overarch-ing recommendations.The recommendation for non-interven-tionist policies are derived from standard neoclassical theory which assumes the absence of credit rationing and informa-tion imperfections and sets out a model of perfect competition with the perfect abil-ity to forecast the future and perfect inter-temporal smoothing. But market failures abound and are well documented in theo-retical and empirical literature. Examples of imperfections in capital markets lead-ing to boom and bust are well known. The logical inference to be drawn from the evi-dence on market failures is that the policy lessons from standard theory cannot be achieved, thus limiting the desired results of policies suggested in this chapter of the DR. Of particular relevance in this context is the standard theory prediction that cap-ital flows would be counter-cyclical; yet the evidence is that they are pro-cyclical [see Ocampo, Spiegel and Stiglitz 2008]. In the same volume Stiglitz (2008) reiter-ates the case against unfettered capital flows with his analysis of market failures. More, Not Less Intervention Recent failures in financial markets indicate the need for more interventionist instead of less interventionist policies. For instance, the ongoing turmoil in financial markets has shown that even in industrialised countries markets are not self-regulating and government interventions are neces-sary. Episodes of major exchange rate alignments in the industrialised world have largely been caused by capital move-ments and dealt with by interventionist policies. The need for intervention in weak and imperfect markets in developing countries is even greater. Government intervention is required for crisis preven-tion through regulations that reduce risk, curb market exuberanceandmakemarkets work better.The DR does cite the lack of evidence that capital account liberalisation (CAL) will increase economic growth. It touches upon some of the risks associated with open capital accounts. These two findings are also covered in recent literature, such as the earlier cited study by Ocampo, Spiegel and Stiglitz (2008), which pronounces that the intellectual battle over the harmful effects of capital account liberalisation has for the most part ended following public acknowledgement by anIMF paper [Prasad et al 2003] of the risks inherent in CAL. While there is universal acceptance of these findings, Kose et al (2006) asserts that there are collateral benefits of CAL in the form of financial sector development and efficiency gains. The box in the DR on ‘The State of the Academic Debate on CAL’ states that this evidence is increasing but not conclusive. Thus the case for further CAL in theDR is being made not because it leads to growth but because of its benefi-cial impact on financial sector develop-ment and efficiency gains. Is there a case for this claim in India? The evidence cited does not talk about the degree of capital account openness that would be sufficient to reap this collateral benefit. Reverse Sequencing?A rich literature exists which make a case for gradual opening of the capital account on the ground that financial sector reforms and development precede the opening of the capital account based on a richer array of case studies.1 These were considered by the first RBI Committee Report on Capital Account Convertibility (1997) even before the outbreak of the east Asian financial crisis and it passed a more nuanced judgment on sequencing financial sector development before a fully liberalised capital account.
DRAFT RAGHURAM RAJAN COMMITTEE REPORTaugust 9, 2008 EPW Economic & Political Weekly20The east Asian crisis reinforced the conclu-sion of the first committee and its conclu-sions have received attention in policy cir-cles and the literature thereafter. The DR considers the recommendations in the report but concludes that the logic and sequencing in the report is inapplicable today as the capital account is already quite open. The report instead suggests reverse sequencing, further capital account open-ness to garner financial sector development and efficiency gains. Is there any country evidence to support the case for reverse sequencing? Is fuller integration the need of the hour in India? What have been the collateral benefits of the present level of openness? Is there evidence that the present level of integration is not enough to reap the collateral benefits of an open capital account and further opening will lead to tangible collateral benefits? The volume by Ocampo and Stiglitz (2008) throws doubt on the realisation of collateral benefits. They include analysis of the pro-cyclical nature of capital flows and their volatility, which have the opposite effect on financial market and institutional development. Similarly, the discipline imposed by short-term flows is not necessarily a positive force for long-term development. Further, following the results in Aizen-man, Pinto and Radziwill (2004) that domestic resource mobilisation is the main factor driving growth, is not the natural policy conclusion to pay attention to domestic resource mobilisation rather than emphasise further capital account liberalisation? In addition, the report does not address the all important crisis pre-vention framework for the existing fairly open capital account, besides the belief that a move to further liberalisation of financial markets, demand management through fiscal policy and transparency in RBI operations in general and in inflation targeting are desired policy moves. Indeed, policymakers in India and other emerging markets have a formidable task to map out the next generation of macr-oeconomic policies and the course of future actions for the capital account and financial sector at a time when risks have gone up in the international economy. The DR is silent on