Rakesh Mohan: New economic geography and monetary policy in a flattening
world
Comments by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, as an overview
panelist at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole,
Wyoming, 24 August 2006.
All the papers presented in the Symposium are available at
http://www.kansascityfed.org/PUBLICAT/SYMPOS/2006/Sym06prg.htm
* * *
Let me first thank Tom Hoenig and his colleagues for inviting me again to this symposium. It is always
a treat to be here in more ways than one: to partake of the rich feast of insightful and interesting
papers, illuminating commentaries and discussions, accompanied by the warm hospitality of the
Kansas City Fed in this incomparable setting in the shadow of the majestic Tetons.
It is difficult to provide an overview of this rather disparate set of sessions reflecting various facets of
globalisation ranging from the new economic geography to monetary policy. Only someone as skilled
as Martin Feldstein can do that effectively. As it happens, however, speaking on a personal note, the
sequencing of this symposium coincidentally reflects my own evolution as a professional economist. I
started out in research and policy as an urban economist, made my way through policy making in
industry, trade and fiscal areas; while finally ending up as a central banker in charge of monetary
policy. So I will go through a similar sequence in my remarks in this overview, but perhaps spending
more time on my first love, urban economics, since that is central to understanding the new economic
geography. Depending on the time I may not be able to get past my first love today. In any case I feel
more comfortable with my first love than my current marriage to monetary policy!
Asian urbanisation: proximity promoting productivity
Anthony Venables set the stage for this symposium through his succinct presentation on the new
economic geography. Among other issues, he focused on the productivity promoting aspects of
proximity through the realisation of agglomeration economies from clustering of economic activities in
large urban agglomerations. Gene Grossman and Esteban Rossi-Hansberg characterised today's
trade pattern as trade in tasks in trying to understand the burgeoning off-shoring trends in production
and service activities. I would like to draw your attention to some particular characteristics of Asian
urbanisation that have, in my view, contributed to the whole off-shoring process as we now know it -
first in terms of merchandise trade in East and South East Asia and later in the outsourcing of service
activities for which India has come to attention in recent years.
To begin with, one may note that a key characteristic of Asian urbanisation has been the heavy
concentration of economic activities in coastal based urban regions.1 In fact, Japanese economic
growth in the 1950s and 1960s owed much to the conscious strategy of concentrating economic
activity in the 500 km Tokkaido urban corridor stretching from Tokyo through Nagoya to Osaka.
Douglas Irwin talked about the absence of policy effects in Venables', paper. The concentration of
economic activity in this corridor in Japan was policy driven through focused infrastructure investment
in the region as typified by the Shinkansen - the bullet train. By 1970, 60 per cent of Japan's urban
population (and a larger proportion of the economy) was concentrated in this region. This economic
concentration economised on infrastructure investment that would have been larger had it been
spread out over a larger part of the country. The geographical proximity of different activities gave rise
to agglomeration economies that aided rapid productivity growth and also enabled innovation in
traditional production processes through the introduction of new systems such as Just-in-Time (JiT)
modes of inventory management, great outsourcing of components, and total quality control processes
that contributed to the drastic reduction in manufacturing costs that was the foundation of Japan's
competitiveness. The more efficient inventory management resulting from JiT, overall supply
management, total quality control systems also enabled significant reduction in corporate need for
bank financing, leading to significant change in bank portfolios. Furthermore, the Japanese economy
benefited from high savings and investment rates, in excess of 40 per cent of GDP by the late 1960s,
a pattern repeated by some of the later star performers of East and South East Asia. Thus high
economic growth has been achieved in much of Asia, the main growth story of the latter part of the last
century, without significant absorption of foreign savings. It is no wonder then that Raghuram Rajan
and his colleagues cannot find correlation between the use of foreign capital and economic growth.
I describe this process at some length to essentially make the point that this was the precursor to
today's off-shoring of tasks. The idea of outsourcing components in the engineering industry,
particularly the automobile industry, originally emerged in the Tokkaido corridor of Japan where
economic distance between suppliers and assemblers was reduced through investments in efficient
transportation and other infrastructure. What was traditionally done at one plant location under the
same roof got outsourced to many distinct companies located within striking distance in the same
region. Thus intra-regional trade in tasks arose: the way the production process was organised in the
region locally has now been extended through to its logical conclusion across borders through long
distances. If task trade could be done within a region, with the fall in transportation and communication
costs it can be done across borders and long distances as well. As Venables mentioned, "the product
market effects can be long range - firms in New York may benefit from a large market in California,
and reductions in international shipping costs will increase market access for firms from a continent
away".
