Raghuram Rajan: India in the global economy
Text of the First Ramnath Goenka Memorial Lecture by Dr Raghuram Rajan, Governor of the
Reserve Bank of India, New Delhi, 12 March 2016.
* * *
I thank Dr. Prachi Mishra and her team for assistance.
Thank you for inviting me to deliver the first Ramnath Goenka lecture. As you know, Shri
Goenka was a freedom fighter, who built the Indian Express into a national newspaper. In his
time, it was arguably the best investigative newspaper in the country. He was instrumental in
highlighting the excesses of the Emergency, which probably contributed to Indira Gandhi's
defeat when she lifted it. He continued to be a tireless scourge of corruption and government
high-handedness, and was responsible for unsettling many a minister and business tycoon. It
would be fitting in a lecture in his memory to speak about the efforts we are making in India
today on increasing transparency and curbing corruption. However, I have said what I
needed to on that elsewhere. Instead, I will speak today on India's engagement with the
global economy, and how best to manage it in these turbulent times
The global economy is finding it hard to restore pre-Great Recession growth rates - every
report of the IMF seemingly downgrades its previous growth forecasts. Why has the recovery
been so slow? The immediate answer is that the financial boom preceding the Great
Recession left industrial countries with an overhang of debt, and debt, whether on
governments, households, or banks, is holding back growth. While the remedy may be to
write down debt so as to revive demand from the indebted, it is debatable whether additional
debt fueled demand is sustainable. At any rate, large-scale debt write-offs seem politically
difficult even if they are economically warranted.
But perhaps the debt overhang points to a deeper cause; the debt-fueled demand before the
Great Recession, which has led to the debt overhang now, hid a fall in global potential
growth, perhaps because of the difficult-to-understand consequences of population ageing
across the industrial world, and the slowdown in productivity growth.
Structural reforms, typically ones that increase competition, foster innovation, and drive
institutional change, are the way to raise potential growth. But these hurt protected
constituencies that have become accustomed to the rents they get from the status quo.
Moreover, the gains to constituencies that are benefited are typically later and uncertain. No
wonder Jean-Claude Juncker, the former Luxembourg Prime Minister, said at the height of
the Euro crisis, "We all know what to do, we just don't know how to get re-elected after we've
done it!"
Instead, industrial countries are engaged in ever more aggressive monetary policy moves.
This imposes tremendous risks on emerging markets like ours, as we are faced with surges
of capital inflows one day when investors go into "risk-on" mode only to see outflows the next
as they switch risk off. At the same time, overcapacity in competitor countries threatens
some of our key industries.
What should India do?
What should India do in this environment where the international investor is manic
depressive in his behavior and all countries are striving for extra growth? Importantly, when
global growth is uncertain, we should make sure that our domestic environment promotes
strong, sustainable, and stable growth. This requires a firm platform of macroeconomic
stability. Let me elaborate.
The recent central budget emphasized fiscal prudence and adhered to past commitments,
even while allocating resources towards capital spending and focusing on structural reforms,
especially in agriculture. The subsequent fall in government bond yields suggests that market
investors were calmed by the Government's overall message. Fiscal consolidation, combined
with lower commodity prices, has also led to a lower current account deficit.
Inflation is also clearly down since the days of double-digit CPI inflation not so long ago. The
RBI's inflation-focused monetary framework will be strengthened by the constitution of the
monetary policy committee mooted in the Finance Bill. While the RBI Governor will no longer
be able to set monetary policy unilaterally, I believe shifting the decision to a committee is in
the economy's interest. Not only will a committee aggregate multiple views better than an
individual can, it will offer more continuity, and be less subject to undue pressure. I believe
the monetary reforms of this Government will stand out as one of its signal achievements.
The last leg of the stabilization agenda is to clean up the stressed assets in the banking
sector so that banks have the room to lend again. The problem in the past was that banks
simply did not have enough powers to force promoters to pay, or to put stressed assets back
on track. Unlike more developed countries, we do not have a functioning bankruptcy system,
though a bill is currently before Parliament. Therefore, we first had to create an effective
outof-court resolution system. Having done that, we are now working with banks to recognize
and resolve stressed assets, even while getting them to raise capital where necessary. Our
intent is to have clean and fully provisioned bank balance sheets by March 2017.
Perhaps the hardest aspect of this stabilization agenda has been to persuade the economics
commentariat of the need for macroeconomic stability when growth is below expectations.
