Chairman Ninan, distinguished Trustees, and friends,
I am greatly honoured by the invitation to deliver the 17th Prem Bhatia Memorial Lecture. I thank the organizers, in particular, Mr. Anand Bhatia, and my batch mate and friend Mr. G. Parthasarthy, for giving me this opportunity to be with you. I have accepted the invitation with humility, recognizing the galaxy of eminent persons who delivered the Lectures in the past. I did not have the good fortune of knowing Mr. Prem Bhatia personally, since I spent barely eight years of my career in Delhi; and, partly because Mr. Prem Bhatia’s main interests were politics and foreign affairs, while mine has been economics. I gather from senior journalists who knew Mr. Prem Bhatia well, that he was an outstanding editor, professionally impeccable, and meticulous about use of English language. He loved his staff; and they reciprocated it, but when he was angry, he took recourse to appropriate Punjabi words, for the desired effect.
He was respected as an eminent journalist, a political commentator, an effective diplomat and a service spirited person. His writings were characterized by impressive foresight, sound judgment and objectivity, elegantly conveyed with outstanding analytical frameworks. It is not surprising that during the active career of over six decades, he proved himself to be not only an eminent and influential journalist, but also a role model and mentor for the new generation of journalists. I consider it a privilege to pay a tribute to such an outstanding personality in the presence of this august gathering.
Mr. Shivshankar Menon spoke in the last Memorial Lecture about India and global scenario. He examined broader issues of how India relates to the world, and how we see our role and place in the world and in the international community. He rightly pointed out that there will be overwhelming weight for domestic priorities for a longtime to come since we have to address many problems. In particular, he argues that we need at least 15 years or more of 9-10 per cent growth if we are to abolish mass poverty, which afflicts us. My presentation today explores the global developments that are likely to influence our prospects for achieving such a growth rate.
We recorded an average growth of close to nine per cent for about five years immediately before it was interrupted by global financial crisis. The global financial crisis that erupted in 2008 has since turned into a global economic crisis though a collapse of the global financial system and depression in global economy, have been avoided. The economic crisis is showing signs of turning into a series of political crises in a number of systemically important countries and regions. In some parts of the world, there is a serious spillover into social tensions. There is considerable disagreement among economists and policymakers about immediate policy measures needed to bring the global economy into a normal state. Simultaneously, there are many fundamental issues that are being considered in regard to the post-crisis global economy among which, in my view, three are critical.
Post-crisis: Some Fundamental Issues
First, some observers feel that the on-going crisis is the beginning of collapse of capitalist system. However, they are in a minority. There are some others who feel that there is virtually nothing wrong with the capitalist system, and that the boom and bust cycle are a part of the self correcting capitalist system. They cite successes of China and India in recent years as a result of greater market orientation in support of their view. Hence, they feel that nothing fundamental should be done to dilute the capitalist system and capitalism will survive and thrive in its present form. Some of the believers in capitalist system feel that there has been a failure of regulation and larger doses of capitalism are called for. Those who believe in this approach of ‘no need for any change in the capitalist system’, or ‘make it more market friendly’, are also in a minority. A majority of the observers feel that some basic changes are needed in the capitalist system whereby the regulatory systems as well as the economic relationship between different countries undergo significant changes. They also feel that such changes are consistent with the fundamental nature of capitalism which keeps reinventing itself to thrive under evolving circumstances.
We should, therefore, expect some systemic changes in the way capitalism functions, but the basic feature of market system may not change. Hence, India like other countries will have to learn lessons about the reforms that are appropriate to the on-going developments in the global economy, consequent upon the current crisis.
Second, some rebalancing of the relative roles of state and market in economic management seems to be inevitable. However, there is an increasing recognition that the issue is not one of relative advantages and disadvantages of state and market but the interactions between state and market, or in popular terms, interactions between politics and businesses. The original assumptions that the state failures may be avoided through market efficiency, and market failures may be made up by state intervention, have been proved wrong. As a matter of fact, the markets have tended to capture the state apparatus which includes the regulators. This rebalancing between the state and market, therefore, warrants a view on the quality of the state vis-à-vis quality of the market in a given country and institutional context in which such interaction takes place.
