Financing Growth, India Style: WSJ editorial on India's financial non-repression

• REVIEW & OUTLOOK ASIA
• MAY 31, 2011

Financing Growth, India Style

While most of Asia grew through financial repression, New Delhi is bucking the trend.

In the standard Asian growth playbook, governments stimulate exports, hold down the value of their currencies and repress the financial industry. East Asian tigers like Taiwan and Korea ensured that domestic savings were captive and then funneled them, at low interest rates, to export industries. Today China is doing much the same.

India is going its own way. Alone among Asian powerhouses, New Delhi often runs trade deficits, meaning it is developing a strong domestic market. In the last two years, the Reserve Bank of India hasn't targeted the exchange rate, so exporters must fend for themselves when the rupee rises. And far from keeping savings bottled up in low-yielding bank deposits, the central bank is trying to help domestic financial markets mature.

Earlier this month, the RBI changed how it conducts daily operations. Until recently, commercial banks could borrow easily from the central bank, as well as park their excess funds at it. This meant that banks could easily manage their liquidity troubles without going to the market. Now the RBI only allows banks to borrow from it, and only through a restricted facility, forcing money markets to develop.

Because these markets, which borrow and lend at short maturities, were barely needed, India lacks a full yield curve, the mainstay of developed-economy credit markets. Changes in overnight rates are an important indicator of credit conditions, especially when compared with long-term bonds. Similarly, the RBI last year introduced a market-oriented method for commercial banks to price loans.

These moves deserve praise, but there is a ways to go before Indian finance is truly market-driven. State-owned banks still make up 70% of the banking sector, while all banks are forced to hold 24% of their assets in government bonds. But instead of financing exports, as in East Asia, these forced savings go toward welfare spending.

As the main financial regulator, the RBI was slow to increase private competition and allow innovation over the last decade. On the brighter side, in the past two years the central bank has continued to liberalize India's capital account to allow savings to flow across borders, broken some ground in the corporate bond market, and battled to deregulate the interest rate on savings accounts that the government stubbornly keeps fixed.

Seen together, these developments put India in a different corner in the Asian macroeconomic field. In the East Asian policy reckoning, what matters most is mobilizing financial resources to push growth, and cost is no object. Yet the costs materialize sooner or later, for example, in high-speed train projects that get derailed or in property booms that go bust.

In contrast, India's regulators are paying more attention to the price of financial resources and the process of marshaling them. That leaves India less vulnerable to the risks of malinvestment and on sounder footing for a long boom.

India's Inflation Blinders: WSJ editorial

• REVIEW & OUTLOOK ASIA
• MAY 19, 2011

India's Inflation Blinders

Low core inflation led the central bank to tighten too slowly.

Better late than never, thinks the Reserve Bank of India. The country's central bank finally got aggressive in its fight against inflation this month, raising interest rates by half a percentage point. For the last 15 months, year-on-year wholesale price inflation has stayed above 8%, sometimes entering double digits. Figures released this week show April inflation continuing the trend at 8.7%. RBI Governor Duvvuri Subbarao has been reacting slowly to the buildup of these inflationary pressures.

So, in and of itself, this month's move is praiseworthy. But if seen along with the RBI's laggard behavior over the past year, Mr. Subbarao continues to betray his weakness. At fault is his attachment to the concept of core inflation. He believes changes in the prices of non-food, non-fuel items are what really matter, since inflation caused by food and fuel is beyond his control.

In the RBI's defense, some of India's inflation is indeed beyond the control of its central bankers. Above all, the U.S. Federal Reserve's weak-dollar policy plays havoc with global commodities and capital flows, from which an open Indian economy isn't insulated. But it won't do to blame the RBI's problems on Ben Bernanke: After loosening liquidity in the wake of the 2008 panic, Mr. Subbarao has taken his sweet time to close the monetary spigots.

Though the price level started accelerating in late 2009, the RBI only raised rates beginning March 2010, and then only in baby steps of a quarter percentage point on eight occasions until this month. Factoring in the latest hike, the central bank's benchmark rate, at which it lends to commercial banks, now stands at 7.25%. That means that with headline inflation averaging around 9%, this rate has been below zero in real terms for 15 months—and perhaps longer.

Yet the RBI insisted that most of the headline inflation in the past year has been driven by exogenous "supply shocks." Left to the mercy of global oil at $100 a barrel, along with a 2009 drought that battered food supplies, Mr. Subbarao argued that altering interest rates won't accomplish much. Hence, he preferred to look at core inflation, which remained subdued for most of 2009 and 2010.

Yes, a central bank has little power over a weather shock that changes the price of, say, rice relative to general prices. But a regular supply shock doesn't last 15 months. Nor does it change the general price level.

What changes general prices is money. If money were tight, households would reduce expenditure of other items when they were forced to pay for more expensive rice, thereby keeping the general price level constant.

That was a clear lesson of the 1970s, when core inflation became an intellectual refuge for hesitant central bankers. Peddling this concept, then-Fed Chairman Arthur Burns targeted core consumer prices. So, after the oil shock of 1973, Fed accommodation pushed inflation up the next year. In a recent paper, Vivek Moorthy and Shrikant Kolhar at the Indian Institute of Management in Bangalore show what the Bundesbank instead did. The West German central bank tightened in 1973, forcing headline inflation down.

Mr. Subbarao has followed the Burns approach here, and stoked more inflation by tightening slowly. He seems to think that stripping away erratic supply factors is the best measure of real price pressures and expectations in the economy. But that misjudges how ordinary people react to expensive food and fuel.

These apparent "non-core" items affect core expectations—perhaps more in a developing country where these items make up the lion's share of household expenditure. Workers will expect generalized inflation because the food on their dinner plates becomes more expensive. They will demand higher wages and, in turn, producers will demand higher prices.