The constant call of the economic sirens, seeking to lure the economy onto the shoals of
economic distress, is "Lord, give us stability, but not just yet!" Growth is always more
important, no matter how the risks build up. Usually, the sirens call on you to not be
doctrinaire (after all, only academic economists care about fiscal deficits), to be practical
(does it really matter if an NPA is recognized a quarter or three later), and to appreciate
Indian realities (everyone may say they hate inflation but no one really wants to bear the pain
of the disinflationary process).
I believe we are in the process of proving the sirens wrong. Given the inhospitable world
economy and two successive droughts in India, either of which would have thrown the
economy into a tail spin in the past, our focus on macroeconomic stabilization must be part of
the explanation why we have over 7 percent growth, low inflation, and a low current account
deficit unlike some of our emerging market counterparts. Now, we have to build on this
sound base. What will be particularly important is how we engage with the world economy. I
want to talk specifically about trade, the exchange rate, capital flows, and ideas.
International trade
For the first time in decades, global trade has consistently grown more slowly than global
output. There are a number of possible explanations; as countries get richer, non-traded
services constitute a greater fraction of GDP, causing GDP to grow faster than trade. Also,
with trade-intensive capital goods' investment muted because of global overcapacity, trade
grows more slowly than GDP. Finally, as industrial countries become more competitive, and
as China moves up the value chain, more of the inputs going into final products are being
sourced from inside a country rather than from outside the country. Some global supply
chains are therefore contracting. For all these reasons, the heady days when Indian trade in
goods and services were expanding at a double digit pace will probably only be a memory for
some time.
It is useful to examine recent trade data to see how India compares with rest of the world.
Figure 1 suggests the growth of Indian exports of goods and services broadly mirrors that of
emerging markets.
Source. IMF Balance of Payment Statistics. Emerging markets (EMs) include Brazil, China,
Indonesia, Mexico, Russian, South Africa, Thailand, Turkey, and India. The black line shows
a simple average of growth rates across these EMs.
Most recently, of course, emerging market commodity exporters have been hit by lower
prices. Nevertheless, Indian goods exports seem to be doing worse recently than goods
exports from emerging markets (see figure 2).
Source. IMF Balance of Payment Statistics. Emerging markets (EMs) include Brazil, China,
Indonesia, Mexico, Russian, South Africa, Thailand, Turkey, and India. The black line shows a
simple average of growth rates across these EMs.
At the same time, the growth of Indian service exports seems to be doing somewhat better,
perhaps because countries like the United States that we export services to are recovering
more strongly. Of course, these differences are over very short periods, so it is probably
unwise to draw strong conclusions from them. What one can probably take away is that India
is not alone in suffering a fall-off in trade.
Source. IMF Balance of Payment Statistics. Emerging markets (EMs) include Brazil, China, Indonesia,
Mexico, Russian, South Africa, Thailand, Turkey, and India. The black line shows a simple average of
growth rates across these EMs.
However, as Indian trade slows, industry bodies are urging authorities to do something. Of
course, if all countries are experiencing slower trade, the remedies may be beyond the
control of Indian authorities. While we can examine possible dumping in certain industries,
we have to be careful that any remedies that increase prices in the protected industry do not
render other domestic industries uncompetitive.
It is at these times of slowing trade that our pundits look at the exchange rate and argue it is
overvalued. Of course, I have just argued that we are not alone in experiencing a fall in trade,
but let us examine the exchange rate.
The exchange rate
When most people think about the exchange rate, they think of the rupee's value against the
dollar. As Figure 4 indicates, the rupee seems to have weakened by about 6% against the
dollar since the beginning of 2015, approximately the time our relative underperformance on
goods exports started. This depreciation should have helped our exports, though the effects
of depreciation show up only after a lag.
But we should note that other currencies have depreciated against the dollar also. So while we
have gained an advantage versus US producers, other foreign producers may have become
even more competitive because their exchange rate has depreciated more. Economists
therefore advise looking at an index of the nominal effective exchange rate, which compares
the rupee's value versus other exchange rates, weighing each by their share in trade.
Sources. RBI and IMF. The indices are normalized to January 2013=100. An increase denotes
an appreciation.
By this metric in Figure 5, the rupee has remained relatively flat since early 2015. What we
have given up against the dollar, we have gained against the Euro or the Real, so overall, in
trade-weighted terms, the rupee has been flat.