Another area being subjected to rebalancing relates to the relationship between financial sector and the real sector. The original assumption that the development of financial sector and deregulation can lead to development of real sector has been subjected to considerable review after the crisis. The current effort is to explore mechanisms by which excessive financialisation and excessive credit are avoided. The objective is to assure that financial sector serves the broader objectives of growth and welfare in the real sector that is reflected in movements in employment, output, and prices. There is worrisome erosion of trust and confidence in the financial sector, particularly in advanced economies, warranting consideration of relationship between financial sector and other economic policies, as also financial sector and society. [I explored this subject in Per Jacobsson Lecture 2012 at the annual general meeting of the Bank of International Settlements, at Basel, Switzerland, on 24th June 2012. See http://www.bis.org/events/agm2012/sp120624.htm].
There is a greater awareness of the importance of space for public policy at national level in the context of the adverse consequences of globalised finance in an era of regulation governed by national authorities. There is, therefore, a review of the global monetary system, global financial architecture and global financial regulation, with a view to striking a balance between national policies and global coordination. The outcomes in regard to all the efforts of rebalancing between space for national policies and global coordination in the global economy are largely uncertain.
Thirdly, the relative importance of advanced economies and developing economies in the global economy is under review. There is an on-going debate about whether these economies are coupled or de-coupled. More important, there are some who believe that there will be greater convergence in future between advanced economies and developing economies in terms of their economic importance and well being. There are some others who believe that there would be a virtual shift in economic power from advanced economies to developing economies. Whether such a shift in the economic balance between developing economies and advanced economies would take place in a relatively smooth manner or not, is yet another area of considerable uncertainty.
It is clear that the global financial crisis is bound to leave an indelible imprint on the future of economic thinking in general, and economic policy in particular. In any case, the global economy is likely to be different in many ways, compared to what it was prior to the crisis for at least one important reason: the economic thinking, institutions, and policies as they were before the crisis obviously led to the crisis and, therefore, the global economy post-crisis ought to be designed to be better. In any case, it is destined to be different in many ways, in view of the trauma of the crisis experienced, in particular, by the advanced economies, which have been the thought leaders and systemically important for global economy.
In any event, we in India have to recognise that there will be a new normal in the global economy in which India will play a more important role than before.
Global Economy: New Normal
It will be difficult to know what the future global economy will be, since crisis itself is not fully behind the global economy, but for many reasons, it will be different from the pre-crisis period in some important respects.
First, the rate of growth of global economy as a whole may be less than what it was prior to the crisis since admittedly the period immediately prior to the crisis represented the bubble period for the global economy as a whole. The expectations that post-crisis the rate of growth of economies will be similar to that before the crisis may not be realistic unless there are technological or other reasons that accelerate growth in future.
Second, inflation is likely to be higher than what was experienced immediately before the crisis. An important reason for low inflation at that time, described as “great moderation” was globalization of trade and the impact of huge manufacturing activity from China with addition of large labour force. An impact of similar magnitude in future is unlikely to recur even after taking into account developments similar to those in China, in other countries. Further, the exclusive focus of monetary policy on price stability of the pre-crisis period is being moderated. Moreover, several monetary authorities are inclined towards targeting a relatively higher inflation than before, partly to enable countercyclical policies. Finally, advanced economies may be willing to tolerate a higher inflation than before as a way of moving out of high public-debts that are being incurred to manage global crisis.
Third, the enthusiasm for globalization of finance may be moderated since the downsides of global integration of finance have been recognised.
Fourth, there is likely to be a divergence in the expectations of the future between the citizens of advanced economies and citizens of developing economies. The citizens of advanced economies, particularly those which have been affected by the crisis are somewhat uncertain about maintaining their current standards of living in future, unless there is a huge improvement in their productive capacities. They are also less certain about standards of living of their children. In most developing economies, where many people are unhappy with their present situation, people expect their future standards of living to be better, and their children’s standards of living to be better in future. So, there may be contrasting public policy challenges arising out of the fear among the people of advanced economies and hope among the people of developing economies. However, in developing economies, there can be tensions arising out of the sharing of fruits of development.
