Y V Reddy: India and the global economy
Speech by Dr Y V Reddy, Governor of the Reserve Bank of India, at the Lal Bahadur Shastri National
Academy of Administration, Mussoorie, Uttaranchal, 17 July 2004.
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Friends,
I am delighted to be here in the Lal Bahadur Shastri National Academy of Administration, Mussoorie.
You are among the few that have succeeded in perhaps one of the most competitive and fairest
examinations in the world. You have the additional advantage of having spent some time in the rural
and semi urban areas of our country while in the districts. I chose the subject 'India and global
economy' precisely because during the next three to four decades that you will be serving our nation,
the biggest challenges and opportunities for our country would be in the rural and semi-urban areas.
An important driver of change in rural India would be the impact of integration of the Indian economy
with global economy. It is a happy coincidence that the respected Chief Minister of Uttranchal, Shri
N.D. Tiwari, who spoke to you in the preceding session today, urged you to closely follow the
developments in the global economy even while you work in sub-divisions, districts and States. Mr.
Mukesh Puri, your Course Director asked me whether the topic of my talk today was, indeed, 'India
and the global economy' and not 'India in the global economy'. I clarified that it was 'and' and not "in"
the global economy. Simply stated, till recently the issue had been how India would manage its
growing integration with the global economy. Of late, there is some discussion on how the global
economy would adjust to the successful global integration of India.
In the first part of the presentation, as a background, there will be a brief account of global economic
integration and the role of public policy. This will be followed by a review of India's policies in regard to
the external sector. The third section will mention what appear to be the current challenges for the
global economy as India integrates with it. The fourth section would be in the nature of random
thoughts on the public policy challenges in our country to manage the integration smoothly. The fifth
section will elaborate on several issues in regard to financial integration. The issues include the
special characteristics of financial integration and our policy in this regard including that for the banks.
Global economic integration
The concept of globalisation, in the sense in which it is used now, can be traced to the phenomenon of
nation states. In the distant past, there were just human communities. For much of human history,
most people remained confined to their communities, villages or local areas. With developments in
communication and economic activity, it has progressively become easier to move from the local to
the regional and then from the regional to the national level, and finally across nations. Perhaps
globalisation is a process that has been, in some sense, constrained by the authority of the nation
states, particularly in the twentieth century. It may be useful to touch upon the role of the public policy
of nation states, in the context of the concept of globalisation. After the emergence of the nation
states, each nation state perceived that it was in its collective self-interest to promote or restrict
involvement with citizens of other nation states. While developments in technology enabled and
accelerated the movements of goods, people and services, the policies of many nations tended to
impose restrictions. A nation state is presumed to put restrictions on its citizens in their involvement
with other nation states only in the collective self-interest of its citizens. It is, however, not easy to
define what is in the collective self-interest of all its citizens or of only a few at the expense of others.
In the context of the public policy relating to globalization, a critical issue is the trade-off between
individual freedom and the collective self-interest and also whether the onus of proof lies with the
individual or the national authorities. It is difficult to resolve these issues but they must be appreciated
in the context of public policy.
At a conceptual level, a distinction can be made between technology-enabled (or induced)
globalization and public policy-induced restrictions or easing of restrictions. Globalization has several
dimensions arising out of what may be called enhanced connectivity among people across national
borders. Such enhanced connectivity is determined by three fundamental factors viz., technology,
individual taste and public policy. Cross-border integration can have several aspects: cultural, social,
political and economic. For the purpose of this presentation, however, only economic integration is
considered. Broadly speaking, economic integration occurs through three channels, viz., movement of
people, of goods and, of finance or capital.
