Monday, April 14, 2008

Ways to Maximize Growth and Manage Capital Inflows

India’s Primary Need Is Growth
[written for 'Yojana', October 2007, Vol 51 with T.C.A. Srinivasa-Raghavan]

Inflation vs Growth

The positing of inflation versus growth may be academically interesting, but in practice, there need not be a trade-off. This is because inflation is not a consequence of high growth, but of inappropriate policies. If the policies and practices are right, there can be both high growth and low inflation. China provides an example, with growth averaging over 9 percent for the last several years with inflation under 3 per cent (Table 1), although with sectoral discrepancies, e.g., very high increases in food prices.

At this point in India’s political economy, three objectives are essential in the public interest:
a) economic growth;
b) growth in GDP per capita; and
c) equitable distribution.

However, growth needs to be balanced, orderly, and inclusive. The target GDP per capita can be far short of upper OECD quartiles, provided we are thoughtful in defining and pursuing living standards (balanced lifestyles versus consumerist treadmills, integrated area planning versus mass movement to the cities).*

Inflation hurts the poorest the most, creating political instability at higher levels. That said, there can be no doubt that short of instability-creating levels, India’s primary need is growth. This follows from considering the opportunity cost for hundreds of millions of people whose productive capacity is constrained on account of deprived opportunities because of low incomes. It follows also from the likely improvement from inclusive growth in the quality-of-life for everyone, including the more prosperous. This is why the emphasis needs to be on growth as defined above, rather than on containing inflation.

Essentials For Growth

1. Policy Framework Facilitating New Projects

The conditions for sustained long-term growth are determined by a sound policy framework or the lack of it – the end-to-end chain shown below – and how well it facilitates achievement-oriented productive capacity in a given environment.

This is something successive governments have failed to address in India as an end-to-end engineered process, as against a jerry-rigged process of political accommodation. Examples of the latter are: the initial bidding for telecommunications services, the setting up of the first TRAI, its subsequent dismissal, the development of the NTP in 1999 (with which I was closely associated, but alas, like the curate’s egg, in parts, so one can neither take credit nor deny responsibility…).

2. Interest Rates

a) Importance of Low Interest Rates
Low interest rates provide the primary impetus for growth.* Hence, monetary and fiscal policies need to be coordinated to keep interest rates low. However, while this is necessary it is not sufficient: institutional processes are required to make credit accessible, especially to SME’s and small borrowers. Given the current state of global hyper-liquidity as returns from funds-driven activities exceed returns from the real economy, ‘pure financial plays’ have for years earned better returns than manufacturing and infrastructure. When and if there is a major structural correction, e.g., because of a collapse of several hedge funds, or of real estate in America or falling consumer spending perhaps aggravated by sovereign reserves being invested elsewhere than in US treasuries, or unraveling in China, this situation can change. For now, institutional funds need to be consciously channeled to productive enterprises, away from the lure of more profitable financial opportunities.

b) High Interest Can Stall Growth
Interest rates in India are close to the point of destroying economic momentum. Paraphrasing the Economist, recessions often occur when rising interest rates cause firms to slash employment and capital expenditure.** Compressed margins are already constraining corporate performance.

c) ‘Planning Models’ For Simulation
The RBI and Finance Ministry can make rigorous use of planning models to simulate scenarios and responses, e.g., the effects of how much oil/gas is likely to be imported near term, at what likely prices, what exports are in the basket and what currency flows are likely, at what likely exchange rates and prices, with what mix of imports, followed by what-if analysis to decide on alternatives. This will help in making informed decisions so that the RBI and the government can formulate a coordinated action plan.

‘Overheating’ & Inflation

a) Structural Solutions For Chronic Shortages
With India’s explosive growth of the last few years, pressures are likely to arise from demand-supply mismatches. These can be alleviated to some extent with prompt imports and aggressive reductions in duties. However, the kinds of problems India faced in 2007 – wheat, pulses, etc. – need long-term structural solutions. There is no shortcut to developing end-to-end supply capacity, such as strategic alliances in Australia or Myanmar for pulses, or sound acquisition-and-supply for wheat.

b) Dealing With Capital Flows
We are in a paradoxical situation of yearning for capital inflows while reeling from the pressures such flows bring, i.e., inflation, asset bubbles, and exchange rate appreciation. But this happens to all economies in their high growth phase. As long as we have high growth, we will have capital flows. We had better figure out how to manage this problem of plenty.

