Brookings: Experts - Arvind Panagariya

Does Microfinance Reduce Poverty? An Analysis of India’s Crisis

Arvind Panagariya — Fri, 17 Dec 2010 15:19:00 -0500

The recent microfinance ordinance in Andhra Pradesh, India has unleashed a vibrant debate on the rapidly expanding role of this source of credit.

In assessing the role of microfinance and its various modes of delivery, it is important to be clear about what it is that these loans are intended to accomplish. The loftiest goal, which the proponents of the instrument claim, is rapid eradication of poverty. Some, especially among those representing fast-expanding for-profit microfinance institutions (MFIs), can even leave you with the impression that only a few microloans stand between the poor and non-poor.

Yet, according to serious microfinance scholars, so far there is no compelling evidence that microfinance has led to sustained poverty reduction anywhere. Two older empirical studies have found little acceptance among the scholars. A more recent one, based on randomized trials, tracks changes over 18 months—a period too short to judge sustained success or failure. The implication is that any strong claims in favor of microfinance affecting poverty on a sustained basis must be heavily discounted

A lesser and more commonly expressed objective behind microfinance is the funding of projects with high returns that go unfunded because the entrepreneurs in question lack collateral. That the loans substantially fulfill this objective is doubtful as well. Hard evidence to this effect is simply lacking. In conversations, those associated with the MFIs would tell you that their loans are overwhelmingly used to finance high-return projects. But when pressed for the source of such information, they invariably cite their own loan officers who in turn cite the borrowers!

The claim that the loans overwhelmingly finance productive investments with high returns is implausible from another perspective. Interest rates on microloans are rarely less than 20 percent. Admittedly, occasional small and short-duration transactions that yield returns exceeding such high interest rates may exist. But there is almost no evidence suggesting that there is a preponderance of such investments available in the rural areas. A 2007 study entitled “the Economic Lives of the Poor” by economists Abhijit Banerjee and Esther Duflo in the Journal of Economic Perspectives offers no hint that a large number of such projects exist even in urban India.

If these arguments are correct, the vast majority of microloans must be viewed as serving either the function of an income transfer to temporarily soften the blow of poverty or that of filling a temporary financing gap (consumption smoothing). Regardless of which of these interpretations one takes, the essential contribution of microloans would seem to be modest: to help the recipients cope with the ups and downs of poverty, a conclusion also reached by economist Jonathan Morduch in his recent book through an in-depth study of 250 poor families in India, Bangladesh and South Africa.

Small loans in the rural areas come from informal sources such as friends, relatives, moneylenders and landlords as well as formal ones such as banks, self-help-groups (SHGs) and MFIs. A key object of concern in the recent debate has been the MFIs, especially those operating as for-profit entities. Critics express at least two sets of concerns.

First, for-profit MFIs have chosen to rapidly expand in precisely those states such as Andhra Pradesh where microfinance movements had already been strong. C.S. Reddy, CEO of APMAS, complains, for example, that these institutions take the members of existing SHGs and create new joint liability groups out of them to carry out their operations. He further states that pressures to pay the MFI loans are often accompanied by defaults on the SHG loans and that once one member defaults, the SHG begins to breakup. Critics also resent the fact that almost all for-profit MFIs started as non-profit entities and benefited from donor financing during those phases. Moreover, even after they turned into for-profit entities, they could access low-interest funds from the concessional priority-sector-lending window of the commercial banks.

The second concern relates to coercive practices of the MFIs for loan recovery. To be sure, systematic data on the collection practices of various lenders do not exist. We know even less about how these practices differ among for-profit and non-profit MFIs. What seems plausible, however, is that prima-facie the incentives facing moneylenders and for-profit MFIs are not dramatically different. Absent regulation, they have the same temptation to resort to coercion as the moneylender. Some critics go a step further arguing that living as he does in the same village as his borrowers, the moneylender is more restrained than the MFIs.

In 2007, the Reserve Bank of India (RBI) had recommended model legislation to the states for the regulation of moneylenders. A bill along these lines, which would replace the existing multiple moneylender acts in different regions of the state, has been approved by the Andhra Pradesh cabinet and awaits passage in the legislative assembly. The RBI needs to carefully study the issues raises by the critics and recommend appropriate model legislation with respect to for-profit MFIs as well.

Authors

Arvind Panagariya

Image Source: © Danish Siddiqui / Reuters

Raising Investment in India's Higher Education

Arvind Panagariya — Wed, 27 Oct 2010 00:00:00 -0400

While the university system in England is far from broken, in the last several decades, the more dynamic and competitive U.S. universities have relegated it to the second position worldwide. Abandoning the traditional destinations in England, 100,000 Indian students today study in American universities.

Aware of the decline, the British authorities have been reforming the system in the last 15 years. The latest step in this direction is the report of the independent panel headed by Lord Browne. The panel was asked to make recommendations to increase investment in education, ensure that the quality of teaching is world class and make higher education accessible to anyone with the talent for it. While the ailments of our higher education system are wider and deeper than those of the British system, there are useful lessons for us in the Browne report.

Consider first the access issue. In 2000, the gross enrolment ratio in higher education, which measures the number of individuals going to college as percentage of college-age population, was 8 percent in China and 10 percent in India. By 2008, the ratio had shot up to 23 percent in China but crept up to only 13 percent in India. College and university education remain off-limits to many talented Indian students.

On the quality front, consider the QS World University Rankings, which are designed to assess the all-round quality of universities across all disciplines and levels. Two Chinese universities found listing among the top 100 universities in the 2010 rankings, with the University of Peking ranking 47th and Tsinghua University 54th. Sadly, not a single Indian university made it to the list. No doubt, we have institutions of excellence in teaching in the IITs and IIMs. But they are not full-fledged universities. Universities of Hyderabad and Delhi that earn the top spots in the national ranking do not make to the QS list of the top 100 universities.

This comparison with China is especially telling since Mao Zedong had almost entirely wiped out China’s higher education system during the Cultural Revolution of 1966-68. In contrast, India has had an uninterrupted history of modern universities since 1857 when the Universities of Calcutta, Mumbai, and Madras were founded. Soon after the independence, our university system was strengthened but it has languished during the last three decades, precisely the period during which the Chinese have been rebuilding theirs.

To be sure, financing is a key problem facing our higher education system. With tight central and state government budgets and pressures to cut fiscal deficits at all levels, the government lacks the resources necessary to expand access to all who deserve. With salaries rising in the private sector, universities also find it difficult to retain and recruit top quality teachers essential to good teaching. It is here that we could put the experience of England and the advice offered by the Browne report to good use.

Until 1997, college and university students in England paid no tuition fees whatsoever. With public expenditure on higher education stagnating, expenditure per pupil fell by 36 percent between 1989 and 1997. On the recommendation of the Lord Dearing Committee, which reported in 1997, a fee of £1,000 was introduced, but it proved inadequate. The Higher Education Act, 2004, which came into effect in 2006, raised tuition fee further, but placing a cap on it at £3,000. The government had expected that only the best universities will hit the cap but all institutions have come to charge £3,000 today. As a result, there remains no further scope for increased investment to improve access or quality. The reform introduced by the Higher Education Act, 2004 has fallen well short of its objectives.

This is where the Lord Browne report picks up the matter. It proposes to eliminate the tuition cap altogether with two key provisions to ensure access. First, student will pay no fees upfront, with the government footing the entire bill up to £6,000 per student. Institutions charging more than £6,000 will be required to pay a progressively rising tax on the margin. The tax will be used to finance grants to students from low-income background to meet the living expenses. Second, after graduation, students will be required to begin paying back the costs paid by the government as soon as their incomes rise above a threshold, currently recommended at £21,000.

The Browne report rightly argues that this package will force greater competition among universities since it will allow them to charge higher fees for better education. With no fees to be paid upfront, it will also give students greater choice and access. They will be free to join the institution that offers the highest returns net of costs to them. Above all, the package will stimulate the much-needed increase in investment in higher education.

Browne report notes that as a consequence of compelling evidence in favor of substantial private gains from higher education, “it is not surprising that the argument for a private contribution to higher education has been made — and won — in countries with a wide range of political values such as Australia, New Zealand, the United States, Canada, Japan and Korea.” It also states, “Throughout the range of submissions that we have received, there is broad agreement among groups with an interest in higher education that those who benefit directly from higher education as graduates ought to make a contribution to the costs.” This is a sea change from the past rounds of reforms that saw many advocating free university education.

With the growth rate at 8 percent or more, the Indian economy today offers large private returns to higher education. But our universities are unable to hire top-class faculty for want of resources. Our leaders, especially when visiting abroad, tirelessly refer to the impending demographic dividend. Yet, sadly, little thought is being given to harnessing the younger population: unless we find creative ways to massively increase investment in higher education, the potential dividend may fail to translate into real dividend.