Fifth, economic thinking is likely to be more humble and less assertive. Economics as a discipline may be more conscious of what it could learn from other disciplines, in particular, Sociology, Anthropology and Biological Sciences. Economic policy is likely to be more pragmatic, and is likely to eschew corner solutions to many economic problems. Best examples of corner solutions are the advocacy of fixed or floating exchange rates as the only viable alternatives or the insistence that the trilemma (free capital flows, fixed exchange rate and independent monetary policy) has to be resolved and cannot be managed.
In this background, it will be useful to assess the new normal for India, post-crisis. During the years leading up to the crisis, India experienced a rate of growth of nine per cent. At that time, the view of Reserve Bank of India (RBI) was that at a nine percent growth rate, there were elements of overheating and hence several countercyclical policies were pursued by RBI. It was not clear what the potential rate of growth of GDP was at that time, but RBI assessed that it was less than nine percent. It will be useful to assess now whether during the years subsequent to the crisis, we have added to the productive capacities of the economy and, thus, increased the potential rate of growth of output.
It is also necessary to recognise that India is vulnerable to shocks on our external sector, both on current account (due to fuel prices and food supplies) and on capital account (due to dominance of volatile portfolio flows). The medium to long-term rate of growth of output should ideally take into account the buffers that have to be created to absorb the shocks without serious disruptions to the smooth functioning of economy and social cohesion.
At the same time, it will be useful to recognise that the productive capacity in the domestic economy in India is significantly a function of domestic policies, though the external environment could be more favourable or less favourable.
In brief, there are significant challenges for India to achieve a 9–10 per cent growth rate under evolving conditions of global economy in the short-term and, of course, in the new normal over the medium to long term.
Short-term Prospects / Issues for the Global Economy
There is considerable analysis of the short-term prospects for the global economy by multi-lateral agencies, academics and market analysts. By drawing from these, it is possible to make some broad generalizations about the short-term prospects.
First, the global economy is likely to register sluggish growth in 2012 and, perhaps, marginally better with considerable uncertainties in 2013. Relative to advanced economies, the developing economies had initially withstood the adverse impact of the global financial crisis and registered impressive recovery and growth, but most of them have since begun experiencing pressures on their growth prospects from several angles.
The policy headroom available now for many developing economies in terms of fiscal and monetary policy is somewhat limited. However, the effectiveness of tools of public policy available in advanced economies is considerably more dented than that in developing economies. While some of the problems faced by developing economies may be pre-dominantly attributed to global conditions, in some others, such as India, it may be pre-dominantly attributed to domestic conditions.
Second, the advanced economies continue to face deflationary pressures because of sluggish demand in their domestic economies. The developing economies, on the other hand, are facing inflationary pressures. These pressures are partly caused by the considerable global liquidity and capital flows in some countries, while in some others, it is due to supply rigidities. Overall, however, the developing economies do not appear to be constrained by deficiency in domestic demand, though they are impacted by deficiency in global demand.
Third, the economic recovery, however modest, has not been accompanied by any relief on the employment front. Unemployment continues to plague many advanced economies. In some developing economies, there is upward pressure on wages, while in a few the sluggish export-demand is moderating the growth in employment and causing some sectoral unemployment.
Fourth, the commodity markets have started experiencing volatility in prices. The excess liquidity injected by advanced economies to provide stimulus to their economies is finding its way to finance speculation in commodity markets. At the same time, the possible moderation in demand due to pessimistic outlook on growth prospects is having a dampening influence on the commodity markets. Volatility in these markets is likely to continue in the short-term.
