Policy Lessons for the Next Crisis

Op-ed in the Business Standard, New Delhi

January 13, 2009

This crisis is not over by any means. The future may yet surprise us. But Indian policymakers must draw lessons, premature though these may be. Here are possible lessons in several areas of macroeconomic policy.

Self-insurance, exchange rates, and capital flows

The impact of the crisis on India would have been significantly greater had India's foreign exchange reserves been $100 billion or even $150 billion instead of $300 billion. The rupee would have been more vulnerable, and confidence more difficult to sustain. As important, the ability to use countercyclical monetary policy would have been severely constrained if the external situation had been less robust.

Indeed, in the current crisis, deflation cum financial distress is nudging central banks toward a 'credibly irresponsible' abandonment of monetary prudence.

So one possible lesson is that self-insurance is a prudent and even necessary strategy to limit the impact of financial crises. This would, of course, have to be qualified if international collective arrangements-regional and multilateral-can provide liquidity during crises. India should, as a responsible member of the international community, work hard toward building these arrangements, but for the foreseeable future, liquidity provision under them is unlikely to become a full or adequate substitute for domestic self-insurance.

The policies that will help achieve self-insurance are twofold: Minimizing the vulnerability to crises will require limiting the build-up of foreign liabilities, which suggests the need for caution in allowing inward capital, especially debt and volatile flows. And fortifying the ability to respond to crises requires amassing foreign exchange reserves and hence a competitive exchange rate, with the limits on capital flows augmenting the ability to manage the rate.

Capital account convertibility (CAC) has been a hotly debated topic in India and the subject of several officially sponsored reports. This crisis and the attendant self-insurance objective need to freshly inform this debate. Self-insurance could alter the balance of arguments in favor of cautious rather than precipitate openings.

Take the case of developing the Indian domestic government and the corporate bond markets, which is an important objective, especially to facilitate the financing of infrastructure. Bond market development will likely have positive benefits in terms of mobilizing savings and better allocation of capital. But if it is associated with significant net inflows (which is likely, given higher growth prospects in India), the attendant consequences for vulnerability to crises and attenuated ability to self-insure must also be taken into account. This cost-benefit calculus has to be freshly examined in the light of the current financial crisis.

Careful reassessment could spur the search for intermediate solutions. For example, can India allow foreign players to participate in domestic bond markets (FDI) without necessarily leading to a flood of foreign capital? Or, if foreign capital were allowed freely into domestic bond markets, could there be requirements that foreign capital be invested for a minimum period of time (as with, say, hedge fund investments) or that there be price-based incentives and/or taxes to prevent large swings in these flows? Recognizing that financial development that leads to surges in foreign capital flows is not an unmixed blessing from a self-insurance perspective is a key part of the more nuanced and pragmatic thinking that the crisis should motivate.

Fiscal policy

Crises such as these illustrate the vital last-resort role of government. Governments have to take over substantial amounts of private-sector liabilities and should implement countercyclical fiscal policy during steep downturns. India has, sadly, not been in a position to do either effectively because its sovereign balance sheet is shaky; hence monetary policy has borne the burden of providing macroeconomic stimulus.

For the future, therefore, India should aim for a balance sheet that is robust enough to be able to increase public liabilities by large amounts within a short span of time; say up to 10-20 percent of GDP. It is imperative that India reduce its debt during the phase of rapid growth to levels that will permit the ramping up of orders mentioned above. This implies a debt-to-GDP ratio of no greater than 30-40 percent of GDP in good times. Medium-term fiscal consolidation involving a substantial reduction of public-sector indebtedness is an urgent task for the future.

Monetary policy and asset prices

We have learned yet again that asset prices-of stocks, bonds, housing, and exchange rates-that rise very sharply over a short period of time and deviate from broadly sensible norms must be carefully watched and responded to.

Depending on the context, authorities must use monetary and/or prudential policies to, yes, prick bubbles. If sharp increases in asset prices are concentrated in some sectors, directed prudential policies (greater provisioning, higher margins, tighter capital adequacy standards, etc.) will be called for. If, however, increases in asset prices are more broadly based and related to credit expansion more generally, tightening monetary policies should remain an option. The Reserve Bank of India's (RBI) response to asset price inflation in the run-up to the crisis was commendable, and continuity should be the guiding principle. The one outcome that the RBI must studiously avoid is a rapid and sizeable rupee appreciation. This point cannot be emphasized enough because a flood of capital inflows, and hence substantial upward pressures on the rupee, are just around the corner.

Inflation targeting

The chorus of voices calling for the RBI to focus on inflation as a nearly exclusive objective has been rising in India. But during this crisis the US Fed has behaved as if it has not one (inflation), not two (inflation and activity), but three mandates (inflation, growth, and financial stability). Stephen Roach of Morgan Stanley has called for an explicit codification of this triple mandate for the US Fed. Indeed, in the current crisis, deflation cum financial distress is nudging central banks toward a "credibly irresponsible" abandonment of monetary prudence.

Preserving financial-sector stability will be an important objective for India too. Setting up a legal framework with a formal, and somewhat rigid, adherence to one objective does not seem appropriate to times such as these. Moreover, if self-insurance becomes an important objective, it will be hard for monetary policy not to keep an eye on the exchange rate as it strives to facilitate reserve acquisition in the future.

On a host of issues discussed above, the crisis has afforded an opportunity to reassess macroeconomic policy and to find the sensible middle ground between finance fetishism on the one hand and status quo statism on the other. Both sides should heed Talleyrand's admonition: "Above all, not too much zeal."