Authors

Arvind Panagariya

Publication: The Economic Times

On Strengthening India-U.S. Ties

Arvind Panagariya — Wed, 29 Sep 2010 00:00:00 -0400

By all accounts, like Prime Minister Manmohan Singh, President Barack Obama is keen to strengthen the India-U.S. ties. Sadly, however, recent actions by the United States have only reinforced the feeling on the part of many in India that the president assigns significantly lower priority to India-U.S. relations than did his predecessor, President George W. Bush. This is unfortunate since the U.S. interests in the region align most closely with those of India, at least from a longer-term perspective. Whereas China is already positioning itself as a rival, even belligerent, power and the future of Afghanistan and Pakistan remains highly uncertain, India is a rising democratic power whose national interests are better served by partnership rather than rivalry with the U.S.

Perhaps nothing gave a more negative signal to Indians than the recent decision by the president to play along with protection hawks among Democrats and sign into law an appropriations bill that the Congress recently passed. Using the need for raising revenue to finance enhanced enforcement at the Mexican border as the excuse, the new law raises the fees on certain H-1 B and L-1 temporary-worker visa holders by $2,000 or more. While it is doubtful that the President’s party would make any significant gains in the forthcoming elections from the protectionist rhetoric underlying the new law, the U.S. has already lost considerable goodwill in India on account of it.

Under the Uruguay Round, which brought into existence the WTO and the General Agreement on Trade in Services (GATS), one of the small concessions India had successfully negotiated with the US while agreeing to open its services market to foreign commercial presence was guaranteed access for 65,000 temporary foreign workers to the U.S. market. The new appropriations law, passed with virtually no public discussion or debate, requires the firms employing 50 or more workers and having 50 percent or more of them on the H-1 B visa to pay an extra fee of $2,250 for workers coming to the U.S. under the L-1 intercompany transfer visa and $2,000 for those entering under the H-1 B visa.

Facially, this provision is perhaps consistent with the national treatment commitment made by the U.S. under the Uruguay Round Agreement. This commitment forbids the U.S. from discrimination in favor of U.S. companies with respect to the hiring of temporary workers. Since the new provision applies equally to the U.S. and foreign companies that employ 50 workers of which 50 percent or more are H-1 B visa holders, facially the national treatment commitment is satisfied.

Yet, since India is perhaps the only country whose IT firms satisfy the criterion triggering the higher fee, the law has been seen in India almost uniformly as targeting it. Even substantively, it is questionable whether the national treatment commitment by the U.S. is satisfied. U.S. companies such as the Microsoft, Apple and Oracle that employ talented foreign workers (often educated in the U.S. universities) on H-1 B visas have much easier access to permanent resident visa. They are more easily able to shift their H-1 B workers to this alternative visa and hold the proportion of their foreign H-1 B visa workers well below 50 percent, thus, effectively escaping the law.

In his remarks on the Senate floor prior to the passage of the border security bill, Senator Charles Schumer who sponsored the bill stated, “but recently, some companies have decided to exploit an unintended loophole in the H-1 B visa program to use the program in a manner that many in Congress, including myself, do not believe is consistent with the program’s intent.” His underlying political message is that through the new legislation he intended to close this loophole. If such an objective was indeed achieved and the affected companies dropped their H-1 B employees below the 50 threshold, the legislation’s very basis would come into question!

The purpose of the legislation is to raise revenue. If the companies changed their practice of relying on H-1 B visas for more than 50 percent of the workers, no additional revenue will actually be raised. Therefore, the claim that the law closes some real or imagined loophole in the existing rules is just that. Its real effect is to place Indian companies at a disadvantage and transfer some of their profits to the U.S. Treasury.

As President Obama plans his visit to India, it is important that he recognize the importance of containing measures that have at best small payoff in domestic politics and guaranteed fall out in friendly countries. Indeed, if the promotion of a warm relationship with India is a top priority, he must go a step further and drop the common American practice of insisting on matching concessions for every concession the U.S. offers.

Following the visit to the White House by Prime Minister Manmohan Singh last November, some in the administration had pointed to the failure of India to bring anything to the table as the reason for the lack of substantive progress in India-U.S. relations. This mindset must change. Every concession by the U.S. need not be immediately matched by an equivalent or even bigger concession, especially when the player at the other end happens to be as yet a poor and developing country.

In the ultimate, the payoff from a much stronger friendly democratic India in 10 to 20 years in meeting the geopolitical challenges likely to be posed by the rapid rise of China as a rival power and the adverse developments in Afghanistan and Pakistan far outweighs any unmatched concessions the U.S. might offer in the short term. That, in a nutshell, was the approach George W. Bush took when promoting his nuclear cooperation deal with India.

As a final point, it is must be remembered that the real strength of the relationship will have to flow from business-to-business and person-to-person contacts. The governments can reinforce these contacts by resisting protectionist impulses.

Authors

Arvind Panagariya

Publication: Economic Times

True Driver of India-U.S. Partnership

Arvind Panagariya — Wed, 23 Jun 2010 00:00:00 -0400

Following the conclusion of the first India-US strategic dialogue, commentators in the Indian press have nearly uniformly expressed frustration with the lack of action under the Obama administration. To judge whether this dissatisfaction is grounded in reality, we must first ask whether each country has enough reason to invest in a close relationship with the other in the first place.

From the Indian perspective, there seem to be sufficient reasons for an affirmative answer. Accounting for almost a quarter of the world's GDP, the United States is by far the largest economy in the world. It is also the only super power on the globe and likely to remain so in the foreseeable future. It is a democracy that values other democracies. And, finally, it is by far the largest single recipient of India exports of goods and services. If we seek rising economic prosperity and increasing voice in the world affairs, America is a good bet.

An affirmative answer seems less clear-cut from the US perspective, at least on the surface. True, India is by far the world's largest democracy. But this cannot be a game changer by itself since it has been true for the last 60 years. At $1.25 trillion, Indian economy is just a little more than 2% of the world economy. Globally, it ranks a low 11th in terms of the economic size, ranking behind China and Brazil. Above all, India accounts for less than 2% of the US exports and imports.

Seen in this context, the puzzle is not why the Obama administration is not doing more to promote ties with India but how India has come to command so much attention on the global stage. The main explanation of this puzzle lies in where the United States sees India going in the next 15 to 20 years.

In the last seven years, India has grown 11-12 % per year in real dollars. Based on the current dynamism in the economy, high and rising savings rate, a young population that is expected to grow younger and the past experiences of countries such as South Korea, Taiwan and China, India can be reasonably expected to sustain a 10% growth in real dollars over the next 15 years. This would turn the country into a $5 trillion economy catapult it into the fourth, if not third, position worldwide, behind only the US, China and Japan. No forward-looking nation — least of all the US — would ignore an economy with such potential.

But this is not the only factor working in favour of a partnership with India. American perceptions of India are also shaped by the vast numbers of highly successful Indians — a large majority of them first-generation immigrants — that they see around them. While the presence of Indians in the US is not new, their phenomenal success is. In the last 15 years, their influence in the tech and finance industries and higher education has grown as that of no other single group. A year ago, when microprocessor giant Intel decided to put its employees in its TV commercials, the first person it chose was Ajay Bhatt, the inventor of the USB port who had received his first engineering degree in the Maharaja Sayajirao University of Baroda. And to ensure that his Indian origins are not lost upon the viewers, it replaced the real Bhatt by an even more Indian-looking moustached actor!

Complementing this feature is the presence of 100,000 students from India on the US campuses. The US leadership recognises that these are not any 100,000 students. Instead, they are among the brightest young men and women anywhere who would be among the movers and shakers of tomorrow around the globe. And this flow is likely to continue. Therefore, as a country that looks ahead, the US has plenty of good reasons to seek a longterm partnership with India.

Therefore, it is no surprise that during the first India-US strategic dialogue, the US took great pains to counteract the impression that it lacked enthusiasm for India in any way. The secretary of state Hillary Clinton warmly wrote in the Times of India about what this partnership meant to her and President Obama did the unusual by dropping in on the reception at the state department in honour of the visiting Indian external affairs minister S M Krishna.

How do we then explain the continuing frustration among the commentators in the Indian press? The answer perhaps is that outside of the highly complex security area, there is very little beyond the atmospherics that the governments can do to promote partnerships . Even commentators who deplore the US for failing to match its words with action and exhort it to move beyond symbolism do not offer a concrete set of actions they would like the latter to take. Demands for the removal of certain export controls and access to or extradition of David Headley, which find frequent mentions, do not make a coherent agenda.

While the governments can make some contribution in areas of mutual interest such as research in agriculture and clean energy, cooperation in science and technology and higher education and possibly dialogue on trade and climate change issues, the bulk of the long-term relationship will be built on business-to-business and individual-to-individual contacts outside of the government sector, as has been the case to-date. The outsourcing relationship between the two countries did not have its origins in any US government decision to promote it. Nor did the American investors in India or Indian investors in America end up in their respective destinations because their governments placed them there. While continuing dialogue has signalling value, the ultimate key to achieving a true partnership remains sustained rapid growth that turns India into a $5 trillion economy in no more than 15 years.