Viewed in this light, the solutions are:

1. To Formulate Investment Policies That Work

Create receptive circumstances for direct investment in productive undertakings across sectors. This may seem a truism, but our receptivity to new investments (not secondary market transactions) appears very limited. Take electricity: the addition to capacity in the last five years has been at 4,000 MW a year, compared with the previous record of about 3,000 MW. Yet, without major changes in the whole end-to-end process chain described above, there are plans for 15,000-plus MW a year by 2012. For such targets to be realistic, comprehensive and integrated changes to the project startup process have to be made in our systems. Otherwise, we will get suboptimal choking of economic capacity because of ubiquitous power shortages, as usual.

Clearly, a prerequisite is enabling infrastructure: energy, transportation, communications, basic education, and health and sanitation. Practical considerations dictate a prioritized, phased approach to sectoral investment, together with interim measures as described in the next paragraph.

2. Asset-Liability Management of Foreign Currency Reserves

Invest excess capital in profitable investments abroad. The RBI and the government have been grappling with currency inflows ballooning India’s foreign currency reserves. Effective management determines whether this is a blessing or a curse, because of excess liquidity, inflation, and rupee appreciation. To the extent that the flow is direct investment, it is clearly a benefit if these flows can be channeled to start productive enterprises. For instance, investments for infrastructure should readily translate to projects-on-the-ground in energy/power, transportation, or communications; they do not. Second, while some flows into secondary markets are beneficial, excess secondary market flows inflate demand unduly. Therefore, there is little reason to encourage hedge funds seeking alpha.

An asset-liability management approach suggests the deployment of ‘excess’ reserves, focusing on the liquidity risk of sudden outflows. These reserves can be invested abroad in profitable liquid assets through approved fund managers. In the event of a liquidity crunch, these assets can be cashed. Such investments will simultaneously:
a) reduce inflationary pressures, while
b) reducing short-term flow pressures on the rupee to appreciate.

While conceptually straightforward, successful practice needs real expertise – in asset-liability gap estimation, and asset management – and not committees of economists/academics, parliamentarians, or ministers. It is useful to remember that experience is no substitute for expertise.

However, a multi-partisan political initiative is indeed necessary to begin this, as the RBI cannot do this in the ordinary course. Better to address this head on with an empowered Group-of-Ministers conferring with a multi-partisan committee aided by experts, rather than continue to subsidize American consumers by funneling India’s reserves into US treasuries. Just the opportunity cost at 15% incremental earnings on $150 billion is $22.5 billion per year (Rs. 90,000 crore).

3. ‘Jawboning’ To Influence Outcomes

To the extent that governments act objectively to sustain orderly markets without undue favor to interested parties, ‘jaw-boning’ by the government constitutes healthy governance. The difficulty arises in curbing partisan actions or overzealous interventions that are not in the public interest.


The path forward is uncharted. We can draw lessons from elsewhere, but India has to fashion its own way, define where it wants to go, and how. This requires coordination of monetary and fiscal policies with private sector expertise, focusing on growth. Expertise in many dimensions has to be brought together for these initiatives, inducting ideas while being especially careful about applying inappropriate models (e.g., the very different relationship between interest rates and growth in emerging markets compared with developed economies). The reserves management needs planning and evaluation with probabilistic cash flows, gap and investment management, and creative structuring. For the policy framework, regulatory and privatization policy formulation with an integrated systems approach, solid legal and organizational inputs, spatial planning with sectoral expertise in areas such as energy, electricity generation/supply, transportation, sanitation – all rendered with the discipline and competence of sound project management. We have to create systems appropriate for our purposes at this stage of our development, and learn to manage our way.

Shyam Ponappa and T.C.A. Srinivasa-Raghavan

* See for articles from the Business Standard: “Interest Rates, Living Standards & Inflation”, and
“'Ideal' Inflation & Exchange Rates”.

** “The business of making money”, The Economist, July 5, 2007:

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