Firstly, on the aspect of movement of people, the most notable achievement of recent globalization is
the freedom granted to many, if not all, from the tyranny of being restricted to a place and being
denied the opportunity to move and connect freely. Secondly, in regard to trade in or movement of
goods across the national boundaries, two types of barriers generally are described viz., natural
barriers and artificial barriers. Of late, while the multilateral trade agreements are encouraging
reduction in such artificial barriers, the developments in technology are also making it difficult for
national authorities to enforce artificial barriers. The pace and nature of globalization will naturally
depend on the combined effect of technology and the public policy, both at the national and the
international level. The third dimension relates to capital movements for which also, the interplay
between technology and the public policy becomes relevant. There have been, however, some special
characteristics of capital flows in recent years mainly led by revolutionary changes in telecom and
computing capabilities. These have highlighted the phenomenon of what is described as "contagion",
which implies the risk of a country being affected by the developments totally outside of its policy
ambit, though domestic policy may, to some extent, influence the degree of its vulnerability to the
contagion. In any case, cross-border flows of capital have wider macroeconomic implications,
particularly in terms of the exchange rate that directly affects the costs of movement of people as well
as goods and services and, also in terms of the conduct of monetary policy and the efficiency as well
as stability of the financial system. Capital flows, by definition, generate further liabilities or assets and
could involve inter-generational equity issues. In this regard, it is useful to distinguish the extent of
globalisation in respect of three different types of economic entities viz., individuals or households,
corporate entities and financial intermediaries. It has been noticed that financial intermediaries impinge
on the contagion effects impacting financial stability in the developing countries. Experience in Asia
and Latin America has shown that the external liabilities of the private sector tend to devolve on
national governments in the event of crises and hence, there is a role for the public policy in trying to
prevent crises and creating capacities to meet crises, if and when they arise.
In managing the process of economic integration that is driven by several forces, developing countries
face challenges from a world order that is particularly burdensome on them. Yet, it is necessary for the
public policy to manage the process with a view to maximizing the benefits to its citizens while
minimizing the risks; but the path of optimal integration is highly country-specific and contextual. On
balance, there appears to be a greater advantage in achieving a well-managed and appropriate
integration into the global process, which would imply more effective - but not necessarily intrusive or
extensive - interventions by governments. In fact, while there are some infirmities in interventions by
government, markets do experience market-failures and cannot exist without some externally imposed
rules and prescriptions of the public policy. As the poor, the vulnerable and the underprivileged
continue to be the responsibility of the national governments, there is relevance of national public
policy - particularly as it relates to global economic integration.
External sector policies: a review
It is useful to outline the major developments in external sector policies since our independence as a
background to enable an appreciation of the current and future challenges. During the first three
decades of planned development, successive plans emphasized the need for financing development
largely from resources mobilized domestically. Firstly, Indian planners shared the export pessimism
then pervading the developing world. Secondly, the existence of a large domestic market provided
scope for internalising forward and backward linkages. Thirdly, development strategy hinged upon a
programme of industrialization to break through the vicious circle of backwardness. Fourthly, the
availability of foreign exchange was a major constraint, especially after the running down of the
Sterling balances during the 1950s and 1960s. Export pessimism permeated the policy stance
throughout the early decades of our planning. Accordingly, exports were regarded as a residual, a
vent-for-surplus on those occasions when such surpluses were available. Import substitution was the
principal instrument of trade policy and was regarded in the early years as not only the correct strategy
but also inevitable in a continental economy like India.
It may be of interest to note that the objective of self-reliance did not find an explicit commitment in the
second and third five-year plans which were mainly concerned with generating the foreign exchange
resources required for the plans. The third plan reflected the first signs of rethinking in the policy
strategy by dedicating itself to 'self-sustaining growth' which required 'domestic savings to
progressively meet the demand of investment and for the balance of payments gap to be bridged
over'. The fourth plan contained an articulated approach to achieving self-reliance. While an export
growth of seven per cent per annum was considered an essential element of the strategy, it was
envisaged that the dependence on foreign aid would be halved during the course of the fourth plan
(1969-74). It was in the fifth plan (1974-79) that self-reliance was recognised as an explicit objective.
