Gods of financial liberalisation

In its country report no. 15/62 [(‘India: Selected Issues (March 2015)], there is a chapter on spillover from surges in global financial market volatility. Its conclusions are worth noting and internalising:

The key findings of this chapter are as follows:

  • We confirm Rey’s (2013) view that there is a global financial cycle in capital flows and asset prices, as derived from our GVAR modeling framework.
  • We show that global financial market volatility (e.g. induced by monetary policy normalization uncertainty in advanced economies) has significant spillovers to emerging market economies (operating through trade and financial linkages, global liquidity and portfolio rebalancing channels).
  • We observe that there are heterogeneities across countries in their responses to a surge in global financial market volatility. This would reflect the scale of EMs’ trade and financial exposures to AMs, their individual cyclical positions, and their internal/external imbalances.
  • Consistent with Rajan (2014), we conclude that a prolonged term-premium compression raises financial stability concerns as the magnitude of financial spillovers has become larger over time, while asset prices and interest rates have become more correlated globally during the period of unprecedented monetary easing by advanced economies (see Figure 2).
  • We argue that strong fundamentals and sound policy frameworks per se are not enough to isolate countries from an increase in global financial market volatility. This is particularly the case where there is a sudden adjustment of expectations triggered by monetary policy normalization uncertainly in advanced economies. This argument is supported by the impulse responses in Figure 3, where no country (neither AMs nor EMs) appears immune from the impact of a surge in global financial market volatility.

There is a global cycle in capital flows; regardless of fundamentals being good, all countries are affected. There is a hetoregenity of impact on countries and therefore, differentiated policies on interest rates and capital flows are required. It is obvious that there is ‘no one size fits all’ approach.

That is why it was rather strange to note Mr. Ajay Shah, Professor at NIPFP writing as follows in his blog post on March 2:

By this time, serious people in Indian macro/finance knew where India needed to go: Inflation target + Open capital account + Floating exchange rate. All the other expert committee reports supported this. [Link]

If expert committees appointed in India have recommended these, then one must remember that they were a product of the times during which these were unquestioned. Now, all three have been proven to be wrong and dangerous, if taken to a cultish extreme. The conclusions of the IMF study cited above is but the latest example of the rethinking, induced by real world developments. We in India seem to think that the clock stopped in 2007 and that all needed to be learnt on monetary policy, capital flows and foreign exchange were learnt before that.

Open Capital Account + Inflation Targeting + Floating Exchange rates – all three are wrong at worst and, at the minimum, need to be context-specific and based on responses and policies of other countries on their capital accounts and their currencies.

Inflation targeting blinded the West to credit and financial market excesses before 2008 and they are at it, again. That is why India’s adoption of an inflation targeting regime at this stage, seems utterly misguided and unnecessary and second, taking into account India’s unique circumstances (supply rigidities caused by government intervention and high component of food in CPI basket), represents an unfair distribution of responsibility for meeting the inflation target between the Government and the Central Bank.

The IMF that battled for free and unrestricted capital flows in the 1990s has substantially modified its stance on capital flows. It advocates capital controls. Jonathan Kirshner’s ‘American Power after the Financial Crisis‘ has a riveting account of the efforts made by the US Treasury under Robert Rubin and Larry Summers (mostly during his period), egged on by Wall Street, to include a commitment to free capital flows in the IMF charter.

Now, it has not only dropped that but also turned around to accepting the usefulness of capital controls. In fact, the Independent Evaluation Office of IMF has noted that the Fund has been more open in advising member-countries on the usefulness of capital control measures than it had done so in its 2012 paper linked above.

This blog post has a useful summary of issues on which the Fund has now become intellectually more flexible while some folks in India have hardened their stances and are pushing the country in the wrong direction. Unfortunately, their views are being heard too seriously and not with the degree of scepticism that is both warranted and suggested by empirical developments elsewhere in the world.

India can have truly floating exchange rates if every other country has a genuinely floating exchange rate. QE is nothing but exchange rate manipulation and the RBI Governor is correct to say that emerging markets, adopting QE policies, would have been labelled currency manipulators by the US Treasury Department. The Federal Reserve Board, the European Central Bank and the Bank of Japan have been at it for quite some time now and the intent is to free ride on external demand through cheaper exchange rates. Bank of England did so too. That they have not succeeded is altogether different matter. Now, China may follow these big three with its own QE and currency devaluation down the road. I had discussed these potential moves by China in my recent column in MINT and have a detailed discussion document coming up at Takshashila Institution.

Given this backdrop of unprecedented global monetary easing and ‘beggar thy neighbour’ exchange rate policies, it was rather amusing to note the observation in this blog post that India’s foreign exchange intervention has increased under the current RBI Governor as though it was a crime!

Proponents of financial, foreign exchange and capital account liberalisation policies must wake up and smell the coffee instead of dragging a largely underinformed and uninformed country into the dangerous wild west land of finance driving the real economy. The world is trying to move forward into a saner and more stable policy setting with regard to the financial sector whereas India is being dragged backward, as usual. India should examine the efforts being contemplated by Iceland. There is no point in making India go through the horrible experiences that Western nations endured before turning to sensible and prudent oversight and regulation of the financial sector.

Finance must remain the handmaiden of the real economy and policymakers should not become the handmaidens of the financial sector.

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