Exchange Rates Must be More Flexible: An Interview with Raghuram Rajan, Economic Counsellor and Director, Research Department, IMF

December 23, 2003

"Exchange Rates Must be More Flexible"
An Interview with Raghuram Rajan
Economic Counsellor and Director, Research Department
International Monetary Fund
Economic Times, December 23, 2003

Raghuram Rajan is just two months into the job as Chief Economist, IMF. It's a big change from his days in academia but no, he doesn't feel it cramps his style. But some of his answers may be a bit bland, he confesses with a disarming smile to Mythili Bhusnurmath. Excerpts: 

The IMF was rather guarded as in its World Economic Outlook released in September 2003. Has it become more positive since?

The IMF is certainly more positive than we were when it released the second bi-annual World Economic Outlook in September 2003. But having said that, it's as though right now we are flying on two engines - US and China , more correctly Emerging Asia. The other two engines, Japan and Europe are still spluttering. The question is whether these two will come to life and how long that is going to take. 

So is it safe to say that deflation worries are over and inflation is the new worry?

Well one can't say deflation worries are over. But certainly they are far less of an issue. There is still an output gap in the US and this is what lends confidence to the Fed that it does not need to tighten in a hurry. The other issue of concern is employment, whether it is picking up and picking up robustly enough because if it isn't then there will be questions as to whether consumption is sustainable going forward.

Has fiscal deficit (FD) become irrelevant? 

The US , you must remember, is starting from very low levels of debt also, so a certain amount of FD is affordable. But if they go this route long enough then clearly it becomes unaffordable. It is not as though we've sort of broken the laws of economics and FDs have ceased to matter. I know in India too there is this feeling that we can run FDs continuously in the range of around 10% and not suffer the consequences. One reason could be that investment hasn't competed strongly with government borrowing. But if it does then you could see a surge in rates very quickly. 

Do rigid rules like the Stability and Growth Pact or the Fiscal Responsibility and Budget Management Act help?

Things like the EU's Stability and Growth Pact and India 's own Fiscal Responsibility and Budgetary Management Act do help because they instill a certain amount of discipline. Many emerging markets follow pro-cyclical policies in good times like now; in bad times they are forced to really cut  back. And this is exactly the reverse of what they ought to be doing. In good times they should be saving for a rainy day, in bad times you can't borrow any more and you get shut out of markets so you can't spend precisely at the time when people need these expenditure. We keep telling people that the good times are when you prepare for the bad but the tendency is to say the bad times are not going to come in my tenure and since the good times are here, let me not spoil it now.

What are the other major concerns on the global economic front? 

The US current  account deficit is a concern that calls for movement on a number of fronts. To begin with, we need a mix of private saving and reduction of government deficit. That is one part. The other part would be greater consumption in the rest of the world. A third possibility is greater flexibility in Asian currencies.

How much will revaluation of the yuan help?

It is a complete red herring to hold the yuan responsible for the US ' bilateral deficit with China . The deficit is driven to a large extent by the fact that direct exports from other Asian countries that used to go to the US earlier now go to China for finishing. So what you see as a huge US deficit with China is actually reflected in a deficit between China and the other Asian countries so in some sense this deficit is not a new thing really.

Even if the yuan is revalued and there are various estimates of how much it should be revalued, I don't think it is going to change China 's comparative advantage.The deficit is not going to disappear. China was increasing its exports even when the yuan was appreciating in1999-2000.

But it is China's decision. China should decide in its own interest and its own interest is to have a more flexible exchange rate. Look at the cost of absorbing so much inflows and the impact that the spillover of liquidity is having on credit. If you have a higher exchange rate you also have higher local consumption.The problem with a misaligned exchange rate is that if at some time you think it is going to get aligned, investment decisions that are being made now are being made on a wrong basis and when you have a financial system that is not so great at allocating credit then you are possibly setting in place problems down the line when you become market oriented. 

Don't these concerns apply to India too?  

Certainly, though we are far lower in terms of reserves to the total economy. It is time  we started thinking about allowing more flexibility. Is the accumulation of reserves a conscious choice or is it a residue because investment hasn't picked up yet?

Maybe what we need is not so much a focus on exchange rates  as  a  focus on how to stimulate investment.  As for worries about rupee appreciation, we need to consider: are there areas where a small appreciation of the rupee will really affect our comparative advantage? If we don't move to some sort of equilibrium exchange rate and stay artificially depressed too long then we set in place distortions that will come to haunt us down the line. We will create industries that are competitive only at those rates and, in addition, suppress local consumption.

What is your view on the common South Asian currency suggested by the PM?

I think you need to take integration in steps. The first step is increase trade to levels that you would normally have between close neighbours. When you are talking about common currency you are talking about extreme levels of trust and we need to take a lot of steps in between. Remove the irritants. I have a Pakistani colleague who each time he comes to India has to report to a police station. Now you are not going to get increased trade with those kind of obstacles. Why not remove these irritants? That will build confidence and trust and then start thinking about things like a common currency  

How do see the backlash against Business Process Outsourcing (BPO)?

It's worrisome and the hope is when the economy recovers and employment picks up the protectionist backlash we are seeing goes down. The benefits of free trade are one of the hardest things to explain to public in any country because the public sees the immediate effect, which is job losses, more competition etc. They do not connect with the benefit in terms of lower prices - the fact that they can now buy in Wal-Mart stuff that is made in China instead of paying three times the price for stuff made in the US .

The public doesn't see that as much as it sees that Joe lost his job at the factory and now has to work at McDonalds. If politicians jump on the bandwagon then that creates a movement that is hard to stop. Many politicians are responsible and understand how there is mutual benefit to be gained from trade  but the costs of standing up to this can get high if job losses continue.


Public Affairs    Media Relations
E-mail: E-mail:
Fax: 202-623-6278 Phone: 202-623-7100