The sixth plan (1980-85) emphasized the strengthening of the impulses of modernization for the
achievement of both economic and technological self-reliance. The seventh plan (1985-90) noted the
conditions under which the concept of self-reliance was defined earlier, particularly in the preceding
plan. It conceptualized self-reliance not merely in terms of reduced dependence on aid but also in
terms of building up domestic capabilities and reducing import dependence in strategic materials. The
concept also encompassed the achievement of technological competence through liberal imports of
technology. The gulf crisis and its impact on India provided several lessons for us, and one of them
was that a relatively closed economy does not provide immunity from a foreign exchange crisis.
Incidentally, India excelled in managing the crisis and emerged as one of the very few countries in the
world, amongst both the developed and the developing, to have never defaulted on its external
obligations.
In the aftermath of the Gulf crisis, policy actions were initiated as part of the overall macroeconomic
management well coordinated to simultaneously achieve stabilization and structural change. External
sector policies designed to progressively open up the Indian economy formed an integral part of the
strategy for structural reforms. In this context, the Report of the High Level Committee on Balance of
Payments (Dr. Rangarajan Committee, 1993) recommended improvement in exports, both
merchandise and invisibles; modulation of import demand on the basis of the availability of current
receipts to ensure a level of current account deficit consistent with normal capital flows; enhancement
of non-debt creating flows to limit the debt service burden; adoption of market-determined exchange
rate; building up the foreign exchange reserves to avoid liquidity crises and elimination of the
dependence on short-term debt. It is evident that the external sector policies of the 1990s, based on
the Report, paid rich dividends in terms of growth and resilience to a series of external and domestic
shocks.
In the new millennium, however, there has been a dramatic shift in our approach to external sector
management in tune with the changing circumstances. First, with the emergence of marginal current
account surplus, it appears that the sustainability of current account deficit may not be a problem
though the deficit on trade account persists and has been increasing. Second, the main contributors to
the positive outcome in current account are workers' remittances and export of software, both being a
result of process of global integration. Third, the exchange rate regime as well as external debt
management served us well, especially the avoidance of sovereign debt through commercial
borrowings. The policy regime helped us withstand several global crises while maintaining a
respectable growth. Fourth, the management of capital account has acquired the primary focus rather
than the current account. Fifth, a judicious integration with the global trade regime has imparted some
competitive efficiency and confidence to the domestic industry and perhaps, even to commercial
agriculture though to a limited extent. Finally, it has become evident that the management of the
external sector is closely linked to the domestic sector and the major thrust of public policy now has to
be managing the integration and not 'grumbling' as the Nobel Laureate Amartya Sen is reported to
have said a couple of days ago. Integration of the Indian economy with the global economy and
policies aimed thereat have to address domestic and external sectors in a holistic and harmonious
way. In brief, we have moved from managing external sector to implementing an optimal integration of
domestic and external sectors, and the global economy.
Adjustments by the global economy
The debate in India has customarily been on the contours of the public policy in the context of
increasing global economic integration. More recently, however, a debate in the rest of the world has
been in evidence on the challenges likely to be faced by the global economy on account of
progressively increasing global integration of the Indian economy. The emphasis is of course on
successful integration which will no doubt depend on the appropriateness of our public policies and
the private sector responses. Hence, there is a need to have an ongoing appreciation of how the
global economy is responding to the challenges of our integration while we move forward with our own
agenda of securing an optimal integration.
Currently, the major issue in the global economy appears to be the significant build up of current
account imbalances. The current account deficit of U.S.A. has been rising and is around 5% of GDP,
while current account surpluses are noticed in Asia and to some extent in Latin America and Russia.
The external financing of the US deficit moved away from equity in the late nineties to debt in the
recent years, possibly reflecting a perception of productivity growth in the former period and fiscal
stress in the latter. The official reserves played a greater role than in the past in financing the US
current account deficit in recent years. There is a perception that the US dollar is still relatively
overvalued warranting a correction. Simultaneously, the unique combination of easy monetary policy
and lax fiscal policy in major industrialised countries is set to end and the financial markets are already
in a state of uncertainty. Even assuming that the transition of monetary policies to a more neutral
stance is managed well and that trade gets to be more evenly balanced, associated with some
corrections in the USA, the simultaneous emergence of China and India with significant competitive
strengths in trade in goods as well as services will have to be accommodated by the global economy.