Authors

Arvind Panagariya

Publication: Economic Times

India and the United States: A Strategic Partnership

Fri, 04 Jun 2010 09:00:00 -0400

Event Information

June 4, 2010
9:00 AM - 3:00 PM EDT

Root Room
Carnegie Endowment for International Peace
1779 Massachusetts Avenue, NW
Washington, DC

The 2009 nuclear agreement between the United States and India transformed relations between the two countries, further advanced by new economic, cultural and social ties. In the months after the two countries concluded the nuclear agreement, the Obama administration and the government of Prime Minister Manmohan Singh committed themselves to further developing their bilateral relations. In July 2009, Indian External Affairs Minister S.M. Krishna and U.S. Secretary of State Hillary Clinton met in New Delhi and pledged that the two states would develop an enhanced strategic partnership. They met again on June 3, 2010 in Washington.

On June 4, Foreign Policy at Brookings and the Federation of Indian Chambers of Commerce and Industry hosted a conference to explore the content and purpose of this partnership as seen from Washington and New Delhi. This event focused on two dimensions: the overlap and intersection of American and Indian policies in Asia and the impact of growing economic ties. Panelists discussed the future direction of the U.S.-India relationship and U.S. and Indian strategic interests in Asia. The event was part of a new South Asia initiative at Brookings that focuses on the interconnected issues facing this vital region today.

Video

Transcript

Event Materials

Participants

Panelists

Rajan Bharti Mittal

President, Federation of Indian Chambers of Commerce and Industry

Bill Burns

Under Secretary of State for Political Affairs, U.S. Department of State

Nirupama Rao

Indian Foreign Secretary

Co-Moderator and Discussant: Lalit Mansingh

Former Indian Foreign Secretary and Ambassador to the United States

Co- Moderator and Discussant: Frank Wisner

Former U.S. Ambassador to India

Marshall Bouton

President, Chicago Council on Global Affairs

Gautam Adhikari

FICCI Fellow, East-West Center

Co- Moderator and Discussant: Amit Mitra

Secretary General, Federation of Indian Chambers of Commerce and Industry

Co- Moderator and Discussant: Thomas Pickering

Former Under Secretary of State

Teresita Schaffer

Director, South Asia Program, Center for Strategic and International Studies
Former Deputy Assistant Secretary of State for South Asia

Co- Moderator and Discussant: Kanwal Sibal

Former Indian Foreign Secretary and Ambassador to Russia and France

Co- Moderator and Discussant: Stephen Cohen

Senior Fellow, Foreign Policy

Jonah Blank

Policy Director for South Asia, Senate Foreign Relations Committee

Edward Luce

Washington Bureau Chief, Financial Times

Karl F. Inderfurth

Director, Graduate Program in International Affairs, George Washington University
Former Assistant Secretary of State for South Asian Affairs

Ajay Shankar

Distinguished Fellow, The Energy and Resources Institute, New Delhi

An Agenda for Secretary Geithner's Visit to India

Arvind Panagariya — Mon, 05 Apr 2010 11:06:00 -0400

In the early days of the Obama administration, many in India had felt that unlike President Bush, who vigorously fought for the U.S.-India nuclear cooperation deal and successfully saw it through, President Obama was keener to promote U.S. cooperation with China rather than India. The visit of India’s Prime Minister Manmohan Singh as the first state guest of President Obama was partially aimed at countering this impression. Yet, this sense of uneasiness on the part of the Indians still remains since the visit did not produce any concrete results.

Against this background, Treasury Secretary Timothy Geithner’s forthcoming visit to India to meet his counterpart Indian Finance Minister Pranab Mukherjee offers a unique opportunity to transform U.S.-India relations. Recent developments in the U.S.-China relationship including the effective exit of Google from the Chinese market and threats of a retaliatory action by the U.S. Congress on the exchange rate issue should calm down Indian fears that the Obama administration is keener on China than India. Symmetrically, from the U.S. perspective, the current Indian leadership is well inclined towards continuing to build U.S.-India relations.

Therefore, the real question concerning Secretary Geithner’s visit to India is how it can help advance U.S.-India economic ties. At the basic level, it must be recognized that economic ties between countries are largely a matter of private businesses and entrepreneurs exploiting profit opportunities in each other’s markets. As such, it would be wrong to expect that the visit by itself would produce direct and immediately observable economic gains for either country.

However, this being said, there remain important areas in which the proposed partnership dialogue between the United States Treasury and Finance Ministry in India could advance economic ties between the two nations. The official agenda agreed between the two sides proposes to focus on macroeconomic, financial sector and infrastructure issues. Within these three areas, the subject with the greatest potential is infrastructure. India is on the cusp of launching a massive build up of its infrastructure including power, railways, roads, ports, airports, telecommunications and urban housing and transport. The current estimates are that India will need to invest $1 trillion on infrastructure over the next ten years.

Yet, India remains inadequately prepared for this gigantic task, especially in terms of financing. Given a debt-to-GDP ratio of nearly 80 percent and a high existing fiscal deficit that must be brought down, it is unlikely that the Indian government can increase public investment in infrastructure beyond the current level of 5 percent of the GDP. This leaves an annual financing gap of almost $50 billion per year over the next several years. Thus, private resources including those from abroad will have to be mobilized and the United States could play a major role in filling this gap.

At present, while infrastructure companies from Italy, Germany, Spain, Singapore and Malaysia have a visible presence in the Indian market, U.S. infrastructure companies have remained relatively disengaged. Therefore, the visit by Secretary Geithner could focus on forging necessary agreements with his Indian counterpart to bring the U.S. companies prominently to India’s infrastructure market. The visit could also help bridge the information gap that seems to exist among the U.S. infrastructure companies with respect to the Indian market.

A second important potential area of cooperation between the U.S. and India is higher education. The Foreign Universities Bill, which the Indian Cabinet recently approved to be tabled in the Parliament, will finally end a regulation that currently forbids foreign universities from awarding degrees in India. India produces a large number of extremely talented students while the United States has a large number of world-class universities. Once the barrier to the entry of foreign universities is removed, the two countries stand to mutually benefit big from cooperation in this area. As many as 70,000 Indian graduate students currently study in the U.S. and could be hired as faculty members on Indian campuses of the U.S. universities.

The third major area of possible U.S.-India cooperation is financial sector development. In particular, while the equity market has been coming along very well in India, long-term debt market in instruments such as corporate bonds and municipal bonds is almost non-existent. This has indeed been a major barrier to raising private infrastructure finance. A large part of the action to develop the debt market has to come from the Indian government. For example, regulation on insurance and pension funds that encourages them to heavily invest in government securities needs to be gradually liberalized. But the experience and expertise of U.S. financial sector firms can be exploited as a part of cooperation between the two nations. Symmetrically, India has perhaps shown greater prudence in regulating its banks and financial institutions, which helped it largely escape the recent global financial crisis. There may be lessons for the United States to learn from India in this area.

Fourth, trade, which can be included as a part of macroeconomic agenda of the Treasury-Finance Ministry partnership dialogue, could be a very important area of cooperation. The Doha negotiations have remained stalled and their revival and conclusion remain in the interest of both India and the United States. U.S. Trade Representative Ron Kirk has been lukewarm to resuming talks, but perhaps the Geithner-Mukherjee dialogue could help break the ice. Thee may also be scope for liberalization in agriculture by India outside of the Doha negotiations. But this will require a quid pro quo from the United States in areas such as temporary worker visas for which the latter may not be ready.

Finally, Federal Reserve Vice Chairman Donald Kohn who will accompany Secretary Geithner has said that rebalancing the global economy will also be a part of the discussions in New Delhi. In the Indian context, the precise rebalancing issue is not clear. Unlike China, with rare exceptions, the current account of India has been in deficit in most years. As such, there is little scope for the appreciation of the rupee to accommodate larger volume of imports and smaller volumes of exports. On the other hand, the statement is meant to hint at asking India to join hands with the United States in pushing China to revalue its exchange rate, Mr. Kohn will need to tread carefully. India perhaps has its own worries about managing the bilateral relations with China.

As Secretary Geithner embarks upon the visit, Indians will be keenly looking for concrete evidence of a desire to strengthen the partnership between the two countries on the part of the Obama administration. Rather than insisting on balancing every single concession offered, as the United States frequently does, Secretary Geithner should exhibit greater flexibility and generosity. In the end, the success of the largest and most diverse and complex democracy of the world holds many rewards for the United States in the long run even if its concessions are not immediately reciprocated.

Authors

Arvind Panagariya

Image Source: © Molly Riley / Reuters

The Republic of India at Sixty

Arvind Panagariya — Mon, 25 Jan 2010 13:54:00 -0500

On January 26, 2010, the Republic of India will celebrate its 60^th anniversary. Though India had won its independence on August 15, 1947, it was not until January 26, 1950 that it adopted its permanent constitution. The 60^th anniversary of the republic offers an appropriate occasion to take stock of its economic accomplishments.

While India began by implementing sound institutions—a robust parliamentary democracy, independent judiciary, well-functioning bureaucracy and fiercely independent press—the economic policy framework it adopted was deeply flawed. By imposing licensing restrictions on products to be produced and imported, their quantity, selling prices and allocation among buyers, the government scuttled private initiative. It also reserved economic activity in a number of sectors exclusively for public enterprises. And, beginning in the late 1960s, the government went on to nationalize the largest banks, insurance sector, oil companies and coalmines. With such straitjacketing, even the sound institutions and India’s talented entrepreneurs could deliver only modest growth: the economy grew at the average annual growth rate of 3.8 percent during financial years 1951-52 to 1987-88 (India’s financial year begins on April 1 and ends on March 31).