To the extent that a good deal of the off-shoring activity is concentrated in Asia, there are good
reasons for it. The strategy of concentrated spatial development in urban concentrations was emulated
by the flying geese of Asia mentioned by Venables. The focus of growth in the 1970s and 1980s
shifted to the tigers like Singapore, Hong Kong, South Korea and Taiwan. Singapore and Hong Kong
being city states naturally exhibited strong natural economic concentration. Furthermore, economic
activity got concentrated in Seoul/Pusan in South Korea, and in Taipei/Kaohsiung in Taiwan. By the
late 1970s/ early 1980s, 70 per cent of urban population in South Korea was concentrated in the Seoul
and Pusan regions. This concentrated pattern of development later spread from the tigers to the cubs,
the Bangkok region in Thailand, Jabotobek (Jakarta and its environs) in Indonesia, and Kuala Lumpur
in Malaysia. It then moved on to the coastal regions of China - specifically to Pearl River Delta Special
Economic Zones and Shanghai. Once again even a large country like China decided to concentrate
economic activity in specified coastal regions.
What were the common characteristics of all these regions? First, there was heavy investment in
transportation links with rest of the world, such as, airports, ports and communication infrastructure.
Second, export oriented outward oriented labor using manufacturing gained prominence while
consistently ascending the technology ladder over time.
Did all these lead to a death of distance? Consider the following. An urban coastal corridor emerged
from Tokyo to Sydney, through Seoul, Taipei, Shanghai, Hong Kong, Kuala Lumpur, Singapore and
Jakarta. If we extend Venables' argument on productivity enhancement through increase in size of
urban agglomerations, we can begin to appreciate the productivity effects of this mega urban corridor
in East Asia. Business and production linkages within this corridor are intense: there is a great deal of
off-shoring and task trade within the corridor resulting from the death of distance. It is the emergence
of this corridor that has brought off-shoring into its own with the grafting of these dense linkages within
Asia to the outside, particularly to the US. These productivity effects have presumably contributed to
the overall downward pressure on prices of products produced in this multi-country Asian region: the
globalisation effect on relative prices that Rogoff has talked about.
The various examples given by Gene Grossman and Rossi-Hansberg on the one hand and by
Friedman (2004) on the other, mostly concentrate on the interlinkage between these countries and
with and within multi-national corporations (MNCs) from the US and Japan. The manufacturing flat
world essentially spans the Asian coastal corridor linked with the US. The dense inter-linkages have
also been possible because of an unusual degree of openness to external ideas that can be observed
throughout the region, particularly through receptivity to high level professionals. Even Beijing is now
said to be host to about 100,000 foreign citizens. It is the physical location of these international
professionals that has also promoted off shoring and trade in tasks.
What is interesting is how India is somewhat different, but how this difference itself promoted the trade
in services. First, the ethos in India was of dispersal of development. In fact, urban concentration was
frowned upon and discouraged. Second, as described by T.N. Srinivasan, the import substituting
inward oriented manufacturing approach persisted till the 1980s. Third, investment in infrastructure,
particularly urban infrastructure was of lower intensity - this includes ports, airports, railways, and
highways. Furthermore, no attempt was made to concentrate activity in coastal areas. Imagine what
would have happened if India had developed her East coast in accordance with the East Asia miracle
- a point similar to that made by T.N. Srinivasan. Interestingly, metros like Calcutta, Madras and
Bombay slowed down in the 1980s and 1990s and became Kolkata, Chennai and Mumbai, while
inland cities like Delhi, Pune, Bangalore, Chandigarh and Hyderabad have prospered. Though
infrastructure investment in transportation hubs and logistics is finally receiving importance now,
biases against labour using manufacturing continue and hence India has still not followed the labour
using export-oriented manufacturing strategy that was in vogue in East and South East Asia. What are
the features of the cities that have prospered? They all exhibit affinity to high technology, have
concentration of higher education, culture of meritocracy, a high knowledge base and research &
development laboratories. All that was needed was communication infrastructure, which appeared in
the 1990s and Y2K was an added bonus. It was this very lack of investment in transportation and
communication infrastructure, both within the country and to the outside world, that has ironically led to
these inland cities becoming software off-shoring concentrations. All that was needed was investment
in communication and electronic infrastructure that could enable information technology transmission
at low cost across the world: again the death of distance for services off-shoring.
