Policy design as fine balance

The policy of being too cautious is the greatest risk of all, noted Nehru tentatively contemplating policy reform in the early years of Independence. That was then when globalisation, trade and development were routinely hampered by a panoply of distortions in the economic environment.

Fast forward to the here and now, and Prime Minister Manmohan Singh can be expected to make a strong pitch for a much larger role for fast-growing, high-growth potential economies like India in global financial governance, at the latest G-20 Summit in Pittsburgh, in the US. But while we get to think increasingly global, we must also act local and be proactive in the policy domain as well.

The past year has seen truly unprecedented use of fiscal and monetary policy instruments to rev up enterprise, markets and growth, the world over. In the mature markets where financial excesses were clearly committed with massive resort to securitisation and structured products, there's economic contraction still underway, although the mavens are now on record that the Great Recession is all but over and growth is around the corner.

Here in India, the global financial crisis did also affect growth, although more in a relative sense, and led to considerable deceleration in the trend rate. The policy response was a combination of loose fiscal policy — lowering of taxes and higher budgetary outlays — followed by accommodative monetary policy — lower benchmark interest rates, easier mandated cash reserve ratio for the banks, albeit after a lag.

Following the lowering of indirect taxes in the last two Union budgets, it is notable that that the Direct Tax Code also calls for considerable reduction in the rates. Such a tax design appears, by and large, to be in the right direction although the fine print — such as the move to tax long-term savings on withdrawal — does call for several modifications in the draft.

It is possible that there’s much buoyancy in taxes, on the back of lower rates. But the immediate policy impetus is likely to be due to increased consumption, with the likely tax savings being seen as an added bonus. And heightened consumption expenditure can be willy-nilly expected to boost investment, and hence spur on growth.

The way ahead, in policy terms, is to have a suitably accommodative monetary policy, including proactivity on the exchange rate front. Now the recent policy decision of the Reserve Bank of India to allow the rupee to depreciate following the relative hardening of the dollar has paid rich dividends, quite across the board.

However, now that stepped up capital inflows are on the cards, yet again, the RBI ought not to allow the rupee to appreciate in tandem, certainly not right away. The purpose of economic reform is, of course, to reduce distortions and enhance efficiency. But decreasing policy distortions does not really have an equal effect on growth in all and sundry circumstances.

So while, for instance, a more 'market-determined’ exchange rate — in the face of increased capital inflows and the like — may seem in order, the move may well turn out to be thoroughly sub-optimal given the distortions and inefficiencies rife in the real economy for goods and services.

The point about reducing distortions via a particular policy move — say the lack of RBI intervention in the forex market so as to make way for the exchange rate to be determined by way of supply and demand — is that the effect depends on how flexible the economy actually is, how large is the share of the parameter being supposedly corrected in the policy process, and the how high the general distortions are to begin with.

And there is low elasticity of substitution available for Indian goods and services in the export market. Also, trade in goods and services now accounts for a substantial share of economic activity. Further, there are glaring distortions economy-wide — of shortages, poor quality and high costs. All this calls for under-valued exchange rates to be suitably policy-engineered through central bank currency intervention.

The empirical evidence is that when there are 'n' number of distortions in the economic domain, a policy move that does not allow for n+1 distortion — for example, a more 'managed' exchange rate — may actually be regressive. Now the policy maker ought certainly to essay removing distortions when the payoff from such reduction is high, such as when bridging the yawing infrastructure deficit.

But a more market-determined exchange rate at this juncture, when there's been much slowdown on the growth front, seems wholly unwarranted. Also, greater co-ordination of fiscal and monetary policy would be better. Hence the need for the monetary authority not to revise upwards its policy interest rates in the next quarter, and perhaps further tweak the CRR lower.

In a similar vein, while the move to set up a debt management office separate from the RBI — so that the latter does not both manage government debt and the banks — would be logical in the medium term and beyond, doing so in the midst of a quantum increase in borrowings by the Centre is inadvisable.

http://economictimes.indiatimes.com/articleshow/5044718.cms