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The Reserve Bank of India's Fateful, Fatal Action?

by Arvind Subramanian, Peterson Institute for International Economics

Op-ed in the Business Standard, New Delhi
September 29, 2010

© Business Standard

A global war of capital is being waged subtly but clearly, according to my Peterson Institute colleague Joe Gagnon. Except that it is a war not to attract but to repel capital from a country's borders. An alternative term for this war might be mercantilism because the aim of sending capital out and/or preventing it from coming in is to keep currencies competitive, thereby shoring up economic activity, in this case, at other countries' expense.

China has been the prime aggressor in this war, having sent capital abroad through massive interventions in the foreign exchange market spread over many years. China's actions are part of a structural growth strategy, but more recently other countries have engaged in this for cyclical reasons, in response to the postcrisis downturn. Switzerland, Ireland, and recently Japan have been intervening in their foreign currency markets to prevent a rise in their currencies; Brazil, Taiwan, Indonesia, and Korea have all imposed some form of restrictions on inflows of capital. And, in a fresh twist, governments are trying to actively purchase the securities of other governments: China is reportedly buying Japanese government bonds, Japan wants to return the favor, and my colleague C. Fred Bergsten has called for counterintervention by the US government to buy up Chinese assets [pdf] with a view to driving up the Chinese currency.

India, true to style, is the striking odd man out. The Reserve Bank of India (RBI) announced last week that it was liberalizing (yes, liberalizing) foreign inflows into domestic government and corporate bond markets. Developing domestic bond markets is a worthy goal, but the arguments being used, the sequencing of actions, and the timing of the move raise serious questions about the RBI's action: It is based on an unproven, probably erroneous, assumption; it actually compounds the problem in relation to government finances; and it ignores important costs at a time of macroeconomic vulnerability.

...[I]n India the tail of finance is again wagging the dog that is the economy. This headlong embrace of foreign finance is as though the obvious lessons of the crisis don't apply to India.

Start with the underlying assumption. The case for the RBI's move runs something like this: The major constraint on India's growth is infrastructure, which, in turn, is constrained by the supply of finance. Relieve this bottleneck and India will be on its way to Chinese-type growth rates.

Even if one were to accept the importance of infrastructure, it is far from clear that the binding constraint on its development is the lack of finance as opposed to regulatory and governance problems, especially relating to land. It is possible that some fly-by-night operators with dicey credit histories are finance constrained. It is also possible that some projects need the kind of long-term financing that bond markets provide. But would this really apply to large and reputable potential investors in infrastructure such as Bechtel and Ambani with pockets as deep as the Mariana Trench?

In fact, the finance-as-binding-constraint is even more problematic than it first appears. For the RBI's actions to be convincing, we would have to believe that investors' reluctance to invest stems not from lack of access to domestic finance but to foreign finance, and not just to foreign finance but to foreign finance mediated through domestic bond markets. In other words, potential big-name investors are being turned away by domestic banks and foreign banks, and cannot raise equity from domestic investors or foreign investors, so that the only recourse for them is to float bonds so that foreign portfolio investors can buy them. Put this way, it almost seems that these big companies are the victims of a massive conspiracy by banks and investors all over the world and actually deserve our sympathy. And all this at a time when the pool of global capital is plentiful?

Consider next the perverse impact on government financing. The chain of logic here is that developing domestic corporate bond markets (considered the ultimate goal) requires first fixing the government bond market. Hence the RBI's moves to increasing caps on foreign holdings of government bonds. This move is actually perverse, having the effect of reducing the pressure on the government to fix its fiscal house. Instead of letting the government off the hook—in the name of promoting corporate bond development—the RBI should have done the opposite, namely, reduced the statutory liquidity ratio (SLR), which is the sine qua non for developing the right price signals in the government bond market, and hence the corporate bond market.

Reducing, and eventually eliminating, the SLR would have increased the resource envelope for the private sector and given RBI better control over the domestic monetary transmission mechanism. Allowing the government to borrow more money from abroad instead of changing the status quo that allows the government to "capture" domestic resources is a retrograde step.

Finally, there are the well-known costs to allowing foreign capital and overheating. These costs are especially high at this juncture because of the macroeconomic situation as Shankar Acharya argued last week in these pages. Trade and current account deficits are high, and rising to levels that are typically considered "flashing amber" territory, and the fiscal situation remains tenuous. It seems odd that the RBI, instead of dampening flows to protect against future reversals, is facilitating them.

And, instead of countering the strengthening currency, the RBI is doing the opposite. Think of it this way. China is doing its damnedest to prevent the yuan from rising; India is doing its best to allow the rupee to strengthen—it is a double whammy for Indian exporters and producers of import-competing goods. We may be trading away a bird in hand (our tradable sector) for the bird in the bush (infrastructure). Above all, what is remarkable, even astonishing, about the RBI's move—which may just be the thin end of the wedge toward expeditious capital account convertibility—is what it signals about the narrative on finance within India. The world has emerged from an experience that has been unambiguous in its warnings about finance in general and foreign finance in particular. Yet in India the tail of finance is again wagging the dog that is the economy. This headlong embrace of foreign finance is as though the obvious lessons of the crisis don't apply to India.

Perhaps India is different. Perhaps its financial markets are near perfect. Or even if they are not, perhaps they are effectively regulated by strong, public institutions, operating incorruptibly and at arm's length from atomistic, far-sighted financial sector participants, who are immune to herding behavior and other pathologies, and who scrupulously work to avoid rigging the system in their favor. Perhaps pigs fly, tooth fairies exist, and the Age of Kalki is at hand.


PIIE Briefing 15-4: India's Rise: A Strategy for Trade-Led Growth September 2015

Working Paper 15-1: The Economic Scope and Future of US-India Labor Migration Issues February 2015

Testimony: US-India Intellectual Property Rights Issues: Comment on USTR Special 301 Review March 7, 2014

Testimony: Effects of Trade, Investment, and Industrial Policies in India February 12, 2014

Testimony: Assessing the Investment Climate in India and Improving Market Access in Financial Services in India September 25, 2013

Working Paper 11-17: India’s Growth in the 2000s: Four Facts November 2011

Book: Reintegrating India with the World Economy March 2003