But wait a minute, our economist friends will say. Inflation in India is higher than inflation in
most other countries. This affects competitiveness. If a widget cost a dollar to make a year
ago in the United States, and ₹63 in India then, the Indian producer would have been
competitive with the United States because the dollar was worth ₹63. But if inflation in India
is 5% and zero in the United States, it would cost the Indian manufacturer ₹66.2 to make it
today. If the rupee stayed at ₹63 to the dollar, the Indian manufacturer would have become
uncompetitive today - the US producer would be able to manufacture the widget at a cost
equivalent of ₹63 only. In other words, to retain competitiveness, the rupee has to depreciate
by the inflation differential vis a vis a trading partner. An index of how competitive we are is
called the "real effective exchange rate". Think of that as the nominal effective exchange rate
adjusted for inflation. The higher it is, the less the exchange rate has depreciated to offset
inflation, and the more uncompetitive we are.
Sources. RBI and IMF. The indices are normalized to January 2013=100. An increase denotes an appreciation.
Figure 6, where I plot the real effective exchange rate, shows the age old truth that
interpretation is in the eyes of the beholder. If a columnist wants to blame the exchange rate
for our export slowdown, she can look at the index from the low point of September 2013 and
argue it has appreciated 20% (based on the IMF measure). Of course, it would be hard to
argue that the low point our exchange rate reached in September 2013 represented an
equilibrium rate. Moreover, our exports were doing quite well relative to emerging markets for
much of that period (see Figure 1).1 Indeed, over the last year when goods exports have
slowed, the real effective exchange rate has been rather flat. So someone who wants to
absolve the exchange rate of blame will point to the recent period.
But there is another reason to absolve the exchange rate of accusations of overvaluation.
The real exchange rate is only one measure of competitiveness. Productivity also matters. In
a rich country, firms are already at the productivity frontier, so they typically can improve
productivity only through innovation. In a poor country, productivity can be improved simply
by reducing existing bottlenecks or by moving a little closer to the productivity frontier through
the adoption of already-known best practices. Productivity in India, for example, can improve
simply if a better road is built from a factory to the rail head, or if the firm manages its
inventories better. One reason Indian manufacturing GDP has been growing so fast when
firms have been experiencing little increase in final sales is that firms have been focusing on
improving productivity. So offsetting any rise in the real exchange rate is any productivity
differential we enjoy with respect to the rest of the world. Assuming conservatively that this is
about 2 percent a year, much of the real appreciation that economists complain about is
offset by productivity differentials.
The bottom line is that even though Indian trade has been slowing, the slowdown is similar to
what has been happening elsewhere, with a significant portion due to a fall in commodity
prices, and a smaller share due to a fall in trade volumes. While goods exports may have
suffered a little more over the last year, it is too early to discern a clear pattern, and certainly
hard to pin the slow down on the exchange rate.2
The goldilocks rate
It is worthwhile to push this discussion a little further though. If the RBI could press a button
and get the exchange rate it desired (as some economists imagine is possible) should it aim
for a strong rupee or a weak rupee? Non-economists typically advocate a strong rupee - not
only does it convey national strength, but you can buy more stuff with your rupee when you
go abroad, and imports are cheaper. The non-economist is consumer focused.
Of course, it is precisely because domestic tourism and domestic production are
disadvantaged relative to tourism abroad and foreign production that many economists prefer
a weak rupee. Yet these modern day, producer-focused, mercantilists do not acknowledge
that undervaluation is a subsidy to domestic producers paid for by domestic consumers and
savers. The domestic consumer pays too high a price for foreign goods, and interest rates
have to be kept artificially low so as to reduce the cost of holding the enormous foreign
exchange reserves built up through intervention. There are costs over the long run also. A
sizeable portion of the investment made in the country based on an artificially low exchange
rate will turn out be uncompetitive when the exchange rate normalizes. One might argue that
this reflects the experience of Japan in the 1990s and possibly the experience of parts of
Chinese industry today.
An undervalued exchange rate might have made sense in the past for countries that had
weak firms and small domestic markets. India is in a very different position today from the
export-led East Asian tigers when they embarked on their growth path. The ideal exchange
rate for us is neither strong nor weak, it is just right. Typically, market forces get you to this
Goldilocks rate. Yet there are circumstances where rapid capital inflows or outflows can
move the rate to a level that is unlikely to be supported by fundamentals. While the RBI
would not claim to know precisely what the equilibrium level of the exchange rate is at any
given point in time, we intervene to moderate adjustment whenever we believe the
movement is extreme, driven by sentiment, and likely to be reversed. Our intent is to prevent
overshooting and undue volatility, rather than to stand in the way of the needed adjustment.
Of course, temporary irrationality in the market can overwhelm a central bank. Much like a
bank run, a falling currency can prompt further fall as foreign investors attempt to get out
before they lose everything. To maintain orderly movement of the rupee versus other
currencies, we believe we need three ingredients. First, good policies that ensure
macroeconomic stability and convinces investors their money is safe over the medium term. I
have already discussed this earlier.
