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"The Fiscal Deficit Will Come Back To Haunt India"
An Interview with Raghuram Rajan
Economic Counsellor and Director, Research Department
International Monetary Fund
Financial Express, December 15, 2003
The youngest and first Asian Director of Research and Economic Counselor at the IMF, Dr Raghuram G. Rajan was till recently a professor of finance at the Graduate School of Business, University of Chicago, where he specialised in the study of financial institutions and markets in developed and developing economies. Awarded the 2003 inaugural Fischer Black Prize by the American Finance Association for contributions to finance by an economist under 40, Dr. Rajan started off as an alumnus of IIT (Delhi) and IIM (Ahmedabad) before securing a doctoral degree in economics from MIT. Dr. Rajan has frequently visited India to speak at conferences and on assignments with the SEBI and RBI. He has also co-authored the book "Saving Capitalism From The Capitalists" with Luigi Zingales. Two months into his new job, Dr Rajan gave his first interview as IMF's chief economist to Deepa Kamat of FE. Excerpts:
There is now greater optimism about global economic growth. What, in your view, is driving this growth and what are the main engines of growth?
I think the US economy is still the most energetic of the developed economies. You can see that it is leading the world economy out of recession right now. US productivity numbers in the last quarter were phenomenal. So, in terms of innovation and growth, the US economy is driving growth. There is another smaller engine - Emerging Asia - China, India and other Asian economies outside Japan. Of course, as other countries grow, the role of the US, and it's consequent share of world GDP, may fall. But still, the strongest engine is the US economy. There are hopeful signs right now in Japan, that it's coming out of its decade-long recession. But the growth is nowhere near the torrid rates of the '70s and '60. Europe is still barely growing. But the hope is that next year it will pick up. Latin America is also starting to show signs of growth. But a lot still depends on the US.
What should national governments do to sustain this growth revival in the medium to long-term?
In the western countries, clearly the biggest challenge is the ageing of population. And in order to meet this challenge, they have to get their fiscal houses in order. The deficits in all the big economies - Europe, US and Japan - have been considerable. Some of it is cyclical, because of the downturn, but some of it is structural. All these areas have to start working on diminishing deficits. In Emerging Asia, the biggest challenge is structural reforms, to get the economies in even better shape to participate in global economic growth. The type of structural reforms that are needed varies from country to country. Many need to get their financial sectors in better shape, to make them more transparent and more resilient. Emerging markets must also figure out ways to cope with the volatility resulting from becoming a more open and modern economy. Safety nets, that many developed countries have in place, are needed but this should be done in ways that don't replicate the mistakes of the developed countries.
So, is the fear of deflation that was haunting the US behind us?
I won't say that. A lot of stimulus was given to the US economy through tax cuts and, to some extent, through the accommodative monetary policy. I think the signs are that some growth is coming from areas outside of consumption. And that is a good sign. And there are some good signs of employment growth. But I would say that until those signs become really strong (and we have seen some emerging evidence of that), we still have to worry what happens when the tax stimulus weakens. I therefore won't say there is zero probability of deflation, but I'd say that it is much less likely than a few months ago.
How long do you expect Central bankers, especially the Federal Reserve, to follow an accommodative, easy monetary policy?
My sense is that they are waiting, like everybody else, to see that things look really firm. Now, the difficulty in this situation is precisely that the fiscal stimulus from tax cuts will be wearing off sometime towards the middle of next year. So you want to be really sure that the economy has caught on before the monetary policy starts tightening. But at the same time, you don't want to wait too long, given that monetary policy works with lags, because you have let the inflation genie out of the bag. Given that there is still a substantial output gap in the US, a wait-and-watch approach is still not excessively risky. The Fed will tighten when it sees enough signals to convince itself. But I think before that we might see the Fed moving away from the statements they have made about remaining accommodative for a reasonable length of time. It might start preparing the markets by moving away from the word "remain accommodative" to saying "we will be standing ready to tighten it". It's hard to predict when anything will happen. But as more and more evidence of growth comes in, the policy will move towards being a little less accommodative.
With the recent upward trend in world commodity prices, if global economic growth slackens, is there a fear of stagflation? What is driving the growth in prices?
If growth is driving the growth in prices, it's hard to see a scenario of stagflation. Because, once growth falls, prices too will fall. I think stagflation is more a phenomenon where you have rigidities in the various markets which prevent adjustments to price changes and, as a result, growth starts petering out. My suspicion is that we have come a long way since the '70s in terms of having more labour market flexibility across the globe. Maybe there are a few areas which might face the stagflation threat, but I definitely don't see it as a global phenomena. I also don't see commodity price inflation as a significant drag on growth.
Do you think China and India have built up excessively high foreign exchange reserves?
One has to first ask why countries are keeping "high" reserves. Are they simply the reflection of the fact that they have plenty of money pouring in and don't have particular use for this money immediately? Or does it reflect other kinds of problems? The work that our department at the IMF has done suggests that in a number of countries the level of exchange reserves is beyond what they would need for traditional purposes, like keeping precautionary balances to accommodate uncertain outflows, etc. So, you are getting to a point where reserves are too high, given the various potential uses.
How should this issue of high reserves be resolved?
The question is how does the high level of reserves hurts a country? Let's look at it from the country's perspective. These reserves are not earning very much. If you are investing in these reserves, as opposed to investing in other higher remuneration activities, then the question you have to ask is whether this is a good use of your money. Also, there are always risks associated with these reserves holdings, such as the risk that they will fall in value. You also have to ask if you are trying to maintain a certain level for your exchange rate. And, if by doing that, are you targeting the right level? Are you setting yourself up for certain kinds of distortions, going forward? For instance, if you are maintaining a very low exchange rate, then the question is, are you giving wrong signals to some of your industries who appear competitive at this low exchange rate. These industries are therefore investing a lot of money, but the true equilibrium exchange rate is much higher. Therefore, in the long-term, if and when the country moves to a flexible exchange rate (I believe that most emerging markets should move eventually to a more flexible exchange rate), then you find that these industries are totally uncompetitive and the investments made are worthless. Are you sending a lot of wrong signals to your industries by manipulating the rate?