Fifth, the financial markets are experiencing considerable uncertainties and several paradoxes are appearing. Both the stresses in Euro Zone countries and the polarized political economy in U.S.A. are at the core of the continued uncertainties. There is a scarcity of, what may be described as safe financial assets since the government debt papers of some advanced economies are not free of credit risk (that is, the servicing of debt in full may not be certain). A considerable part of government borrowing programme in advanced economies and, to some extent, in select developing countries, is being funded indirectly by the central banks. The forex markets have been experiencing volatility. The main reason for this is the fact that U.S. Dollar continues to be a safe haven, though its medium and long-term prospects are under some stress. It is reasonable to expect that the financial markets will continue to display considerable volatilities and uncertainties in the near future. In particular, significant unconventional policy measures by central banks in U.S.A., U.K. and Euro Zone, inject uncertainties about their effectiveness, in the past and the near future. Assuming that there will be a pick-up in economic activity in advanced economies at some stage in the future, the central banks will be required to withdraw the ample liquidity that they have injected, which itself could potentially cause some turbulence.
In brief, globally coordinated public policy actions in response to the crisis have averted the collapse of the financial system and the depression in the global economy on account of the recent global crisis. They served the immediate interests of all concerned nations and markets. The subsequent uneven recovery created some problems for global coordination. More recently, the tradeoffs between short-term and long-term became acute in different degrees in different countries. Overall, the short-term prospects for the global economy are not optimistic, and in any case, are characterized by considerable uncertainties with potential for volatilities in several markets.
For India, the short-term policy challenge is to equip itself with adequate policy tools to cope with the uncertain prospects around a pessimistic outlook in the global economy, while managing the domestic expectations of a rapid restoration of pre-crisis levels of growth and inflation. The policy challenge for the short-term is compounded by less than optimistic sentiments in the market place in India.
Medium to Long-term Prospects / Issues for Global Economy
As already mentioned, there are several areas of global economy and national policies that will be subjected to rebalancing in the post-crisis period. Such a rebalancing will have to be based on three factors, viz. (a) the lessons of experience from the events leading to the crisis; (b) the after-affects of policies undertaken to manage the crisis; and (c) the fundamental socio-political and economic factors in different parts of the world, including demographic profiles, spread of technology and technological progress. The presentation today is restricted to exploring the major parameters of some relevant global economic factors in such rebalancing, namely, capital, trade, employment, monetary system, financial architecture, and above all, global power balances.
First, it was assumed that globalization of finance will result in the capital flowing from advanced economies to developing economies, thus helping the developing economies to accelerate the growth potential. However, the global capital has moved uphill, viz., from poor countries to advanced economies, on a net basis. This phenomenon may persist and even intensify in future. Many advanced economies have incurred large public debt to manage the crisis. A large part of such debt is short-term, requiring repeated approach to the financial markets for refinancing the debt. The demographic trends in advanced economies indicate dis-savings and fiscal stress in future. Hence, the allocation of global capital between debt and equity; between public debt and private debt; and between advanced and developing economies, will, in future be governed by new sets of demand for capital and supply of capital in the global economy.
India has to recognise that it may be seeking access to foreign savings, in competition with some advanced economies. India’s participation in the global capital movement will be both in terms of outflows and inflows, in particular, through foreign direct investment. However, the net access to global capital for funding growth of Indian economy has to take into account multiple new demands of other countries and governments on global capital.
Second, the global trade continues to be a source of hope for growth for many developing countries. However, the enthusiasm for globalised trade is getting moderated in advanced economies due to the crisis and high levels of unemployment. The extent of current unemployment in advanced economies may be partly cyclical and significantly structural. The technical solution to solve this problem is improving the productive capacity of the labour force in advanced economies to match their current standards of living, but their age profiles make it difficult to improve the skills among them. The economic activity in developing countries in the global economy is likely to increase significantly, and hence trade among developing countries is likely to grow faster than trade between advanced and developing economies. Some of the developing economies may shift their demand to consumption from investment, while in some others, investment may gain priority. The labour costs are likely to increase in some of the developing economies. Overall, replacement of advanced economies as the locomotives of growth in global economy by the emerging market economies may be inevitable, but may occur over a longer term than widely believed.