Thus, the issue for the immediate future is that both, correcting current global imbalances and
integrating the two Asian giants, may have to take place simultaneously in the global economy.
It is evident that China and India will have to give a high priority to generating employment and are
poised for substantial increases in productivity. Consequently, the global economy will have to
consider the implications of these developments on prices, exchange rates, wages and structures of
employment in industrialised countries. Over the medium term, it is felt that outsourcing will grow in
geometric progression, particularly to India, and may also cover high-end research and development.
In manufacturing, China has emerged as a leader and India is poised to join the race. Though
agriculture is heavily subsidised in major industrialised countries, such subsidisation could be difficult
to sustain from a fiscal point of view, since many of the countries concerned are poised to meet the
mounting pension liabilities not to speak of burgeoning health care costs of maintaining the changing
demographics. One sector where the industrialised economies continue to show considerable strength
and dominance is the financial sector, partly attributable to the confidence factor in financial markets
that favours the industrialised economies and traditional international financial centres. It is essential
for us to carefully monitor the developments in both real and financial sectors, and to modulate our
policies in tandem with the global developments so that global integration continues to be a positive
sum game for all the countries.
Random thoughts on our policies
As mentioned, global economic integration is technology induced and, simultaneously, policy
constrained or policy restrained - in other words, policy-managed. While the economic integration of
India with the global economy will continue to take place, a successful integration, with due regard to
the interests of a vast majority particularly, the poor in our country would be possible only through
sound public policies - evolved and redesigned from time to time. The key phrases here are
"successful economic integration", and "sound public policies" - both involving processes spread over
time and also interaction with global economies. If one were to make an informed guess on the
prospects of such a successful integration of India, it may be said that upside and downside risks are
evenly balanced with a short term bias towards upside risks - which would give us some time to work
on mitigating the downside risks in the medium term. Indeed, the well publicised BRIC report1 reflects
considerable confidence in the future of the Indian economy, though it is necessary to see the fine
print to realise that while India would be a super power in 2050, "if development proceeds
successfully", the per capita income would still not be at a high end. What is important to recognise is
that the report leans on the demographic strength that India derives from its huge workforce. In order
to harness the demographic advantages, the quality of labour force, (in terms of relevant skills which
need to be sustained, reoriented and upgraded in a globally competitive era) and the physical health
of the workforce become crucial. Education and health, therefore, provide the link between supply and
demand for labour through increases in productivity. In this background, here are some random
thoughts on the priorities for public policy to ensure successful economic integration of India with
global economy.
First, pragmatic policies in the external sector, particularly in the management of capital account and
exchange rate, have served us well by contributing to growth, resilience to shocks and an overall
stability. There is merit in continuing the pragmatic, cautious and, gradual approach in this regard,
subject to improvements in fiscal arena and the progress in strengthening the domestic financial
sector.
Second, the management of financial sector has been oriented towards gradual rebalancing between
efficiency and stability and the changing shares of public and private ownership. Enhanced
competition among diverse players, including from branches of foreign banks, has been encouraged.
Considerable improvements have taken place in prudential governance as also in moving away from
administrative measures to market-orientation. Improvements in efficiency and stability are palpable
and there is merit in continuing with such rebalancing while refocusing on consolidation, governance
and moving towards Basel II - albeit gradually, as in the past.
Third, on the fiscal front, the ratio of public-debt to GDP is high in our country, but the structure of
public-debt displays characteristics that make us less vulnerable than other countries with similar debt
magnitudes. There is advantage in continuing the progress in public debt management keeping
structural aspects in view. As we proceed with fiscal consolidation, clearly focussed in the latest Union
Budget 2004-05, there will be greater flexibility in conduct of monetary policy and greater confidence
for proceeding with financial sector reforms. Furthermore, an effective and qualitative fiscal adjustment
would enhance the scope for a more successful integration with the global economy.