Last, if you are keeping the exchange rate lower than what it should be, then your people are not getting the consumption power that they should have. For the same local currency, they should be able to buy more foreign goods. As a result, you are reducing their level of consumption below what they could otherwise enjoy. Why are you offering this free service to the rest of the world? In the long run, a country is much better off having an exchange rate that reflects fundamentals. I don't think it's that easy for a Central Bank to determine exactly what that level is, and therefore it is better to allow some flexibility.
Do you agree with the view that the Chinese yuan could do with some appreciation?
Let me answer this in two parts:
b) But I do think, however, that in the medium to long run, the Chinese are better off with a more flexible exchange rate. Also, the world economy will be better off. That's because if, in fact, the US dollar depreciates much more (as it has been doing in the recent past) and if the Asian currencies depreciate along with the it, then it will just exacerbate some of the imbalances that are being created. It puts more of a burden on some of the currencies that are more flexible, like the euro, to bear the imbalances. In that sense, there would be some gain towards greater flexibility. But I don't think one should make the argument from the perspective of solving the bilateral trade deficit between the US and China. I don't think that is a solution. If China takes the decision, it should be because it is (a) in China's best interest, and because (b) incidentally, it can also help to alleviate further imbalances in the world economic scene.
In India too, there is a policy dilemma on whether the rupee should be allowed to continue its appreciation or should it devalue from its current level? Your views?
I haven't studied the Indian situation that carefully. Therefore, I don't know whether the level is right or not. All I would say is that it would not make too much sense to fight the markets strongly. I think that the process of letting the market decide what the level of the rupee should be, given that we already have some flexibility, is appropriate. As you know, we do manage, to some extent, the volatility of the currency. While we may not want to go for a free float, I think we should also be careful that we don't manage too much.
Given the lack of fiscal prudence, do you believe that India's recently witnessed im- pressive economic growth performance is sustainable?
The beauty of India's fiscal deficit is that somehow, the consequences of the lack of fiscal prudence aren't showing up. But, that said, we would be making a mistake not to deal with the fiscal issue on a priority basis. Part of the problem is that private investment has been at a low ebb over the last few years. As a result, the government has been able to borrow without much competi- tion. If we see signs of growth taking off and private investment starts becoming significantly higher, I think there will be more competition for funds in India. If you look at China, investment rates are 40% of GDP. That's way beyond what we are doing. I'm not saying that we should be there; I'm just saying that when we start moving in that direction, then we'll get a lot of competition for funds. At that point, if our domestic savings rate does not adjust appropriately and to the extent that we don't necessarily want to depend too much on foreign inflows, I think we will have to curb our deficits or else see tremendous increase in interest rates as private investment competes. I'd say that it should be a priority to control the deficit. If nothing else, we know from the experience of many countries, that eventually it comes back to haunt you. One can't imagine that India is a special situation where the deficit is not going to be a problem.
Are you happy with the pace of reforms in the Indian financial sector? What, in your opinion, are the urgent issues within this sector, that need immediate attention?
First, let me say that I haven't been following everything that has been happening in the last few months very closely. Therefore, take what I'm saying as a broad brush view. There are areas within the Indian financial sector that are moving very fast. I think, the pace of reforms in these areas have been extremely good. However, I think there are areas which are less well. If I had to paint a broad brush picture, the area that's moving extremely well is certainly the markets, especially with the automation of the exchanges, T+1 settlement forum, growing emphasis on governance, attempt to clean up market practices, etc. So, I think, in these areas we are moving well and those are good signs. However, where we are moving less fast is on the whole spectrum of small and medium banks - from cooperative banks right upto nationalised banks. Some of these banks are very dynamic but the broader issue is whether they are participating fully in the growth process. I think, we need to figure out ways of making it more effective than it has been. Overall, as Indians we should always be dissatisfied, because however fast the pace of reforms takes place, we have a backlog of 40 years to make up for since Independence. So, we can never move fast enough (though to move fast does not mean to move imprudently). We should be acting as if we have a fire under us, and that we don't have time, because we have an enormous mass of people whose aspirations need to be met. And the only way that we can do that is through growth. I am actually very encouraged by what I read about these recent state elections, that the emphasis of political dialogue in India has shifted towards growth and well-being, away from cultural and religious issues. That is an extremely good development.
What do you mean when you say that the broader issue is whether the smaller and medium-sized banks are participating in growth?
The entire sector, in the longer run, needs to be upgraded in terms of technology, skills, supervision, regulation, etc. We are moving in the right direction there, but clearly, more needs to be done. In some sense, credit to small and medium industries/farmers is going to be critical for broad-based strong growth. The large companies would be able to tap the stock market or the global markets. But the small or medium-sized farmers/ firms, who want to improve their production tech- niques, will rely on small banks for their credit needs. The credit assessment process, the process of managing risks, supervising these banks, trying to see that they have the right skill mix, whether they can offer the right set of products to their clientele - all these are extremely important if one wants balanced broad-based growth. But I don't think we are there. ICICI Bank is state-of-the-art, but the co-operative bank in a less developed area is not computerised, doesn't have good cash-management techniques, and doesn't have good risk assess- ment or management techniques. And that is going to be extremely important for unleashing the process of broad-based economic growth.
IMF EXTERNAL RELATIONS DEPARTMENT