Financial sector reforms

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Financial sector reforms - I

The draft report of the High Level Committee on Financial Sector Reforms (Report) headed by Raghuram Rajan has been placed by the Planning Commission on its website. The Report offers some down-to-earth suggestions to tweak our economy.

CJ: S Shivakumar

Fri, Apr 11, 2008 17:59:39 IST

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Financial Report Review :

ALTHOUGH NEWSPAPERS, especially the financial newspapers, of late have been carrying excerpts of the Report, I felt the Report should be read in toto. I share the salient features of the Report with merinews readers. Since the Report is voluminous, I am serialising the salient features.

The Report examines the challenges that cross border capital flows pose for macroeconomic management. It admits that the scale of capital flows to be managed has been larger than anticipated. All the same, our economy’s managers need to develop a policy framework that would help deal with larger inflows and larger outflows. Why? Inflows largely represent a minor adjustment in global portfolios in favour of India. But there would be a larger outflow of funds if either domestic or global circumstances were to become adverse. The fact that India continues to run a current account deficit, albeit modest, makes it vulnerable to a sudden stop of inflows.

The exigencies of dealing with this large volume of flows have slowed financial sector reforms in India. They have also led to an increase in the fiscal burden through the cost of sterilization. In the circumstances, there is a need to think through the institutions and markets needed to facilitate a more effective response to what is likely to be a recurrent phenomenon (of voluminous flows). The response to the ‘capital flows’ problem points to some uncertainty on the part of the authorities.

The Report admits that there are no ideal solutions for managing the integration of a large domestic financial system into the global economy. But one thing is clear: consistency, clarity, credibility and continuity of policies are important. Imbalances between the supply of and demand for foreign exchange can arise from trade flows just as much as from the capital account. A completely open capital account creates familiar and well-known issues for monetary management. The monetary authority finds difficulty in reconciling exchange rate stability with interest rate autonomy. As the experience of the oil-exporting countries (or of China) shows, imbalances between the supply of and demand for foreign exchange can arise from trade flows too and generate pressures for the nominal exchange rate to appreciate. Thus, exchange rate appreciation and measures to counter it (such as central bank purchases of foreign exchange), are not phenomena that arise exclusively from an open capital account. On the other hand, progressive opening of the capital account enhances the scale (and potential volatility) of foreign exchange flows and links these flows to domestic monetary conditions, particularly efforts to set domestic interest rates and / growth of domestic credit

India has been managing its nominal exchange rate to maintain “external competitiveness”, with generally positive results for growth in exports of goods and services. Stability and predictability of the exchange rate of the rupee, nominally against a basket of currencies but primarily against the U.S. dollar, has been an established feature of our policy landscape. The link to the dollar over the years can also be seen as representing an informal “nominal anchor” for the Indian monetary system, necessary in the absence of either fiscal restraint or a formal inflation target. While in the present decade there has been a boom in exports of business services, the magnitude of the ensuing surpluses did not present major problems for either exchange rate or monetary management. Thus, in the mind of the Indian policy makers, pressure on the nominal exchange rate to appreciate and the perceived threat to competitiveness, have come to be associated with the surge in capital inflows. The management problems have been aggravated by the decline of the dollar against other major currencies and the tight link of the currencies of major Asian competitors of India in third world markets, particularly China, to the dollar.

Capital inflows have generated pressures for nominal exchange rate appreciation of the rupee against the dollar. In order to counteract this pressure, the central bank has intervened by buying foreign exchange. But too much intervention could lead to excess domestic liquidity and consequent inflationary pressures. Balancing these two considerations, viz., external competitiveness versus domestic inflation has become an increasingly complex problem.

What matters for external competitiveness is the real effective exchange rate (REER) rather than the nominal dollar-rupee exchange rate per se. The factors that drive the REER go beyond just capital flows. The primary factor tends to be differentials in productivity growth between a country and its main trading partners and between the traded goods sector in a country and the non-traded goods sector. This is because more productive manufacturing workers in a country will earn more and push up the price of housing or haircuts (non-traded goods sector), thus causing the real exchange rate to appreciate. In the short to medium term, the exchange rate can also be influenced by conditions of domestic aggregate demand and supply, and, of course, the net capital inflows into a country.

In India, a confluence of forces has in recent years put enormous pressure on the real effective exchange rate to appreciate. Relative productivity growth of the traded goods sector has been higher than in most industrial countries that constitute final markets for India’s exports, as well as relative to the domestic non-traded goods sector. Aggregate demand has been higher than supply, in part due to the large government budget deficit (centre and states together). Foreign investors have been pouring money in.

Even if it were granted that the real exchange rate is appreciating too quickly, it does not necessarily follow that the most efficient response is to attempt to restrain the nominal exchange rate through sterilized intervention. Indeed, if the real appreciation is an equilibrium phenomenon, attempting to resist it through sterilized intervention can lead to an outcome of higher inflation, higher debt and a more repressed financial system than the alternative of allowing the nominal exchange rate to take on some of the burden of adjustment.

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