Fourth, in matters relating to trade, significant liberalisation of external trade has taken place smoothly,
which has imparted competitive efficiency to the domestic sector. The apprehensions that existed till a
few years ago of the adverse impact of such trade liberalisation, have abated and the business
confidence in the country has improved. While the gradual approach with a commitment to a
liberalised trade regime has enabled productivity increases - almost up to the global best standards in
many of the sectors - there are signs of pick up in investment activity which could catalyse the needed
demand for credit and create employment. There is one significant incongruity, however, which should
be corrected sooner than later, viz., the continuing trade restrictions within the country even as there
has been progress in liberalising external trade. There is incontrovertible, though generalised,
evidence to show that persisting trade restrictions in a country are not in the public interest and hence,
as many distinguished economists plead, most of the exceptions to Article 301 of the Constitution
permitted on 'public interest' grounds perhaps need to be done away with. (Article 301 reads as
'subject to other provisions of this part, trade, commerce, and intercourse throughout the territory of
India shall be free'). This may warrant repeal of several legislations that restrict trade domestically in
the "public interest". To alleviate any adverse impact on vulnerable sections, a straight forward subsidy
could be considered in favour of the poor. There is another well recognised distortion, vestiges of
which still continue, in the form of reservation for small scale industries. With liberalisation of external
trade, it is anomalous to persist with such distortions, even if on a reduced scale. Thus, there is still an
unfinished agenda on trade reforms especially in regard to domestic trade and a policy commitment to
remove such distortions in a defined short time frame would be ideal.
Fifth, it is interesting to note that the two sectors where India is globally most competitive, namely,
software and pharmaceuticals, are not power intensive and do not require bulky transportation. The
competitiveness of the manufacturing industry is admittedly a function of the availability of reliable
power supply at reasonable cost. The budget of 2004-05 has rightly emphasised the importance of
power, airports and seaports (apart from tourism, which has significant employment potential) but
there is need for implementation at a pace significantly faster than we have ever witnessed in any
sector so far.
Sixth, there is universal recognition of the need to improve both productivity and output in the
agriculture and related activities to meet the objectives of growth and employment. Yet, despite the
best of efforts and excellent results achieved in that direction, there will have to be a massive shift of
the workforce from agriculture to non-agricultural avocations. While it is difficult to estimate at this
stage, we should be prepared for a large-scale migration of the workforce to the tune of 10 million per
year, from rural to semi-urban and urban areas. The quality of urban infrastructure even in the
metropolitan cities is not conducive to globally competitive economic activity. The inevitable large
scale redeployment of the migrating workforce would, therefore, need institutional arrangements, be
they in public or private sector, for skill-imparting and skill up gradation. In these two matters relating to
the workforce, some supply-led approaches appear to be in order, rather than waiting for the demand
to be generated.
Seventh, improvements in institutional infrastructure in matters relating to administrative, judicial and
other systems of governance are admittedly important. Needless to say, if we fail to record rapid
progress in these critical areas, we will fail in everything, especially in economic arena.
Eighth, the quantity and quality of water, education and health care infrastructure are far from
adequate, and are not even at the minimum level consistent with a modern society. These fall under
the ambit of delivery of public services and the Prime Minister has already accorded a high priority to
this issue. Any tangible reform in this area would require action on several fronts, i.e., legislative,
executive and judicial and at several levels, Centre, State and local.
Ninth, there are regional inequalities in growth and several analysts have tried to find the causes and
suggest remedies. Recognising that the next phase of reforms in most of the physical, social and
institutional infrastructure, especially in the area of delivery of services, would fall within the realm of
the States, one should hope that the demonstration effect of a few high-performing States will spur the
other States, in the medium term, to compete for better governance and economic performance.
Finally, enhanced investment activity, particularly in the infrastructure area, would necessitate higher
domestic savings, especially in the public sector coupled with efficient financial intermediation. In
addition, foreign savings need to be attracted and absorbed with a strong preference to Foreign Direct
Investment in all sectors though in some sectors like banking, a calibrated approach may be
warranted. At the same time, our enterprises should be enabled to attain a strong global presence in
all sectors. In brief, our global integration has to be a two way process, encompassing movement of
people with some caveats, trade in a free and equitable manner and financial integration on a
specially sequenced basis. Hence, it is necessary to elaborate on the financial integration.
