The last week of March saw the inaugural conference of the India Policy Forum, a collaboration between the National Council of Applied Economic Research and the Brookings Institution (of Washington, DC) to launch a journal focused on the Indian economy and Indian reform.
The initial issue of the journal will be published in September, after the draft papers have been revised. The discussion at the conference provided a valuable occasion to reflect on the management of the economy over the last decade, and the agenda that a new government will face.
Nobel Laureate Jan Tinbergen articulated the theory of economic policy in the early 1950s. He argued that policy-making would be optimised by 'assigning' one policy instrument to each economic policy objective.
While real life policy-making is always messier than theory, one could characterise the classical policy assignment in India (till about the mid-1990s) as follows.
The Monetary Policy was assigned the job of controlling inflation, while fiscal policy was assigned to promotion of growth, both through Keynesian demand expansion and through public investment. External balance was achieved through a combination of trade policy and management of the exchange rate.
The exchange rate remained an independent policy instrument owing to the presence of capital controls, particularly on inflows. As with much of the rest of Asia, the authorities targeted the real exchange rate by depreciating the nominal exchange rate from time to time, through exchange market intervention.
This policy assignment has come under increasing strain as India has become a more open economy in the 1990s, even though openness still has a long way to go.
Both trade and financial liberalisation have had beneficial effects on the competitiveness of the economy, but both have imposed a fiscal burden which has not yet been adequately replaced. While a welcome shift from indirect to direct taxation has occurred, poor revenue buoyancy has been a key factor in generating the large fiscal deficits, particularly at the centre.
Both central and state deficits have largely been financed on the domestic bond market, as the Reserve Bank has maintained its targets for growth of reserve money. Despite the relaxation in mandatory pre-emption through the SLR, much of this debt has been absorbed by the banking system.
The combination of large deficits and administered interest rates has kept nominal domestic rates high. As international interest rates have declined, the interest differential has attracted funds through both the current and capital account.
The pursuit by the RBI of its reserve money target has required additional bond sales in the market (sterilisation) which has entailed even further absorption of government debt by the banking system. The nominal exchange rate has come under pressure from these inflows.
Despite these strains, India's economic management over the 1990s was assessed relatively favourably at the conference. The steady progress in unilateral trade liberalisation and the evolution to a managed but increasingly flexible exchange rate received particular commendation.
At the same time there were clear concerns that the build-up of public debt increases vulnerability to a financial crisis, particularly as the capital account liberalises.
The liveliest discussions were accordingly on the wisdom, value, preconditions and pace of further liberalisation of the capital account; the appropriate exchange rate regime; and the sequencing of fiscal adjustment, trade liberalisation and financial sector deregulation. There was a sense that the present policy mix was reaching the limits of its usefulness, and that a rethink would be necessary by the new government.
What might be elements of this new framework? These are my own views; I would not wish to implicate others at the conference. Indeed, several of the participants would disagree sharply, as would many distinguished contributors to the debates in these columns.
A useful general principle would be to target objectives on the real side of the economy with policies that deal with real variables. This would imply that the nominal exchange rate should not be seen as the critical instrument for delivering competitiveness or growth.
This burden should instead be carried by the more micro oriented policies, such as policies on trade, taxes, competition and regulation, including in the financial sector. The nominal exchange rate should instead become just one dimension of monetary policy, with a dominant medium-term focus on control of inflation, perhaps as part of an inflation-targeting monetary regime.
More importantly, the main consideration in the choice of a nominal exchange rate regime should be to limit the financial vulnerability of the economy. This is best served by further moves toward an even more flexible, lightly managed exchange rate, one that generates and reflects heterogeneous market expectations.
This is necessary to permit liquid and deep foreign exchange derivatives markets to emerge, and to create incentives for individual economic agents to manage their own balance sheet risks.
Aggregate fiscal policy should concern itself with the sustainability of the public debt under a range of economic outcomes.
The newly revitalised privatisation programme can play an important contribution in this regard, by helping pay down public debt.
The true medium-term developmental role of fiscal policy should be to ensure the adequate provision of quality public goods at moderate levels of taxation. These goals greatly outweigh the cyclical benefits of high fiscal deficits.
This raises the vexed issue of sequencing. The customary view for emerging markets is for trade reform, financial sector reform and fiscal balance to precede significant opening of the capital account.
There is also a widespread view that capital account convertibility is essentially irreversible, that the benefits are outweighed by the risks; in sum that it is a game for mature, consenting adults.
The counter-arguments (some of which were made at the conference) are that there is a clear revealed preference by governments in emerging markets to aim for greater capital openness, and that this has not been significantly reversed despite the crises of the last decade.
There are the additional arguments that providing capital mobility to international firms and large domestic corporate entities while denying it to other local entities is discriminatory; that with increasing trade openness it becomes difficult to discriminate between current and capital transaction and; that greater capital mobility can help to stimulate both fiscal and trade reform.
An additional argument that is specific to India is that greater integration with world financial markets could help make India an important global provider of financial services.
For all these reasons my own instinct would be to make gradual capital account liberalisation an integral and concurrent thrust of the reform agenda, rather than leave it for some indeterminate medium-term.
As was pointed out by one participant, the crucial test of commitment will come not when the money is pouring in, as at the present, but when it threatens to pull out, as will inevitably happen.
Domestic and external circumstances have rarely been better for a truly bold push for reform and liberalisation. The opportunity is associated with risk, but the risks can be managed. One hopes that, as in 1991, the political class is able to seize the moment to transform the economy.
But there are important conceptual shifts that also need to occur. Analysts have their role to play as well in guiding policy in these unfamiliar waters. Let us hope that we are up to the task.
The author is director general, NCAER, New Delhi. The views expressed are personal.
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