Modest liberalization and fiscal expansion, financed by incurring debt abroad, had begun to improve growth performance in small measures in the 1980s. The growth rate shifted up to 4.6 percent between 1981-82 and 1987-88 from 3.7 percent over the preceding 15 years. With liberalization receiving some impetus under Prime Minister Rajiv Gandhi in the mid-1980s, and fiscal expansion continuing apace, a bigger spurt in the growth rate occurred in the late 1980s. But a mounting external debt to finance the fiscal deficits also culminated in a balance-of-payments crisis in June 1991. That crisis paved the way for systematic and systemic reforms beginning in July 1991. Prime Minister Narasimha Rao during 1991 to 1996 and Prime Minister Atal Bihari Vajpayee during 1998 to 2004 presided over wholesale economic reforms, which eventually led to an unprecedented economic boom.

Even though the command and control regime during the first four decades had led to corruption in virtually every governmental agency—thus, worsening the quality of institutions—improved policy regime resulted in superior overall governance and economic outcomes. Entrepreneurs no longer needed a license for setting up manufacturing units or for importing the necessary machinery and inputs. Entry of private operators in telecommunications meant consumers could buy phones instantly rather than wait for years in the queue, thanks to the Department of Telecommunications monopoly. Entry of private airlines meant the customers were no longer hostage to Indian Airlines monopoly for securing seats on flights. Entry of new Indian and foreign private banks gave customers considerable options, forcing better service even from public sector banks.

For a long time, skeptics had argued that democracy was a barrier to East Asian style miracle-level growth. Until the early 2000s, only authoritarian regimes such as those in South Korea, Taiwan, Singapore and Hong Kong in the 1960s and 1970s and the People’s Republic of China in the 1980s and beyond had grown at rates exceeding 8 percent on a sustained basis. Chile had been regarded as a highly successful case of development under democracy but it too had not grown faster than 6 percent on a sustained basis.

But Indian democracy has now cracked the myth of incompatibility of democracy and miracle-level growth. Its growth rate shifted to approximately 6 percent in the 1990s and early 2000s and then jumped to 8.5 percent between 2003-04 and 2008-09. Alongside, poverty has declined as well. The proportion of those living below the poverty line fell from 36 percent in 1993-94 to 27.5 percent in 2004-05.

What has been remarkable about years 2003-04 to 2008-09 is that with rare exceptions all states, whether rich or poor, have grown faster than in any other period. Likewise, poverty has declined in virtually all states between 1993-94 and 2004-05. One other important indicator reinforces these observations: the spread of telephones. As late as the end of March 1999, India had a total of just 23 million phones, translating into 2.3 telephones per hundred individuals. Within 10.5 years, at the end of September 2009, the two indicators had climbed up to 509 million and 43.5, respectively. Even in rural India, on the average, there now exists one phone per household. Bihar, the poorest state in India, can boast of 23 telephones per 100 individuals.

The Indian economy has shown remarkable resilience to the recent global financial crisis. During the crisis year of 2008-09, the country managed to grow at 6.7 percent. During July-September 2009, the second quarter of financial year 2009-10, the economy has already recovered to 7.9 percent growth over the corresponding quarter of the last financial year. In large part, the credit for weathering the crisis without much damage goes to Y. V. Reddy, the former governor of the Reserve Bank of India, who resisted the pressures from virtually all corners, including the Finance Ministry, to rapidly liberate the investment activity of Indian banks. Thanks to him, Indian banks had virtually no investments in the toxic assets and did not require significant infusion of capital to survive.

Increased incomes made possible by accelerated growth have placed ever-increasing amounts of tax revenues in the hands of the government. The present United Progressive Alliance (UPA) government has chosen to take advantage of these revenues to beef up social programs. The central plank of these programs has been the National Rural Employment Guarantee Scheme, which guarantees one member of each rural household 100 days of employment at the minimum wage.

While this acceleration of social programs is to be applauded, the downside is that economic reforms have come to a standstill under the UPA government. Indeed, there are signs of a creeping return to the past interventionism. For example, a decision was recently made to require all ultra-mega power projects to buy their equipment domestically. Likewise, a move is under way to extend the minimum wage legislation to 340 million workers in the unorganized sector and, thus, bring the inspector raj to the doorstep of even the tiniest enterprises and to households employing domestic servants. Resort to indirect and distortionary instruments such as this, rather than targeted instruments such as direct transfers to help the poor, is a source of worry if India is to sustain and accelerate the pace of growth and poverty alleviation.

Authors

Arvind Panagariya

The Copenhagen Accord and India

Arvind Panagariya — Mon, 21 Dec 2009 15:38:00 -0500

Judging by his public pronouncements, Prime Minister Manmohan Singh had set two distinct goals for himself when deciding his strategy for Copenhagen negotiations. First, he wanted to leave no room for the western media and politicians to paint India as obstructionist as had repeatedly happened during the as Doha negotiations. Second, being firmly of the view that in the long run India will suffer disproportionately more from catastrophes resulting form global warming, he wanted to cut a deal that would lead to major reductions in carbon emissions worldwide.

To avoid any impression that India was less than serious in its efforts to reach an agreement, Singh went so far as to state in his maiden speech in Copenhagen that India will deliver on its promise of bringing down its 2005 emission intensity by 20 percent by 2020 even if an agreement were not reached in Copenhagen. In the end, he was successful in impressing upon President Barrack Obama that India had offered to do more than what a poor, vulnerable country could afford. Obama applauded India for voluntarily committing to “very significant mitigation” effort. Reminding his audience at Copenhagen that India has hundreds of millions of people living in abject poverty and without electricity, Obama stated in his speech, “For them, even voluntarily to say, we are going to reduce carbon emissions relative to our current ways of doing business by X percent is an important step. And we applaud them for that." Singh had scored a decisive public relations victory—after this endorsement by Obama, no newspaper or TV commentator would dare point a finger at India as the obstruction to an agreement.

Singh’s success in scoring a diplomatic victory was matched by his failure in achieving a deal that would credibly arrest global warming, however. He had staked much on being able to persuade the United States to agree to an ambitious agreement in Copehagen, committing India to ever-higher levels of mitigation on a voluntary basis. From his initial position that given the country’s low per-capita emissions, India should not be subjected to any mitigation commitments, Singh went on step-by-step to raise the level of his country’s voluntary commitments. First came his promise not to let per-capita emissions of India ever to exceed the average of per-capita emissions of industrial countries. Then, he proceeded to commit to the goal of holding the average temperature increases around the globe to 2°C. This was followed by the announcement of eight national missions aimed at mitigation, which included plans to introduce building codes, tighter auto emission standards, increase in the share of green sources of energy to 20 percent by 2020 and even a cap and trade program for selected sectors. Finally, in the last week prior to the beginning of the Copenhagen summit, he committed India to cutting 2005 emission intensity by 20 percent by 2020.

As a part of as yet non-binding Copenhagen Accord, Singh also accepted the U.S. demand for submission of mitigation plans to the United Nations Framework Convention on Climate Change. Additionally, India will submit a progress report on mitigation every two years that will be subject to “international consultations and analysis under clearly defined guidelines.” In principle, this provision can be seen as a first step towards the conversion of what are currently “voluntary” steps towards mitigation into internationally mandated commitment that Singh and his environment minister have promised not to accept under any circumstances.

These progressively rising levels of concessions have not led to any improvement in the offer by the United States, which currently stands at cutting it’s the country’s 1990 emissions by merely 3 percent by 2020. This commitment compares rather unfavorably with the commitment to cut 1990 emissions by 7 percent by 2012 under the 1997 Kyoto Protocol that the United States had signed but refused to ratify. One may argue that the United States has put on the table financing for adaptation and mitigation by the developing countries as a part of the Copenhagen Accord. But the proposed level of funding at $30 billion in the first three years, which must be spread over more than 150 countries, is tiny. More importantly, much of this funding is likely to go to the least developed and island countries. It is unlikely India will reap any benefit from this fund.

This meager U.S. response testifies to Singh’s failure to achieve his second objective. Unless Singh is able to persuade the United States (and other industrial countries) to undertake far more ambitious cuts in emissions under a final agreement that is to succeed the Copenhagen Accord, his own commitments on behalf of India could prove costly to his country. On one hand, he will not have achieved the goal of avoiding environmental catastrophes and on the other, he would have ended up compromising growth and poverty alleviation. Under existing technologies, cuts in emissions or their growth are almost sure to translate into cuts in energy consumption or its growth, which would in turn adversely impact India’s GDP growth and poverty alleviation.

It may be recalled that India is a poor but rapidly growing economy. Its ability to withstand natural disasters in the next two to three decades depends crucially on its ability to sustain and accelerate its current growth rate of 8 to 9 percent. Such growth would allow the citizens to access shelters that can withstand cold, heat and rain and impart them with the means of rapid transportation and communications. The income increases will also place more resources in the hands of the government to build bridges, roads and dikes to help deal with natural disasters more effectively. In so far as mitigation commitments compromise growth, they will undermine the ability of Indians to withstand natural disasters that would occur in the next two to three decades regardless of emission levels around the globe.