the impact of the prevailing external environment for India which is already financially integrated with world capital markets. The task is to assess the channels through which the Indian econ-omy and the region2 could be at risk because of the turmoil in international financial markets, the persistence of large global imbalances requiring assessments of the implications of a re-balancing process and the risks of some turnaround on capital flows if there is an unwinding of the yen carry trade. If this is not enough there is the growing spectre of global inflation fuelled further by high oil and food prices with fears of recession in the US economy looming large on the horizon. In addition, domestic inflation is fast becoming a problem of major concern. Absence of Nuanced JudgmentThe case for a greater degree of liberalisa-tion of capital flows and non-interventionist exchange rate policy along with recom-mendation for the conduct of monetary and fiscal policies in the DR are not grounded in a satisfactory assessment of the implications of either the domestic situ-ation or the international environment for India. The vast literature documenting analysis, experience and lessons learnt from Latin American crises, the east Asian financial crisis as well as from the problems in Russia and Turkey reaching the near uni-versal consensus on the need for gradual-ism and caution, including the justification for some types of capital control as tools of capital account management, are not con-sidered in the report. The analysis on the capital account in previous committee reports had a more nuanced judgment of these issues. Pragmatism in the short-run and medium-term has to be the hallmark of actions by central banks and ministries of finance. With liberalised capital flows, it is not enough if a country does everything right. The interlinkages with the world financial system make it imperative to devote considerable attention to the inter-national environment and gaps in inter-national financial architecture3 and inter-national policy coordination. The com-mittee is silent on the implications of thesegaps for India with its present level of openness and the possible risks of fur-ther liberalisation.4 International political cooperation has an important bearing on making globalisation work. The limited progress made by the IMF in its consultative process on global imbalances is an indication of the problems in international policy coordination. The state of the Doha round of trade negotia-tions is further evidence. The food crisis is building up expectations of protectionist policies in some countries which would spell backtracking on globalisation. In mapping out its policies towards the capi-tal account a country would be well advised to consider the state of play in trade poli-cies. Further a country needs to consider its bargaining power in the boards of the IMF and World Bank and negotiations with the private sector. It should be in a position similar to the industrialised nations in its ability to raise short-term funds in distress periods. Managing an open capital account requires a country not only to pay atten-tion to designing suitable macro policies and policies towards the financial sector but also give consideration to its capacity to bear the risk of external problems and its ability to garner financial resources at short notice. A country needs to work out a safe degree of capital account openness taking cognisance of the inadequacy of international financial architecture to sup-port open capital accounts. Non-interventionist Policies?The recommendation of non-intervention-ist policies on the exchange rate and capi-tal flows in the DR stems from the concern around the high costs of sterilisation in the form of interest costs and the implica-tions for the banking sector to perform its operations. These are hindered by their role as a captive market for government securities and hence the DR is rightly con-cerned with the high costs of sterilising capital inflows in the present scenario in India. In their view the problem can be resolved by cutting down the level of the prevailing fiscal deficit and liberalising capital flows further.5 While there is no dispute about bringing down the fiscal deficit in India, the case for abandoning controls over capital movements and for abandoning the present approach of man-aging the exchange rate is not that clear-cut.6 TheDR rules out the usefulness of capital controls in stemming inflows or outflows of capital on grounds that they are ineffective. The committee may want to look at recent literature which continues
DRAFT RAGHURAM RAJAN COMMITTEE REPORTEconomic & Political Weekly EPW august 9, 200821the discussion on alternative forms of intervention. Some believe that the ability to manage the capital account, including restrictions, is necessary for counter- cyclical capital account management. Others argue against this approach and suggest indirect tools of intervention.7 Although there is consensus on the risk of CAL and doubts about its ability to con-tribute to growth, the debate on the forms of intervention is ongoing and has possible lessons for Indian policymakers. Debatable ViewFurther, the conclusion reached in the report on the ineffectiveness of capital con-trols is not generally accepted. The former chairman of the Federal Reserve Board suggested in the late 1990s that a leaky umbrella was better than no umbrella. Even the OECD Code of Liberalisation for Capital Movements provides for transi-tional arrangements to retain controls if a member’s economic and financial situation does not justify liberalisation and also to contain adverse developments in the bal-ance of payments. Evidence of selective controls can be found in line with financial sector developments and strategic consid-erations