If one looks at the pattern of outsourcing in India, one finds that outsourcing of service activities got
born in Bangalore and then spread elsewhere. T.N. Srinivasan talked about the relatively slow growth
of India's merchandise trade: what he didn't mention is that gross Indian service exports are now
almost equivalent to its merchandise exports. Gross exports and imports of merchandise trade and
services put together are now in excess of 45 per cent of GDP, and growing at about 20 per cent a
year. This figure was just under 20 per cent in 1990-91. There is perhaps no other country which has a
similar composition of merchandise and service exports and illustrates the large role of service
offshoring in the flattening world as it extends to India. The openness of the Indian economy is quite high
now, even on the capital account as indicated by the large increase in gross capital flows, (i.e., both
inflows and outflows), which are now in excess of 25 per cent of GDP.
It is in this way that East and South East Asia have led the way in facilitating the flattening of the world
in merchandise trade and trade in associated tasks, and India's different pattern of development to the
outsourcing of information technology activities that have enabled wider trade in services. The flat
world therefore extends from the United States through East and South East Asia to India. The
distinction I have made between the merchandise trade and that in services is now getting blurred as
East Asian countries also partake in information technology outsourcing and as Indian firms get their
act together in manufacturing.
Where do we go in the future?
What of the future role of Asia in the flattening world? What are the implications of on going Asian
urbanisation patterns on the future direction of capital flows and world real interest rates? Let me
address some of these questions in a futuristic scenario.
Asian urban population is expected to double in the next 30 years; about 1.3 billion people, equivalent
to about 60 per cent of total expected urban population growth in the world, and equivalent to the
urban population growth in Asia that took place over the last 50 years, are likely to be added to urban
areas in Asia during this period. 12 of 21 cities of over 10 million by 2015 will be in Asia. So the
doubling of the global labour force talked about by Venables will accelerate adding to the further
flattening of the world, especially if we take account of the resurgence of Eastern Europe and Africa as
talked about by Svejnar and Collier. If large urban agglomerations promote productivity growth, as
posited by Venables, the shift in the mega city fulcrum to Asia is itself suggestive of relatively higher
productivity growth in this region. Since Asia is still a technology follower, with much catching up to do,
the potential for further significant productivity growth is high, and hence the likelihood of continuing
low inflation in the world.
Chairman Bernanke has earlier talked about the savings glut. Since world savings haven't really grown
since the late 1990s, while investment has fallen, particularly in Asia after the 1997 financial crisis, he
could perhaps have talked instead about the investment drought in Asia. The relatively higher decline
in investment in Asia, compared to savings rates, has probably contributed to the emergence of
foreign exchange surpluses, and consequent rapid accumulation of foreign exchange reserves, after
the 1997 Asian crisis. The mirror image, of course, is the US current account deficit, reflecting its
opposite savings/investment imbalance. The question is whether the Asian relative investment drought
will continue well into the future?
The expectation of urbanisation in Asia in the next 30 years in India, Pakistan, Bangladesh, Vietnam,
Indonesia and China would suggest that there will be unprecedented demand for investment in
infrastructure in the coming decades in this region. Chinese infrastructure investment is shifting inward
from the coast: this may be less efficient than on the coast and hence the demand for resources could
well be correspondingly higher. Although India and other countries in South and South East Asia may
concentrate investments more towards the coast, the backlog of infrastructure investment in India is so
high that its demand for resources can be expected to be correspondingly higher.
The question that I am concerned with is whether regional savings will be adequate for meeting this
demand as they have been in the last decade. Will the globalising world face the opposite of a savings
glut or investment drought? With the kind of urbanisation pattern that I have outlined for Asia in the
next 30 years, and the associated demand for enhanced resources for infrastructure investment, it is
likely that the demand for external savings will re-merge. If we add the possible emergence of similar
demand from Africa, the likelihood is that we will revert to the traditional pattern of financial capital
moving in the right direction, from the rich to less rich countries in Asia and also in Africa. If Raghuram
Rajan repeats his correlation exercises in 2030 he might emerge a happier man. This will, however,
coincide with the adverse demographics of Europe and Japan contributing to contraction of world
savings.