Prime Minister Singh will need to carefully weigh this cost of India’s own mitigation commitments against the benefits to be reaped from improved commitment offers from industrial countries in the negotiations for a final climate accord. He must remember that given just 4 percent share in global emissions, mitigation by India by itself has virtually no impact on future global warming. His commitments will acquire value only if major emitters countries sign on to an ambitious mitigation agreement.

Authors

Arvind Panagariya

Climate Change and India

Arvind Panagariya — Mon, 10 Aug 2009 00:00:00 -0400

During her recent visit to India, Secretary of State Hillary Clinton tried to prepare the ground for the major negotiation on carbon emissions in Copenhagen in December by calling upon India to join hands with the United States to "combat global warming." Recognizing that Clinton was indirectly calling for India to accept mitigation commitments at Copenhagen, India's environment minister Jairam Ramesh reacted swiftly and sharply stating that his country was "simply not in a position to take on legally binding emissions [reduction] targets."

Is India being self-righteous and risking its own interest, as the Financial Times and The New York Times claimed in the wake of the tough stance by Ramesh, or acting in self-interest while asserting its reasonable rights? A good case can be made in favor of the latter.

Let me make clear at the outset that the opposition to mitigation commitments at the aggregate level is not to be confused with opposition to all mitigation. If replacing regular light bulbs with "green" bulbs would lower carbon emissions while also bringing down the cost of lighting the house, the change is obviously welcome. Likewise, if clean energy sources are available at no extra economic cost over those that pollute, their use is to be encouraged.

Therefore, the issue subject to debate is whether mitigation at the aggregate level would best serve the interests of India. To answer, begin with a few relevant facts. Going by the most conservative estimates, 300 million Indians currently live in abject poverty. Forty percent or more of households in the country are without electricity—they literally lack an electricity connection. On a per-capita basis, India ranks 137th in carbon emissions. Even when compared to China, India's carbon emissions are approximately one-fifth in aggregate terms and one-fourth in per-capita terms.

Setting aside the equity issue for the moment, if India were to accept even modest mitigation commitments, it will have to seriously compromise its growth. Economic growth of 9% to 10%, necessary to bring electricity to all households and offer a modest living standard to all citizens in the next two to three decades, cannot be achieved without significant increase in aggregate emissions. One way to see this is to ask how much lower the emissions of China could be if it adopted overnight the most cost-effective clean technologies currently available. Even making the generous assumption of a 25% cut on this basis, the Chinese emissions would remain 3.5 times those of India. It is simply unrealistic to think that India can achieve the income standards China currently enjoys while holding its emissions to current levels.

What about the argument that India is highly vulnerable to the risks posed by global warming and therefore risks devastation unless it accepts mitigation commitments? Frankly, such argument borders on fear-mongering, while obfuscating the fact that mitigation advocated by the IPCC (Intergovernmental Panel on Climate Change) is entirely feasible without subjecting India to binding commitments for some decades to come. India accounts for just 4.4% of the current annual emissions. Given this tiny share and the vast existing stock of carbon from emissions in the last 100 years in the atmosphere, mitigation by India can add no more than a drop in the ocean.

Indeed, if we were to seek a solution to the emission problem based on maximizing any reasonable global-welfare objective, we would likely exempt India (and Africa, which also has a large poor population and accounts for a small part of annual global emissions) from mitigation obligation until it is able to provide a humane living standard to its citizens. It is astounding that liberals in the West entirely turn a blind eye to the poor in India when insisting on compulsory mitigation by the latter, some even going so far as to advocating import tariffs to enforce mitigation by it. Surely, rich nations can undertake to do just a bit more in the early decades to accommodate the poor, with today's poor nations joining the clean-up effort later.

The argument for mitigation commitments by India for some decades to come looks even weaker once we take into account the existing international agreements and equity. The United Nations Framework Convention on Climate Change to which 192 countries currently subscribe explicitly exempts the developing countries from mitigation commitments. Consistent with this provision, the Kyoto Protocol, negotiated under the auspices of the UNFCCC, set mitigation targets exclusively for developed countries. The insistence by the United States that the post-Kyoto agreement on mitigation, to be negotiated in Copenhagen in December, must subject India and China to binding commitments is in violation of the UNFCCC agreement.

As for equity, developed countries have emitted the bulk of the carbon in existence in atmosphere today. They accounted for more than 70% of the emissions between 1850 and 2000, with India's share being a paltry 2%. Even in terms of current emissions, Canada, the U.S., Europe, Eurasia and Japan together release more than 50% of the carbon into the atmosphere. Any principle of moral philosophy would require the developed countries to substantially cut their emissions before asking developing countries to commit to mitigation.

Indeed, developed countries have chosen to play strategically by framing the negotiation in terms of mitigation commitments rather than emission rights. Given their disproportionately large current emissions, even very substantial mitigation commitments leave them with disproportionately large future emission rights. They can claim the high moral ground for having made large cuts and yet walk away with the maximum rights to pollute in the future!

Finally, it should not go unrecorded that while the Obama administration and the Democratic Congress have moved climate change up on the U.S. national agenda, their efforts to date are scarcely laudable. Even ignoring the protectionist provisions for import tariffs and the decision to distribute 85% of pollution permits freely to the firms that successfully lobbied, the Waxman-Markey legislation—which still awaits approval by the Senate—requires emissions to drop to only 20% below the 2005 levels by 2020. Under the original Kyoto Protocol, which a prior Congress chose not ratify, the United States had agreed to bring the emission levels to 7% below their 1990 levels by 2012. Because the United States substantially expanded its emissions between 1990 and 2005, by shifting the base year to 2005, it has now set its 2020 target 12% above the 1990 emissions. This can hardly be hailed as "leadership" by a great nation, as much of the Western press has implicitly done by chastising India for standing up to U.S. pressure.

Authors

Arvind Panagariya

Publication: Forbes.com

India Policy Forum 2009/10 - Volume 6: Editors' Summary

Suman Bery, Barry P. Bosworth and Arvind Panagariya — Wed, 01 Jul 2009 00:00:00 -0400

The sixth annual India Policy Forum conference convened in New Delhi from July 14-15. This fourth issue of the India Policy Forum, edited by Suman Bery, Barry Bosworth and Arvind Panagariya, covers the global financial crisis and the implications for India. The editors' summary appears below, and you can download a PDF version of the volume, or access individual articles by clicking on the following links:

Download the India Policy Forum 2009-2010 agenda »
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EDITORS' SUMMARY

The sixth annual conference of the India Policy Forum was held on July 14 and 15, 2009 in New Delhi. The meeting was dominated by considerations of the global financial crisis and its implications for India. The events of 2009 provided evidence of India’s growing integration with the global economy, an illustration of the resilience of country’s economic growth, and its emergence as a major participant in an expanded system of governance for the global economic system. This issue of the journal includes four papers and the associated discussion from the conference, and a fifth paper that was originally presented at the 2007 conference.

Indian Equity Markets: Measures of Fundamental Value

Beginning in 2005, the Indian equity market underwent a period of explosive growth rising from a valuation equal to about 50 percent of GDP to a peak of 150 percent by early 2008. Growth of this magnitude raised concerns that the market was hugely overvalued and it was often characterized as an example of an asset market bubble. The market valuation subsequently fell back to about 70 percent of GDP during the global financial crisis. This experience stimulated interest in India in the question of what would constitute a reasonable or fair value for equities that could be use as a standard for evaluating market fluctuations. In “India Equity Markets: Measures of Fundamental Value,” Rajnish Mehra examines this question by comparing corporate valuations in India over the period of 1991–2008 relative to three key market fundamentals: the corporate capital stock, aftertax corporate cash flows, and net corporate debt.

Mehra’s model builds on the idea of a link between the market value of the capital stock and the debt and equity claims on that stock—a concept known as Tobin’s q. He extends the existing framework using some prior work by McGrattan and Prescott on US equity valuations, and he incorporates both intangible capital and key features of the tax code. It is a multi-period model in which firms maximize shareholder value subject to a production function with labor and two kinds of capital—tangible and intangible—as the inputs. Wages, intangible investment and depreciation of tangible capital are treated as tax-deductible expenses. It yields an equilibrium representation of the relationship between the market value of equity and the reproduction value of tangible and intangible capital in the corporate sector. All of the nominal values are normalized by GDP and the result is a framework that can be used to evaluate the effect on equity prices of a range of different policy actions, such as changes in the taxation of corporate dividends.

The model is calibrated to the Indian situation with respect to the capital stock, tax rates, and the characteristics of economic growth in the nonagricultural sector. Mehra also develops his own estimates of the valuation of intangible capital using three different methodologies. The first method is that used by McGrattan and Prescott and is based on the assumption that tangible and intangible capital earn the same rate of return along a balanced growth path. That assumption allows him to derive the equilibrium ratio of tangible and intangible capital. The alternative methods are based on recent work in the United States by Corrado, Hulten, and Sichel that involves cumulating investment flows to estimated stocks. Mehra uses two different methods to calibrate the Indian data with information from the United States, and he estimates the stock of intangible capital for two periods of 1991–2004 and 2005–08. The focus on two sub-periods is designed to capture a structural break in the data: Indian equity valuations as a fraction of GDP were fairly constant over the period 1991–2004, rising sharply starting in 2005. The two estimates of the stock of intangibles based on the comparison with the United States are very similar, but they are significantly lower than the estimates obtained with the McGrattan and Prescott methodology.