Financial integration
From a policy perspective, there are three fundamental issues in regard to financial integration
namely, "how does financial globalization help growth ?"; "how does it impact macro-volatility ?"; and
"how can developing countries harness the benefits of globalization ?". These three issues have been
addressed comprehensively, in an IMF Occasional Paper2 and the following extracts from the
summary of the Paper do provide some answers:
"There is some evidence of a 'threshold effect' in the relationship between financial
globalization and economic growth. The beneficial effects of financial globalization are
more likely to be detected when the developing countries have a certain amount of
absorptive capacity"......... "International financial integration should, in principle, also
help countries to reduce macroeconomic volatility. The available evidence suggests that
developing countries have not fully attained this potential benefit".......... "A type of
threshold effect appears here as well - reductions in volatility are observed only after
countries have attained a particular level of financial integration"........... "The evidence
presented in this paper suggests that financial integration should be approached
cautiously, with good institutions and macroeconomic frameworks viewed as important.
The review of the available evidence does not, however, provide a clear road map for the
optimal pace and sequencing of integration. Such questions can best be addressed only
in the context of country-specific circumstances and institutional feature".
The guidance for policy makers from the above is perhaps clear. Unlike in the case of trade integration
where benefits to all countries are demonstrable, in case of financial integration, a "threshold" is
important for a country to get full benefits. A judgmental view needs to be taken whether and when a
country has reached the "threshold" and the financial integration should be approached cautiously with
a plausible road map by answering questions in a country-specific context and institutional features.
Fortunately, we, in India, have been adhering to a cautious and calibrated approach in our reforms so
far and there is merit in adopting a 'road map approach' building on the strengths that we have already
developed.
One of the major concerns for developing countries in proceeding with financial integration appears to
be the financial stability. Hence, the role of cross-border linkages in this regard should not be ignored.
It would be useful to draw upon the Introduction in an IMF Working Paper3 on the subject which
identifies four major trends in the financial economy of the past decades and mentions the following:
"Although these trends reflect important advances in finance that have contributed substantively to
economic efficiency, they evidently have implications for the nature of financial risks and vulnerabilities
and the way these affect the real economy, as well as for the role of policymakers in promoting
financial stability. For instance, risk management and diversification techniques have, in principle,
bolstered the resilience of the financial system, but the expansion of cross-sector and cross-border
linkages implies more scope for contagion".
It is also necessary to recognise that financial integration complicates the conduct of monetary
management. The growing cross-border integration of financial markets enables massive movements
of capital, which quickly arbitrage interest rate differentials across national boundaries. This is
reinforced by the ever-widening impact of the information technology revolution. Real long-term
interest rates in industrialised countries have been converging since the late 1980s. Financial
integration has also brought with it shocks common to several countries since the "confidence
channel" transmits financial crises across countries swiftly. In a world of generalised uncertainty,
monetary policy in several countries is faced with a progressive loss of discretion. For developing
countries, in particular, considerations relating to maximising output and employment weigh equally
upon monetary authorities as maintaining the price stability. In considering the pace of financial
integration, the implications of a concurrent loss of a degree of autonomy in conduct of monetary
policy of a country and the country context should not be lost sight of. The analytics presented in the
Report of the Committee on Capital Account Convertibility (Tarapore Committee, 1997) are very
relevant in this regard. In particular, they relate to what has been described as 'preconditions' such as
fiscal consolidation and strength of the financial sector, and meeting such preconditions facilitates the
conduct of monetary policy in a more open capital account regime.
It is also useful to recognise a close link between the extent of capital account liberalisation and the
presence of foreign financial enterprises in a country. The nature of the link is best articulated in the
following extracts from a recent book by Martin Wolf4:
"It is i