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 The Macroeconomy and Policy Change

Arvind Panagariya

With the combined central and state fiscal deficits having hit the double-digit levels, the question whether another macroeconomic crisis is around the corner has assumed renewed salience. In an important paper in a recently published volume, Macroeconomics and Monetary Policy: Issues for a Reforming Economy, edited by Montek S Ahluwalia, Y V Reddy and S S Tarapore, Ahluwalia offers a careful dissection of this question. He concludes that though poor fiscal performance and incomplete reforms of the banking sector are sources of weakness, the presence of the large foreign exchange reserves, flexibility in the management of the exchange rate and strict capital controls insulate the economy against the risk of an external crisis. Simultaneously, public ownership of banks and the associated government guarantees moderate the risk of a banking crisis. But this stability comes at a price: banking efficiency is low and high fiscal deficits are crowding out private investment.

On balance, since Independence, the Indian policy makers have performed much better in the macroeconomics area, which covers issues related to inflation, unemployment, exchange rates, business cycles and fiscal and monetary policies, than in the microeconomics area that encompasses industrial, agricultural, trade, labour and taxation policies. With the exception of the relatively mild balance of payments crises in 1956-57, 1966 and 1991, India has exhibited remarkable macroeconomic stability. In turn, macroeconomic stability has been a key factor behind the low but positive growth during the first three decades despite very large microeconomic distortions in virtually all sectors of the economy.

Ironically, the study of macroeconomics in India has lagged far behind that of microeconomics. For this reason alone, the Ahluwalia-Reddy-Tarapore volume, honouring Chakravarti Rangarajan, is an important addition to literature on economic reforms in India. The volume covers a wide range of topics ranging from growth, inflation and business cycles to money, banking, the financial sector and infrastructure financing. It also brings together a distinguished cast of contributors including Shankar Acharya, P R Brahmananda, Andrew Crockett, Bimal Jalan, Rakesh Mohan, Manohar Rao and T N Srinivasan.

Central bankers everywhere face questions regarding appropriate objectives of monetary policy, the choice of an intermediate target to “anchor” the policy, and the selection of appropriate instruments. In his contribution to the volume, Andrew Crockett of the Bank of International Settlement offers an exceptionally lucid exposition of how these issues may be tackled in the Indian context.

A key objective of monetary policy is to achieve an appropriate rate of inflation. But what is the appropriate rate of inflation: 20, 10, 5, zero or any other per cent? The current thinking is that for industrial countries this rate is between 1 and 3%. There are three reasons why this moderate inflation is preferred over no inflation. First, for a variety of technical reasons, measured inflation is higher than actual inflation so that 2% measured inflation may actually be only 1% in reality; this calls for erring on the higher side. Second, because prices and wages are subject to downward rigidity, needed adjustment in the relative prices may be sabotaged by zero inflation. And finally, since nominal interest rates are usually positive, negative interest rates, sometime necessary to stimulate the economy in the face of recession, may be impossible to achieve without positive inflation.

But is the appropriate inflation rate for developing countries such as India different? Crockett leans in favour of a somewhat higher rate — 6 to 7% — that has been advocated by Rangarajan. There are two reasons for this higher rate. First, adverse effects of inflation below 8% are hard to come by. And second, since productivity increases in fast-growing economies are much larger in traded goods sector than services, a higher rate of consumer price inflation may be consistent with stability in the price of traded goods and external competitiveness. If one accepts this view, the current rate of inflation is probably too low and would call for a somewhat more relaxed monetary policy.

Yet another preoccupation of macroeconomists is forecasting of major macroeconomic variables. This task is undertaken in the volume by the ultimate guru of the field, Nobel Laureate Lawrence Klein. In his joint paper with T Palanivel, Klein offers a macro-econometric model of the Indian economy and employs it to forecast the major variables such as real GDP, wholesale prices, gross investment, exports, imports and the current account balance from 1995-96 to 2004-05. The model forecasts the GDP for 1995-96 through 1998-99 with reasonable accuracy but the predictions of approximately 7% over the period 1999-2005 are on the higher side unless the economy manages to perform at rates exceeding 8% in the next two years.

The Ahluwalia-Reddy-Tarapore volume also offers an excellent description of the evolution of institutions and policies in the financial sector over the years. Thus, Y V Reddy offers a most interesting discussion of the evolution of financial-sector developments in India ranging from financial repression in the early decades to the transition to the more recent liberalisation and deregulation. Shankar Acharya carefully describes the handling of the exchange rate and monetary policies during the Asian financial crisis. And A Prasad and Rakesh Mohan tackle the difficult question of the inter-relationship between debt market and infrastructure financing.

The key weakness of the volume, however, is the absence of a clear picture of the future architecture of the financial markets and the road to eventual external capital-account convertibility. Financial asset markets in India remain thin and dominated by public-sector institutions. Likewise the external capital account convertibility remains a distant goal. The volume does not tell how we should go from here to there.

July 30, 2003

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