His analysis suggests that an optimistic estimate of the fundamental value of the current Indian equity market is about 1.2 times GDP, considerably lower than the 1.6 value observed in 2008, but close to the average over the full period. One effect on equity prices that the study does not account for is a change in investor demand from foreign institutional investors. If the effect of this is a change in the characteristics of the marginal investor, the relevant marginal rate of substitution will change, and with it market valuations. Thus, Mehra suggests that the extension of the model to include foreign investors should be a major objective for future research.

Why India Choked when Lehman Broke

Mehra’s paper generated an active discussion that centered on the difficulties of accurately measuring some of the values, such as the rate of technological change and real interest rates, required to calibrate the model to India’s situation. Several commentators also emphasized the important role of foreign investors. Others pointed to the difficulties of applying a model based on equilibrium conditions to the highly transitional nature of the Indian economy. In “Why India Choked when Lehman Broke,” Ila Patnaik and Ajay Shah analyze the rapid transmission of the impact of the Lehman bankruptcy into Indian financial markets. The authors propose an explanation that revolves around the treasury operations of Indian multinational corporations (MNCs). Such MNCs are less subject to the capital controls imposed on purely domestic Indian companies.

The developments that emerged within Indian financial markets in September and October following the bankruptcy of Lehman Brothers on September 14, 2008 were quite extraordinary. First, there was a sudden change in conditions in the money market. Call money rates shot up immediately after September 15. Despite swift action by the Reserve Bank of India (RBI), the tightness persisted through the month of October. The operating procedures of monetary policy broke down in unprecedented fashion and interest rates were persistently above the target range of the Reserve Bank of India (RBI). The call rate consistently breached the 9 percent ceiling for the repo rate and attained values beyond 15 percent. There was a huge amount of borrowing from the RBI. On some days, the RBI lent an unprecedented Rs 90,000 crore through repos. These events are surprising given the extent of India’s de jure capital controls that were expected to isolate its financial markets from global developments. Greater understanding of crisis transmission, the effectiveness of capital controls, and India’s de facto openness could be achieved by carefully investigating this episode and identifying explanations.

The main hypothesis of this paper is that many Indian firms (financial and non-financial) had been using the global money market before the crisis to avoid India’s capital controls. This was done by locating global money market operations in offshore subsidiaries. When the global money market collapsed upon the demise of Lehman, these firms were suddenly short of dollar liquidity. They then borrowed in the rupee money market, converting rupees to US dollars, to meet obligations abroad.

The result was strong pressure on the currency market, and the rupee depreciated sharply. The RBI attempted to limit rupee depreciation by selling dollars. It sold $18.6 billion in the foreign exchange market in October alone. Ordinarily, one might have expected depreciation of the exchange rate in both the spot and the forward markets. However, instead of the forward premium rising in response to the pressure on the rupee to depreciate, it crashed sharply. The authors’ hypothesis is that some Indian MNCs that were taking dollars out of India planned to return the funds within a few weeks. To lock in the price at which they would bring that money back, they sold dollars forward. Thus, the one month forward premium fell sharply into negative territory.

Balance of payments data shows outbound FDI was the largest element of outflows in the “sudden stop” of capital flows to India of the last quarter of 2008. This supports the aforementioned hypothesis. During this time there was no significant merger and acquisitions activity taking place owing to the banking and money market crisis around the world. The explanation for the large FDI outflow when money market conditions in India and the world were among the worst seen in decades, could lie in the offshore money market operations of Indian MNCs. Finally, the authors analyze stock market data, finding that Indian MNCs were more exposed to conditions in international money markets as compared to non-MNCs.

This paper’s main contribution lies in showing that Indian MNCs are now an important channel through which India is financially integrated into the world economy. This raises questions about the effectiveness of India’s capital controls, which inhibit short-dated borrowing by firms. This restriction appears to have been bypassed to a substantial extent by Indian MNCs. This phenomenon contributes to a larger understanding of the gap that exists between India’s highly restrictive de jure capital controls and its de facto openness.

De jure capital controls have not made India as closed to global financial markets as expected. The expectation that a global financial market crisis would not hit India owing to these controls was proved to be incorrect when the financial crisis was transmitted to India with unprecedented speed. This evidence of India’s integration with global capital markets will influence the future discussion of its de facto capital account convertibility.

Climate Change and India: Implications and Policy Options

Climate change and the mitigation of greenhouse gas (GHG) emissions have moved to the forefront of international discussion and negotiations. While global warming may have adverse effects on Indian society, there are also concerns that efforts to mitigate emissions within India could seriously impair future economic growth and poverty alleviation. These concerns are the focus of the paper, “Climate Change and India: Implications and Policy Options” by Arvind Panagariya.

The basic perspective is that India’s current per capita carbon emissions are very small, only one-fourth those of China and one-twentieth those of the United States; and given the strong association between income and emissions, the capping of emissions at current levels would make it impossible for India to sustain the growth required to match Chinese income levels, much less narrow the gap with the developed economies. Panagariya argues that India should resist making binding emission commitments for several decades, or until it has made greater progress in poverty alleviation.

The paper begins with a discussion of various uncertainties relating to the response of temperatures to GHG emissions, and in turn, the impact of any temperature changes on rainfall and various forms of extreme weather. There is further uncertainty about the effects of those weather changes on productivity and GDP growth. The author discusses the changes in temperatures and rain patterns specific to India during the last century, as well as their impact if any on sea levels, glacier melting, and natural disasters such as drought and cyclones.

The paper then explores the question of optimal mitigation and instruments to achieve it. A key conclusion is that, absent any uncertainties, either a uniform worldwide carbon tax or a fully internationally system of tradable pollution permits should be employed to reach the optimal solution. A more complicated issue relates to the distribution of the costs of mitigation. Efficiency dictates that countries in which the marginal loss of output per ton of carbon mitigated is the lowest should mitigate more. But absent any international transfers, this may lead to an inequitable distribution of costs of mitigation. An additional question arises with respect to past emissions for which the responsibility largely rests with developed countries. A case can be made that if countries are asked to pay a carbon tax for future emissions, they should also pay for the past emissions. This is especially relevant since big emitters of tomorrow are likely to be different from big emitters of yesterday.

Panagariya argues that these distributional conflicts are the primary explanation of why countries have found it so difficult to arrive at a cooperative solution. Developing countries argue that since developed countries are responsible for the bulk of the past emissions and are also among the largest current emitters, they should undertake much of the mitigation. In turn, the United States has responded by raising the specter of trade sanctions against countries that do not participate in the mitigation efforts. The paper discusses whether such trade sanctions are compatible with the existing World Trade Organization (WTO) rules. It argues that the legality of the trade sanctions is far from guaranteed although the ultimate answer will only be known after the specific measures are tested in the WTO Dispute Settlement Body.

Turning to the specific situation of India, Panagariya argues that it should resist accepting specific mitigation obligations until 2030 or even 2040. The case for an exemption from mitigation for the next two or three decades is justified by the fact that India is a relatively small emitter in absolute as well as per capita terms. Based on 2006 data, it accounts for only 4.4 percent of global emissions, and in per capita terms it ranks 137th worldwide. This is in contrast to China, with which it is often paired. China currently emits the most carbon in the world in absolute terms, and as much as one-fourth of the United States in per capita terms. In addition, Panagariya argues that India needs to give priority to the reduction of poverty.

Given the situation of India and other poor countries, how can an international agreement to combat global warming be reached? Panagariya proposes first that significant progress can be made through agreements on the financing of investments devoted to the discovery of green sources of energy and new mitigation technologies. He believes that private firms will under-invest in such technologies due to the inherent uncertainties. Thus, he argues for establishing a substantial fund financed by contributions from the developed countries and using it to finance research by private firms with the proviso that the fruits of such research would be made available free of charge to all countries. Second, he argues that there is still considerable work to be done in completing an agenda of near-term actions. If developed countries are serious about the necessity of developing countries undertaking mitigation targets beginning some time in the near future, they need to lead by example and accept substantial mitigation obligations by 2020. Finally, he believes that mitigation targets for the developing countries should be stated in terms of emissions per capita or per unit of GDP.

The paper generated a lively exchange among participants on both the effects of climate change and on how India should participate in the international policy discussion. Some thought that Panagariya underestimated the costs to India of climate change, but most of the discussion centered on the development of an appropriate Indian policy response.

Beginning with the major 1991 reform, India has systematically phased out investment and import licensing. Progressive movement toward promarket policies accompanying this phasing out of controls was expected to bring about major shifts in India’s industrial structure. Partly because the opening up itself was uneven across sectors and partly because responses to liberalizing reforms were bound to differ across sectors and firms, it was expected that the changes would be highly variable.