India’s participation in global trade will, therefore, be critical depending on incremental activity in emerging market economies, essentially based on competitive efficiency. India’s advantage in services can translate itself into competitive efficiency in manufacturing, provided the knowledge edge is embedded into the manufacturing process. Indian entrepreneurial capacities and penchant for innovation should be of special value in uncertain environment. In general, the sectoral position and the geographical composition of the export and import trade of India for the future will have to be worked out in the emerging new complex global economic environment.
Third, the employment trends in global economy have been particularly disturbing after the global financial crisis. The globalization of capital has enabled capital to move to areas where labour is least expensive. This also brought about unionization of global capital along with deunionisation of labour at the national level. The bargaining power of labour has been considerably eroded both by technological progress and breakdown of its union power, though this phenomenon is more prevalent in advanced economies than developing economies.
United States provides an interesting example where growth occurred during the pre-crisis period and general level of employment was maintained, but the wages were kept virtually constant in real terms. Social cohesion was maintained essentially by incurring large deficits. Maintaining employment continues to be the responsibility of national governments, and an important requirement for social cohesion. At the same time, it appears inevitable that the demographic profiles of different countries will induce large scale migration among countries. However, large scale migration in future may occur between emerging market economies because of heightened but potentially differentiated economic activities in these economies. The interplay of employment, demography, migration, and globalization may be more challenging for public policy in future. In addressing these issues, inequalities and social cohesion within each country may dominate the discourses.
The implications for India of the global trends seem fairly clear. It is difficult to maintain acceptable levels of employment without appropriate levels of productivity unless wages are kept particularly low. Wages would depend on productivity of capital and skill of the labour. Social cohesion depends on the level of employment and movements in levels of wages. Considerable migration between emerging market economies and, in particular, migration to India from other emerging market economies, especially neighbours, should be anticipated if India grows at a faster pace.
Fourth, the international monetary system is described as non system because the dominant global reserve currency, viz., U.S. Dollar is not subjected to market discipline, and is not bound by any globally agreed set of rules. The weaknesses have been recognised, but no feasible new system is on the horizon. Replacement of one national currency with another will not solve the fundamental problems of such a non-system. Replacement of one currency with multiple currencies may diversify the risks, but the externalities will push the system towards dominance of one currency. SDR is essentially an accounting unit and not a currency. A global currency is not feasible without a global monetary authority endowed with powers to expand money supply, contract money supply and act as a lender of last resort, when essential. In fact, the problems arising out of current monetary non-system may be more complex in future than those before the crisis because of the threat to U.S. Dollar position over the medium to long terms, without a viable alternative.
The limitations of the present global financial architecture comprising IMF, World Bank, WTO, and possibly G20, are well-known. Improvements in their resources as well as governance have been made, but by all accounts they are marginal. There is an intellectual agreement that systemic improvements are necessary and there are political efforts to make improvements. But, there is no agreement on the new order or the destination, and the progress is at best incremental and hollow. There are signs of diminishing returns from G20, though there is promise of greater role in future. These considerations give rise to a strong possibility of lack of substantial improvement in global monetary and financial systems, and possibility greater uncertainties and tensions in the global monetary system and financial architecture.
Fifth, there are efforts to improve the financial regulation in the global economy, and in particular designing minimum standards of regulation in different countries. Regulation of cross-border activities and financial conglomerates, has gained attention, particularly after the recent developments. The potential for contagion across countries in financial sector has been proven while the benefits of globalised finance are coming under scrutiny. More importantly, re-regulation appears to be called for in advanced economies which have reached a stage of excessive financialisation and unduly complex financial sector. At the same time, developing economies have to assess the scope for deregulation and greater sophistication. The meaning of reform in the regulation of the financial sector in advanced economies (re-regulation) is opposite of the meaning of such reform in developing economies (deregulation).
While the advanced economies are essentially facing problems of cyclical nature in financial sector, developing economies are facing the problems of structural transformation. Hence, the reforms in financial sector regulation which admittedly should be in alignment with macro economic policies in general, are likely to vary significantly among different countries.