Various questions arise. Will we then see a hardening of world real interest rates? What will be the
new challenges that we, as monetary authorities, will face in the years to come? How soon will this
reversal take place in global imbalances? Will they be gradual or sudden? If this scenario is correct,
the commodity price boom that Paul Collier talked about will continue for some time; in which case
additional demand will arise from Africa as well. We should, therefore, expect an acceleration of cross
border global capital flows, with the usual implication for exchange rate and monetary management in
the recipient countries.
Another interesting comment on off-shoring that the Venables and Grossman papers have talked
about is off-shoring low skill activities. What is intriguing is that great investment is taking place in
human resources in Asia as well: Tokyo has 113 universities, Beijing has 59, and Hong Kong and
Singapore are becoming educational centres. US and European educational institutions are
competing with each other to off-shore their activities in Asia. So where will this off-shoring stop?
Contemporary monetary puzzles
Much of discussion in this symposium has centered around the rearrangement of economic thinking to
take account of the efforts of globalisation and the new economic geography. What have the
implications been for central bankers? Rogoff has shown how monetary stability has been
accompanied by price stability and output stability, but not asset price and exchange rate stability. He
goes on to say that exchange rates do not really reflect fundamentals and act more like asset prices.
How do we then to look at exchange rates as equilibrating price mechanisms? Does this mean that
shifts in the Chinese exchange rate determination will have no effect on other variables? Given the
complexity of trade patterns and offshoring of tasks, and complex production patterns behind many
products, it would perhaps not be surprising that exchange rates are no longer to be seen to reflect
fundamentals. If a product consists of a large number of components that have been produced over a
dozen different countries, and even assembled across two countries, how will any bilateral exchange
rate changes be expected to affect trade patterns? Moreover, with the proportion of value added in
upstream (e.g., research and development and design) and downstream (e.g., marketing and trading)
activities increasing, the role of exchange rates in effecting trade flows becomes even more complex.
In fact we have seen low pass through of exchange rate depreciation to inflation - both in developing
and developed countries.
I would like to reflect on a few other contemporary puzzles as well.
Low consumer inflation in the presence of abundant liquidity and increasing asset prices
First, we have been experiencing low global inflation despite abundant liquidity in the last few years,
with little sign of change. Is this a result of globalisation or effective worldwide monetary policy?
Kenneth Rogoff in his paper has argued plausibly that high productivity Asia, particularly China, could
not have exported deflation. As he says, "But hyper-competitive Chinese exports only affect the
relative price. As long as the central bank targets inflation in the overall price level, which it can over
sufficiently long horizons, cheap goods from China simply imply that other goods must become
expensive. From this perspective, we might actually say that China is exporting inflation to other
sectors of the global economies". Whereas I naturally find Kenneth's theoretical argument persuasive,
is it borne out empirically? The global economy is currently awash with liquidity. As we all know,
around eight years ago, the US Fed responded to the 'low probability but highly adverse events'
(Blinder and Reis, 2005) leading up to the Russian debt default and the LTCM collapse by an
emergency cut in interest rates in September, October and November 1998. Even though the
reduction was just 25 basis points each month, it shifted the monetary policy stance to
accommodation. Later, prompted by a deflation scare, the fed fund rate was cut over a 42-month
stretch from December 2000 to June 2003 to a 45 year low of 1 per cent, taking the real federal funds
rate into negative territory. Thus, real policy rates were effectively zero or negative until very recently
in the US and perhaps remain below the "Wicksellian" long-term neutral rate. Real policy rates in the
UK and Euro area are also generally hovering around zero. Coupled with the benign policy rates,
money supply growth has increased worldwide during this period. The policy accommodation pursued
until recently by the US and the European Central Bank has had a global impact, flooding the rest of
the world with an abundance of liquidity. Low interest rates in the US have encouraged capital to flow
into emerging market economies. For the countries that prefer some form of managed parity against
the US dollar this has resulted in a large build-up of foreign exchange reserves and excessive
domestic liquidity, amplifying the Fed's policy stance. Examination of the data clearly reveals a global
glut of liquidity, which has facilitated highly leveraged positions, debt financed consumption and
booming credit growth, raising financial stability concerns. The great puzzle in current global
developments is indeed the co-existence of abundant liquidity and low consumer inflation. Even
soaring oil prices and the elevated prices of non-fuel commodities have yet to affect the overall price
level significantly. Such low levels of inflation have not been witnessed since the pre-World War
period. So I remain puzzled: is Asia not exporting deflation despite overall increases in global
monetary aggregates? Or, will we inevitably see global inflation eventually because of this global glut
of liquidity? Or, is the spill over essentially in asset prices?