even in advanced countries. The ordering and degree of liberalisa-tion are a fine balance between removing the impediments in the way of inter-national financial intermediation. This is part of the overall reform process to ration-alise existing prudential standards and maintain and supervise them while intro-ducing new standards in line with new channels for financial intermediation and existing anomalies in the financial market. Schneider (2001) documents that restric-tions on certain classes of institutions, such as banks, pension funds and authorised dealers, are generally effective. In addi-tion, price-based controls can alter the maturity structure of inflows but have little effect on total flows; while they may pro-vide monetary autonomy in the short run, they cannot be used to insulate monetary and exchange rate policy. Country experi-ences documented in this study suggest that if policies such as sterilisation and lib-eralisation do not stem the inflows of capital, governments may look at prudential restrictions to alter the composition and/or maturity structure which provide monetary autonomy in the short-run. More recent work points to a combination of quantity and price controls, their success depending upon the circumstances in which they are applied. The findings in Epstein, Grabel and Jomo (2008) indicate that policy-makers in China, India, and Malaysia were able to use quantitative capital account regulations to achieve greater policy auto-nomy and effectiveness. Ocampo and Palma (2008) analyse the effectiveness of price vs quantity capital controls in the cases of Chile, Colombia and Malaysia. The measures adopted on inflows helped to contain asset bubbles, bringing about better debt profiles, and improving macro trade-offs faced by authorities. The success in slowing down inflows of capital in boom periods allowed policy autonomy in allowing a restrictive monetary policy to work. In the case of Chile and Colombia, the effects of the price controls adopted were short term, and in Malaysia, the effect of quantity controls stronger. The lesson is that in cases where drastic action is needed, quantity controls may be more effective.8 The concluding suggestion in Epstein, Grabel and Jomo (2008) “that retaining the prerogative and capacity to manage capital inflows and outflows over the long run, should be a permanent part of most developing countries’ economic toolkit” is worth noting by every central banker.On Exchange Rate PolicyThe DR recommends that India follow a non-interventionist exchange rate policy instead of a managed float. This may have been a possibility if there was system-wide coherence in the international exchange rate system. Its absence is evident, and political solutions needed to promote a coherent system are beyond the control of the Indian authorities. Even the executive board of the IMF has no technical consensus on exchange rates [Lombardi and Woods 2007]. There are no generally accepted models that determine the choice of the exchange rate regime and further no gen-erally accepted models that explain how to relate exchange rate policy explicitly to one or more of several macroeconomic goals [Boughton 2001]. The lack of technical consensus does not prevent the IMF from formulating and using a particular view. For example, the speech by the former IMF managing director Rodrigo de Rato on July 28, 2007 at the South East Asian Central Banks Governors’ Conference in Bangkok covers the support for allowing the exchange rate to appreciate and that concerns over competitiveness are exag-gerated. A similar advice in the present report is under discussion. The grounds forunderplaying the Dutch disease effects of a prolonged appreciation are unclear. Central banks are pragmatic institutions and the lessons of the maintenance of pegged exchange rates by the Thai autho-rities in the period 1995-97 which dis-couraged hedging by market participants, and reinforced capital flows have been well learnt. It is well accepted that a flexible exchange rate policy is needed to manage an open capital account. It is also well accepted that exchange rate risk should not affect the balance sheet of the central bank but be borne by market participants by opt-ing for exchange rate flexibility. But correc-tion of exchange rate misalignments cannot be safely led to the market. The choice of an appropriate exchange rate regime involves a trade-off between the benefits of targeting inflation and the external com-petitiveness of an economy. Williamson (2006) is of the view that it would be a mistake for a country to allow its exchange rate to be pushed to an uncompetitive level. The present policy approach iswell bal-anced and a rapid move to further liberalise capital flows could create problems for maintaining that balance. Further, volatil-ity in exchange rates can be exacerbated if the management of volatility of capital flows is completely absorbed through exchange rates, which may be damaging for the growth of strategic sectorssuch as non-traditional exports.9The present level of inflation is hover-ing a little above 11 per cent.10 The fiscal deficit including contingent or off-budget liabilities that are expected to trend upwards in 2009 after years of decline leaves the projected deficit for 2008-09 at 9-10 per cent of GDP. The scenario puts anupward pressure on interest rates and is likely to attract more capital inflows. Further liberalisation is not likelyto yield the benefits for the reasons discussed in this article, but are

It is useful to consider the general theory of the second best – trying to get some flexibility for monetary policy, moderating the extent of exchange rate fluctuations and recognising that some extent of global integration is inevitable.

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