A major part of agreed minimum standards of regulation are expected to be operationalised in 2019. There is considerable skepticism about effective regulatory regimes in the major international financial centres simply because they can continue to be global financial centres mainly through soft regulation. Further, globalization of finance without globalization of fiscal management may pose problem as illustrated by the experience in Euro Zone. Experience has shown that financial sector problem spillover into fiscal, and fiscal problem can impact financial sector in a variety of ways.
India will have to design its financial sector reform taking into account the real sector developments in India, the lessons from global financial crisis and the prospects for a benign global financial market environment. Perhaps, the agenda for financial sector reform drawn prior to the crisis should be carefully reviewed to confirm its consistency with the new realities in the post-crisis world.
Finally, there is an increasing recognition that global power balances would shift from West to the East, and in particular, to Asia. There is considerable consensus that incremental economic activity in the global economy and incremental trade will shift considerably to the developing economies, in particular, Asia. It is not very clear whether financial intermediation will undergo a corresponding shift. More important, in terms of institutional capital and human capital, the advanced economies are way ahead of the developing economies. The shift of global power balances is also influenced by the social and cultural factors. India will inevitably be an important part of the shift in power balances. However, a significant factor in this regard is the capacity of the society and economy of a country to absorb shocks that may emanate domestically or globally. Further, the per capita income is as important as the national income in determining the position of a country in the global power balances. Overall, India has a potential to play an influential role in the global economy because of its diversity in social, economic and political spheres.
How to get a 9-10 per cent annual growth?
As mentioned at the beginning of my presentation, Mr. Menon had said in the previous Prem Bhatia Memorial Lecture that an annual growth rate in Gross Domestic Product of nine to ten percent over a long-term is essential for India to eradicate poverty. I think that there is a broad consensus on that. However, since the global economic environment in future, post-crisis, is likely to be less benign than what it was when India recorded a nine percent growth for a few years, it is obvious that special efforts are needed to restore the rate of growth.
I submit a few of the critical components for a strategy to achieve the goal of nine to ten percent annual growth in output.
First, the level of domestic savings in India should be restored to pre-crisis levels. In addition, the domestic savings should be enhanced to make-up for the possible difficulties of obtaining net foreign savings on an assured basis in future, recognising India’s vulnerability to shocks. This would imply wooing domestic savers who, in any case, finance over ninety percent of investments.
Second, assuming that the aggregate demand will not be constrained, climate for investment should be conducive to domestic investors on an assured basis. The role of small and medium businesses should be recognised not only for their potential for employment intensity but also for their significance for vertical economic and social mobility, particularly for disadvantaged sections.
Third, in addition to removing supply inelasticities, improvements in productivity will be critical not only for containing inflation but also for ensuring that India has capacities to pay for all its imports through exports, over the medium term. India is vulnerable to shocks on account of fuel and food, and the demonstrated unwillingness of global financial markets to fund large current account deficits (say beyond three percent of GDP) warrant an acceptable ceiling of such deficit at three percent of GDP in any year. Experience during the high growth in pre-crisis period has shown that current account deficit close to one percent is achievable. However, in an uncertain global environment characterized by not so smooth shift in economic and political balances, maintaining global competitive efficiency at all times is essential for this purpose.
Fourth, strengthening the capacities and morale of public sector is essential to overcome the most important bottlenecks in Indian economy, namely, social (education, health, etc.) and physical (power, ports, roads, urban facilities, etc.) infrastructure. In particular, Indian society seeks a sense of fairness in public systems.
Finally, the private sector has to demonstrate its commitment to acceptable standards of governance and ethical conduct, and win the trust of Indian society.
The burden of achieving nine to ten percent growth for India has to be shared equally between public policy in India and private sector of India; and both should work together for a strong self-confident economy that wishes to alleviate property and earn respect of global community.
Thank you, ladies and gentlemen.
Delivering Lecture P. R. Ramesh
Receives Awards Shalini Singh
Receives Awards Trustees with Dr. Reddy,