Strong global growth despite soaring oil prices
The second puzzle is the continuing strong global growth despite high oil and commodity prices. Can
we attribute this to increasing oil use efficiency along with productivity effect of globalisation alluded to
earlier?
After the oil shocks of the 1970s, the first half of the 1990s witnessed deflationary pressures in terms
of real oil prices. However, this lull in oil prices turned out to be short-lived. Soaring oil prices have
characterised the period since 2000. Oil prices are scaling new heights every day driven mainly by
growing or unchanged demand, low inventories, lack of spare capacity, and geo political tensions and
uncertainties. While the accommodating global monetary conditions have placed oil futures in the
class of sought-after financial assets, the persisting high levels of oil prices increasingly indicate that a
large part of the oil price hike has attained a permanent character. Yet, global growth remains
remarkably on track. Indeed, the growth momentum has only improved from the second half of the
1990s to the first half of this decade. The growth in world trade volume (goods and services) has also
recovered after some slowdown in 2001 and 2002. Obviously, global activity has benefited from the
stunning decline in output volatility observed by Rogoff which would have also cushioned the oil
shocks.
Slowdon in global saving and investment vs strong global growth
The third puzzle that I would like to mention is high global growth despite slow down in savings and
investment.
Global saving and investment rates have declined in recent years. Notwithstanding the declining
saving and investment rates, global growth has continued its surge from period to period. While
consumption has arguably played a critical role in the industrial countries' growth momentum, exports
might have played a similar role in the emerging markets. The sustenance of consumption as opposed
to investment-led growth has thus given rise to new controversies on present versus future allocation
of resources as also on the relevance of overlapping generation outlooks. Raghuram Rajan and his
colleagues attempt to reconcile this phenomenon as they try to explain the role of foreign capital in
developing countries.
Once again, this unusual phenomenon can presumably be explained by the productivity increasing
pattern of the current Asian growth process, coupled with the positive Asian demographic effects
promoting both consumption and investment growth. Thus, high growth is continuing from resource
availability due to demographically effected Asian savings patterns, along with positive productivity
effects. The resource diversion due to rising oil and commodity prices is accordingly being
compensated.
I therefore feel that, in whichever way we characterise the current new phenomenon: globalisation, the
flat world, or as the new economic geography, economics faces now questions that still need to be
answered. We central bankers have benefited from "the great moderation" but we need to understand
better to what extent we have been responsible for this fortunate turn of events. I hope that the
Kansas Fed will continue to organise such meetings to address these continuing puzzles.
References
Blinder, Alan and Ricardo, Reis (2005): "Understanding the Greenspan Standard", paper presented at
The Greenspan Era: Lessons for the Future,
the Federal Reserve Bank of Kansas City symposium,
Jackson Hole, Wyoming, August 25-27, 2005.
The World Is Flat: A Brief History of the Twenty-first
Friedman, Thomas (2004): Century, New York:
Farrar Straus & Giroux.
Grossman, Gene and Esteban, Rossi-Hansberg(2006): "The Rise of Offshoring: It's Not Wine for Cloth
Anymore", paper presented at Symposium sponsored by the Federal Reserve Bank of Kansas City,
Jackson Hole, Wyoming, on August 25, 2006.
Mohan, Rakesh (2005): "Some Apparent Puzzles for Contemporary Monetary Policy", key note
address at the Conference on "China's and India's Changing Economic Structures", organised by the
IMF, the China Society of Finance and Banking and the Stanford Center for International Development
Reserve Bank of India
in Beijing during October 27-28, 2005, printed in Bulletin, December 2005.
Mohan, Rakesh (2006): "Asian Urban Century: Emerging Trends", Keynote address at the Conference
on Land Policies and Development at the Lincoln Institute of Land Policy and Development,
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Symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming on
August 25, 2006.
Rogoff, Kenneth (2006): "Impact of Globalisation on Monetary Policy", paper presented at Symposium
sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, on August 25,
2006.
Venables, Anthony (2006): "Shifts in Economic Geography and Their Causes", paper presented at
Symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, on
August 25, 2006.