India Transformed? Insights from the Firm Level 1988-2005

“India Transformed? Insights from the Firm Level 1988–2005” by Laura Alfaro and Anusha Chari, sets out to study the responses of firms and sectors accompanying the ongoing transformation of India’s microeconomic industrial structure. Relying on firm-level data, collected by the Center for Monitoring the Indian Economy from company balance sheets and income statements, they study the changes in firm activity from 1988 to 2005. They highlight the differing responses to reforms across sectors, private versus public sector firms, and incumbent versus new firms.

The authors define liberalization as consisting of trade and entry liberalization, regulatory reform and privatization that lead to increased domestic and foreign competition. They present a series of stylized facts relating to the evolution of firms and sectors accompanying and following liberalization. The database covers both unlisted and publicly listed firms from a wide cross-section of manufacturing, services, utilities, and financial industries. Approximately one-third of the firms in the database are publicly listed and the remaining two-thirds are unlisted. The companies covered account for more than 70 percent of industrial output, 75 percent of corporate taxes, and more than 95 percent of excise taxes collected by the Government of India.

Detailed balance sheet and ownership information permits the authors to analyze a range of variables such as sales, profitability, and assets for approximately 15,500 firms classified across 109 three digit industries encompassing agriculture, manufacturing, and services. Therefore, in contrast to most existing firm level studies that focus on manufacturers, the authors are able to study the firms in the services and agriculture sectors as well. The data also permit distinction according to ownership categories such as state-owned, business groups, private stand-alone firms, and foreign firms. The authors divide the years from 1988 to 2005 into five sub-periods: 1988–90, 1991–94, 1995–98, 1999–2002, and 2003–05. This division into sub-periods is intended to capture the effects of various reforms taking place over time.

The authors present detailed information on the average number of firms, firm size, as measured by assets and sales, and profitability as measured by operating profits and the return on assets. The information is presented by sector as well as by category of firm: state-owned enterprises, private firms incorporated before 1985 (old private firms), private firms incorporated after 1985 (new private firms), and foreign firms for the five sub-periods. Sales, entry, profitability, and overall firm activity are interpreted as disaggregated measures of economic growth and proxies for efficiency; and thus, they provide an understanding of the effectiveness of reforms. The authors also look at market dynamics with regard to promotion of competition in order to understand the efficiency of resource allocations. They also examine the evolution of industrial concentration over time.

Alfaro and Chari find some evidence of a dynamic response among foreign and private firms as reflected in the expansion of their numbers as well as growth in assets, sales, and profits. But overall, they find that the sectors and economy continue to be dominated by the incumbent state-owned firms and to a lesser extent traditional private firms that were incorporated before 1985. Sectors dominated by state-owned and traditional private firms prior to 1988–90, where dominance is defined by 50 percent or larger share in assets, sales, and profits, generally remain so in 2005. Interestingly, rates of return remain remarkably stable over time and show low dispersion across sectors and across ownership groups within sectors. Not only is concentration high, but there is persistence in terms of which firms account for the concentration.

The exception to this broad pattern is the growing importance of new and large private firms in the services industries in the last ten years. In particular, the assets and sales shares of new private firms in business and IT services, communications services and media, health, and other services have expanded at a rapid pace. These changes coincide with the reform measures that took place in the services sectors after the mid-1990s, and they are also consistent with the growth in services documented in the aggregate data.

According to Joseph Schumpeter (1942), creative destruction, defined as the replacement of old firms by new firms and of old capital by new capital, happens in waves. A system-wide reform or deregulation such as the one implemented in India may have been the shock that prompted the creative destruction wave. Creation in India seems to have been driven by new entrants in the private sector and foreign firms forcing the incumbent firms to shape up as well. Outside of the services sectors noted in the previous paragraph, and especially in many manufacturing sectors, transformation seems not to have gone through an industrial shakeout phase in which incumbent firms are replaced by new ones. In many of these sectors, stateowned enterprises and private business groups have continued to dominate despite many liberalization measures.

Different explanations may account for these findings. In part, continued dominance of public sector firms in certain sectors may reflect the high barriers to exit that not only impede destruction of marginal firms but also discourage new firms from entry. On the one hand, potential entrants know that exit of public sector firms is unlikely; on the other hand, they may fear paying high exit costs in case they fail to find a foothold. An additional explanation, perhaps not sufficiently stressed in the debate, is the possibility that entrenched public sector and business group firms subvert true liberalization in sectors in which they dominate. The authors find, for example, that both industry concentration and state ownership are inversely correlated with measures associated with liberalization.

Recent literature highlights the idea that economic growth may be impeded not simply by a lack of resources such as capital and skilled labor, but also by a misallocation of available resources. The high levels of state ownership and ownership by traditional private firms in India raise the question of whether significant gains could be made simply through the allocation of existing resources from less efficient to more efficient firms.

Land Reforms, Poverty Reduction, and Economic Growth: Evidence from India

In “Land Reforms, Poverty Reduction, and Economic Growth: Evidence from India,” Klaus Deininger and Hari K. Nagarajan consider the important but relatively neglected issues of land market policies and institutions. They focus attention on three issues: the role of rental markets in land, the contribution of land sales to the promotion of efficiency, and the potential benefits of better land ownership records and the award of land titles. The authors posit that well-functioning rental and sales markets lead to superior outcomes by raising productivity and providing improved access to land. On an average, these markets shift land toward more efficient farmers, thus contributing to poverty alleviation. The paper also brings into question the long-held view that land sales markets are dominated by distress sales whereby poor farmers facing credit constraints are forced to sell their land for below-market prices to their creditors.

In evaluating the impact of rental markets, the authors test three hypotheses:

Whether a household becomes a lessor or a lessee should be a function of the household’s agricultural ability. Efficient but land-poor households would rent additional land to cultivate while inefficient and land-abundant households should rent out their land for cultivation by other more efficient households. In this manner, well-functioning rental markets in land enhance productivity and improve factor use in the economy.
The presence of high transactions costs inhibits households from participation in rental markets. These costs may force households to withdraw from rental transactions altogether and undermine productivity.
Participation in rental markets is crucially impacted by wage rates offered in the market. Increases in wage rates will prompt households with low ability to manage their land to rent their land to other households. The resulting increase in the supply of land to the rental markets leads to lower rental rates.

Using survey data, the authors test these various hypotheses. They show that rental markets improve productivity of land use by transferring land to more efficient producers. The results suggest that the probability for the most productive household in the sample to rent additional land is more than double that of the average household. The paper also shows that higher land and lower labor endowments increase the propensity of households to supply land to the rental market. By transferring land to labor-rich but land-poor households, markets allow gainful employment of rural labor. The current policies have severely curtailed rental and have therefore retarded advancement of efficiency and equity in rural India.

The authors next turn to markets for land sales. They examine the impact of a well-functioning land sales market on land access. The long-held view has been that land sales are primarily motivated by adverse exogenous shocks. To the contrary, the authors find that such markets have helped more productive and more labor-abundant farmers to gain access to land. The authors also show that land sales markets exhibit greater activity in the presence of higher economic growth. This suggests that if other factor market imperfections are removed, the role of sales markets in promoting equity and efficiency will be expanded. Finally, identifying the source of shocks leading to distress sales and adopting policies that directly address these shocks can ameliorate the adverse effects of such sales in otherwise well-functioning land sales markets.

The last issue addressed in the paper concerns the importance of land administration for the promotion of efficient rental and sales markets. In India, there exist multiple institutions governing land records, registration, and transactions. This situation has led to a duplication of land records, leading to confusion and conflicts over ownership. It also creates a general sense of insecurity of tenure. The authors argue that the computerization of land records can help alleviate these problems. They cite Karnataka and Andhra Pradesh as examples of this experience. They note that the computerization of records can reduce petty corruption, ease access to land records, and possibly increase the probability of land becoming acceptable as collateral to obtain credit.

Authors

Publication: The Brookings Institution and National Council of Applied Economic Research

Will the Singh Government Transform India Into a Modern Economy?

Arvind Panagariya — Tue, 26 May 2009 12:00:00 -0400

Originally published in the Wall Street Journal under the title "Mr. Singh's History Lesson."

The media around the world has reported with some sense of amazement that Manmohan Singh is the first full-term Indian prime minister to be returned to power since 1962, and implied that this re-election gives Mr. Singh a mandate for economic reform. But a more meaningful historical parallel exists between his return and that of former Prime Minister Atal Bihari Vajpayee in 1999.

Just as intransigent communist parties held Mr. Singh's fragile coalition government to ransom during his first term in office, the mercurial Jayaram Jayalalitha, the leader of a southern regional party, tried to scuttle every policy change Mr. Vajpayee initiated after coming to power in March 1998. Just as the current election has given Mr. Singh's United Progressive Alliance a near-majority in parliament, the 1999 election returned Mr. Vajpayee's National Democratic Alliance with a clear mandate.

No longer hostage to Ms. Jayalalitha's antics and assured of a full five-year term, Mr. Vajpayee went on to systematically introduce deep economic reforms. India's recent shift to 8% growth from the previous 6% growth rate owes much to those reforms. The million-dollar question now is whether the Singh government will implement economic reforms with the same vigor as the Vajpayee government. Going by media reports and the positive stock-market response last week to the election results, the answer would seem to be an unequivocal "yes."