So it was only a matter of time before expensive food and fuel spilled over into other prices. The RBI's measure of core inflation has been blinking red since December, edging up 7.3% year-on-year in March and 6.3% in April. That was Mr. Subbarao's motivation for his larger-than-usual hike this month.

Yet, because he has been slow to act, he now has to contend with people's expectations getting out of control. The RBI's survey on inflation expectations published last month show that people expect up to 13.1% inflation by the end of this year.

These altered expectations filter down to economic decision making. Despite the promise of 8.6% growth for India's economy, investors are wary, since capital earns low real returns. Inflation paralyzed the country's financial system in December: Indians began pulling money out of low-interest-bearing bank deposits, causing a temporary, yet powerful, liquidity squeeze. To repair this short-term damage, the RBI this month raised the rate on savings accounts—a rate the government still regulates.

The best way now, though, for Mr. Subbarao to repair long-term inflation expectations, as well as the credibility of his central bank, is by staying clear of the very concept of core inflation. The RBI has to keep tightening, no matter the next oil or food shock. The prices of rice and gasoline, and perhaps other commodities and assets too, matter no less for economic agents than the prices of TVs and iPhones. Self-imposed blinders like core inflation will only hide this core truth from view.

India's Balanced Growth: WSJ editorial on balance of payments

• REVIEW & OUTLOOK ASIA
• JANUARY 7, 2011

India's Balanced Growth

Instead of fretting about trade deficits, India should open up more to foreign direct investment.

Late last year, New Delhi reported that its economy clocked 8.9% year-on-year growth in the July-September quarter, further closing the growth gap with China. And as the economics textbooks predict for a country growing this quickly, India is importing capital goods, as its investment cycle picks up again, and consumer goods, as a population with rising incomes aspires to a higher standard of living. Capital is flowing in to fuel growth and a trade deficit.

Yet this is hardly the norm among the fast-growing tiger economies of East Asia, which grow by running trade surpluses and accumulating massive foreign exchange reserves. So established has this model become that India looks like an outlier.

It is cause for celebration that India is bucking the trend. Unlike other countries in Asia that grew by subsidizing their export sectors, India is letting the benefits of free trade accrue to its entire population. The economy's main engine is a stable mix of domestic-oriented investment and demand, and its companies face the rigors of competition. This reduces the risk of malinvestment and balance-sheet recessions.

However, some observers are now sounding the alarm about balance of payments data released by the Reserve Bank of India last Friday, which show the current account deficit widening to $15.8 billion for the July-September quarter, from $12.1 billion in the previous quarter. Does this mean India is going off the rails?

The short answer is, not necessarily. The real worry, though, is that New Delhi still hasn't implemented necessary reforms so it can absorb foreign investment and continue growing at a fast and sustainable pace.

This isn't the first time there is alarm over India's current account deficit. Since it caught the 8%-plus growth train last decade, Indian policy makers have continually fretted about what sort of investment is financing imports. Much like now, from 2006 to mid-2008 low interest rates in the West drove institutional investors to seek higher returns in emerging markets; the flood of capital into India's stock market was contributing to overheating, at least until the post-Lehman shock sent the money flows into reverse for a couple of years.

The Reserve Bank of India is worried that these flows might again prove destabilizing. For instance, in July-September 2010, flows into Indian stocks and bonds made up 88% of foreign investment inflows that totalled $21.7 billion. The central bank considers these flows "volatile." The more stable foreign direct investment trickled in at $2.5 billion, a far cry from, say, the $10 billion in FDI India absorbed in the April-June quarter of 2008. So, in a financial stability report published last week, the RBI marked the current account deficit as a downside risk to the Indian economy.

We're sympathetic to the concern that easy money in the U.S. is causing problems for developing countries like India. But we're not sympathetic to the kind of steps the RBI took in 2007 to "manage" India's capital account: Greater limits on foreign borrowings and more scrutiny on foreign investors, besides stalling on the introduction of new financial products.

To RBI's credit this time, despite last year's episode of "currency wars," it resisted putting new capital controls in place and intervening in foreign exchange markets to weaken the rupee. In fact, it has gradually proceeded with capital account liberalization in the past year: Last September's relaxation of the foreign investment limit in bonds is one encouraging sign.

When it comes to the RBI's lament over the composition of capital account inflows, it's worth noting that New Delhi's own policies skew that composition. As Cornell economist Eswar Prasad explains nearby, investment tends to flow into Indian stocks because that market offers transparent regulation and minimal restrictions. Managers of multinational companies will tell you that's not true for foreign direct investment; each sector from power plants to shopping malls comes with its own labyrinthine set of regulations, on top of general limits on FDI.

Since Prime Minister Manmohan Singh's government was returned to power in mid-2009, it hasn't relaxed any more FDI caps. Wal-mart still can't enter India's retail market because no FDI is allowed in multi-brand retail; the 26% cap in insurance means no global insurance major can enter as a majority owner. What's worse, the government's environmental activism has made FDI more uncertain. For example, Korean steel giant Posco has been nervously awaiting New Delhi's sanction for a $12 billion project in the eastern state of Orissa. Though a government panel on Monday gave Posco its clearance, the project needs final political approval. This explains why FDI into India is now slowing down.

India has the potential to establish a new model for more sustainable and balanced growth in competition with the East Asian export-led model. But if it fails to undertake reforms to make it a more attractive destination of foreign capital, it will cap its own growth potential. New Delhi deserves praise for remaining more open to portfolio investment than other Asian nations, but going to the other extreme of hampering FDI is inconsistent with its laudable record of balanced growth.