Second, we should focus on attracting stable capital flows that will stay for the long run. This
means resisting the temptation to open up too much to short-term- as well as foreign currency
denominated debt flows in good times, no matter how low an interest rate they charge. In the
last few years, we have limited foreign portfolio debt investment in short term rupee debt
instruments. It is not that these investors cannot sell long term bonds and leave at a moment's
notice, it is that investors in longer maturity bonds are likely to be a little more stable than
investors who want overnight exposure only. At the same time, we have steadily expanded
investment limits for foreign investors in government bonds, and will continue doing so.
Our new External Commercial Borrowing rules encourage infrastructure projects and other
projects that have limited foreign earnings to either issue rupee Masala loans, or to borrow
really long term tenors. This limits the risk that they will be required to repay when the
exchange rate has moved adversely against them.
Finally, the Government has been encouraging foreign investors to "Make in India". One
offshoot of this campaign has been a sizeable rise in foreign direct investment, the most
stable sort of investment. With two months left in the year to go, net FDI is already at the
second highest level ever, and comfortable higher than the current account deficit.
The bottom line is that our policy towards foreign capital flows is one of steady liberalization,
where we try and not be tempted by cheap finance, but draw in the risk-bearing capital we
need to finance our growth. We intend foreign investors to get decent returns and we do
intend to continuously ease both entry into and exit from the country.
Finally, our third line of defence is our foreign exchange reserves. We intervene in the
exchange markets to smooth volatility, and typically find ourselves buying dollars at certain
times and selling dollars at others in any given year.
How to increase exports
So if the exchange rate is unlikely to be a helpful tool in our quest to increase what we make
in India, how should we export more? The answer is simple - improve productivity by
building out infrastructure; improve human capital with better schools, colleges, vocational
and on-the-job training; simplify business regulation and taxation; and improve access to
finance. Fortunately, all this is what the government is focused on.
I am often asked, "What industries should we focus on, what should we encourage?" Learning
from our past, I would say let us not encourage anything; that might be the surest way of killing
it. Instead, let us make sure we create a good business environment that can support any kind
of activity, and then let our myriad entrepreneurs figure out what new and interesting
businesses they will create. In the 1990s, the IITs that Pandit Jawaharlal Nehru created to
supply engineers to the commanding public sector heights of the economy instead supplied
managers and programmers to body shops focused on dealing with the Y2K bug. These in turn
evolved into our world-beating software giants. While the government did not create the
software industry, it was not inconsequential by any means to its emergence and development.
Similarly, let us enable business activity but not try and impose too much design on it.
Ideas and analysis
Before concluding, let me emphasize one additional area of engagement with the world,
ideas and analysis. Today, we have a seat at most international tables, many countries want
to draw us into bilateral and multilateral treaties. When we were unimportant, we used to rail
against the proposals that were inimical to us, knowing it would not make an iota of
difference. As we get more power, we need to develop the capability of using it effectively.
Today, it is an unfortunate reality that international meets are still dominated by the old
powers. But it is less through brute power politics and more through the power of ideas,
agenda setting, and organization that they dominate. Agendas in the G-20 are still largely set
by elements of the old G-7, and often we find that they have already agreed on their
preferred approach. It is only when the big powers disagree that the rest of us have some
hope of influencing outcomes.
The fault is not in the power structure, it is in us. Unless we amongst the emerging world put
forward our agenda, build the intellectual and analytical basis for pushing it, and create
coalitions to support it, we will have no chance of moving forward. Encouragingly, the BRICS
do discuss policy issues and try and develop common approaches, but we need to do more.
We also need to build coalitions with sympathetic industrial countries. In India, we need to
build capacity in our think tanks and universities to inform our policy makers on how to
approach and shape the international policy agenda. We need to be well prepared when we
negotiate bilateral and multilateral treaties, so that we do not wake up too late to the fact that
we have given away the house with little in return. With careful analysis, engagement, and
coalition building we will be able to influence the global agenda, and will stop being seen as
an obstructionist but ultimately powerless country that we may have been in the past.
Conclusion
Let me conclude. Shri Ramnath Goenka focused on unearthing facts that would help move
the public debate forward. All too often, our public debates generate more noise than
illumination, and we should learn from the example he set. As we cope with the global
slowdown, and as we frame our policies going forward, we need to debate what our policy
path will be, based on facts, empirical analysis, and sound arguments. I have laid out a view.
I look forward to alternative viewpoints. Thank you for listening to me.