Yet one cannot but help detect some hesitation on the part of the Congress Party president Sonia Gandhi and her son, Rahul Gandhi, who hold a virtual veto over the future direction of Mr. Singh's government. Mrs. Gandhi showed a clear preference for populist policies such as the National Rural Employment Guarantee Scheme over pro-growth economic reforms throughout the past five years and during the campaign. Mr. Gandhi reserved his applause for the multi-billion dollar debt relief package to farmers the Singh government announced more than a year ago. Simultaneously, he roundly criticized the Vajpayee-era reforms in election speeches, arguing they largely benefited the urban elite and corporations at the expense of the poor.

While virtually all economists and policy analysts would agree that the Gandhis display the right instincts when they place the interests of the poor above all else, it is doubtful that those interests can be promoted to the fullest without implementing serious economic reforms. The socialist policies of India's first three decades following independence brought little relief to the poor, while the ad hoc liberalization of the 1980s followed by more systematic reforms subsequently have led to a significant cut in poverty rates.

To be sure, schemes such as the National Rural Employment Guarantee and debt relief can give immediate relief to the poor. But sustaining these programs on a large scale is difficult without rapidly accumulating national debt, which already stands at 80% of the national income. There is no substitute for sustained growth in both rural and urban India if poverty is to be eliminated for good. And this requires reforms both in the rural and urban sectors of the economy.

In the rural areas, the government must introduce reforms that make land leasing and land sales easier; facilitate contract farming; issue titles to land, thus turning it into an effective collateral; and free farmers everywhere to sell their produce to whomsoever they want. It must also speed up connecting villages to the nearest center of economic activity through all-weather roads so that rural people can turn their entrepreneurial talents into effective income.

Urban-area reforms are just as important as agricultural reform. The fate of the rural poor cannot rapidly improve unless reforms that accelerate growth in industry and services are put in place as well. Agriculture currently employs between one-half to three-fifths of the workforce but generates just one-sixth of India's income. Even under the most optimistic scenario, agriculture cannot grow faster than 4% per year on a sustained basis. This growth rate is much too slow to speedily eliminate rural poverty.

If India is to transform into a modern economy, it must create well-paid jobs in industry and services to absorb a substantial proportion of the labor force currently employed in agriculture over the next two decades. Unfortunately, official statistics indicate that employment in the organized sector of the economy currently accounts for less than 10% of total work force. India's unorganized sector can generate some well-paid jobs, but not nearly enough.

If the Gandhis and the Singh government truly wish to eliminate poverty and provide a decent living to Indian workers, focusing exclusively or even primarily on the rural sector simply will not do. The government must make the business environment attractive to large-scale, labor-intensive manufacturing firms and ensure that the rapidly rising service sector is not choked by a shortage of skilled labor. The former requires reform of key labor laws, while the latter requires wholesale reform of the higher education system. The government also must accelerate power sector reforms, build road networks and urgently create urban infrastructure.

Mr. Singh has a rare opportunity to push vital economic reforms ahead that could make poverty in India history. He must persuade the Gandhis that this is the right path for the country.

Authors

Arvind Panagariya

Publication: The Wall Street Journal

India's Political Economy: High Growth, Low Votes

Arvind Panagariya — Fri, 27 Mar 2009 12:00:00 -0400

Predicting election outcomes in India is a hazardous activity; inferring them from economic performance is even more hazardous.

Going by per-capita income growth, one would predict a resounding victory for the ruling Congress party-led United Progressive Alliance (UPA).

At 7.4%, per-capita income growth during the first four years of the UPA rule has been by far the highest of any four-year period in India's post-independence history.

Yet, if the electorate goes by the contribution the present government has made to the accelerated growth in incomes, it would hand the latter its worst defeat.

The UPA government has perhaps done the least of all governments since the 1991 Narasimha Rao-led Congress administration to advance economic reforms.

At the outset, it committed itself to not reforming India's archaic labour laws. Sadly, it also failed to deliver in areas it had assigned high priority.

Unclear answers

Early in its tenure, the UPA had identified pension reform, further opening of the insurance sector and rapid build-up of the country's infrastructure as high-priority areas.

More than four years later, legislation to set up a pension regulatory authority and raising the share of foreign investors from 26% to 49% are languishing in parliament.

In the entirely uncontroversial area of infrastructure, the government lost the momentum its predecessor, the BJP-led National Democratic Alliance (NDA) government, had achieved.

Even trade liberalisation, which greatly accelerated under the NDA government and was initially continued by the UPA, has come to a standstill in the past two budgets.

A costly National Rural Employment Guarantee Scheme, some additional opening up to foreign investment in the telecommunications sector, construction of new airports in Bangalore and Hyderabad, and the setting up of a Food Safety and Standards Authority and Competition Commission after four arduous years remain the main achievements of the government.

Will the excellent performance of the economy benefit the UPA? Or will its near paralysis in carrying forward the reforms hurt it?

At least the past experience does not offer an affirmative answer in clear terms.

The government of Mr Rao, which came to power in June 1991, is credited with launching the most far-reaching and systematic economic reforms.

The reforms not only stabilised the economy following the 1991 balance of payments crisis, they also delivered the hefty 6.5% per annum growth during the last three years of his tenure.

Yet, he lost the 1996 election.

In a similar vein, led by Prime Minister Atal Behari Vajpayee, the BJP-led NDA government undertook massive reforms in virtually all areas of economic activity during its tenure from 1998 to 2004.

Those reforms made a significant contribution to the shift in India's growth rate to the current 8% to 9% growth trajectory. In the last fiscal year of the NDA government, 2003-04, the economy grew 8.5%.

Yet, the NDA government lost power to the UPA.

The popular view is that the NDA lost the election because its reforms, highlighted via its "India Shining"' slogan during the election campaign, mainly benefited the urbanised, industrialised India and left the rural poor behind.

But this view scarcely stands up to close scrutiny: according to the available evidence, the proportion of the poor below the poverty line significantly fell in both rural and urban areas during Mr Vajpayee's rule.

Regional inequalities and the rural-urban divide did rise, as has happened in every country experiencing rapid growth at low levels of development, for the simple reason that rapid growth concentrates in a handful of urban agglomerations.

But that did not drive the election outcome either: there was neither an urban-rural nor a regional divide in the voting pattern.

The BJP-led NDA lost in richer states of Andhra Pradesh and Tamil Nadu while winning in the poorer states of Rajasthan, Madhya Pradesh and Chhattisgarh.

In the former group of states, it lost in both rural and urban areas while in the latter group it won in both.

In recent elections, two factors seem to have critically influenced the eventual outcome: coalition formation and anti-incumbency at state level.

Today, Congress has only 153 of the 272 seats it needs for a majority in parliament. The UPA consists of 11 parties and still needs the outside support of half a dozen other parties to achieve a majority.

A dramatic example of the importance of coalition politics is provided by the role played by the southern regional party, the DMK, in 2004.

It had been with the NDA in the 1999 election but switched allegiance to the UPA in the 2004 election. Its 16 seats, subtracted from the NDA and added to the UPA, provided the balance of votes the UPA needed to from the government.

In recent years, voters have returned state governments to power only when the latter have provided decisively good management and delivered perceptible improvement in living standards.

Therefore, Delhi, Madhya Pradesh and Gujarat represent a handful of the cases in which the electorate returned the incumbent governments back to power.

Excellent chance

In most cases, the electorate has handed punishing defeats to incumbents even if it has meant replacing them with another equally incompetent government.

In turn, the anti-incumbency factor at state level has spilled over to parliamentary elections. That factor substantially contributed to the losses the BJP, the dominant partner in the NDA, suffered in the 2004 election.

If the voters this time around vote on the basis of improvements in their lives, the UPA stands an excellent chance of returning to power.

Growth in agriculture, which employs 60% of India's workforce, has been 4% in the past four years. Prosperity in rural areas is also apparent from the spread of phones. Rural tele-density today is more than 13%.

Making the conservative assumption that each household has four members, this figure implies every other household in rural India now has a cell phone.

Even the sales of motorbikes and automobiles in rural areas are now on the rise. As for urban India, some slowdown in the economy due to the crisis notwithstanding, its face has been dramatically transformed in the past four years.

Why have the average or worse performing incumbents fallen out of favour with the voters?

After all until the 1980s, the electorate had routinely returned the incumbent governments to power. In a Wall Street Journal article in 2004, Jagdish Bhagwati and I hypothesised that the key factor behind the change in voter attitude was the "revolution of rising expectations" unleashed by the reforms and the resulting growth acceleration.

As long as India took the Hindu rate of growth, the voter remained in the grip of fatalism: kya karen, bhagwan ki marzi hai (What can we do, this is God's will!).

But once reforms showed him that change was possible and that poverty was not God's will, he became more demanding: If the incumbent won't deliver fast enough, he would try someone else.

In concluding, let me raise a slightly different question. Between the UPA and the NDA, the major contenders, who will provide a better government in the next five years?

Reform advocates who are also social liberals face a dilemma in answering this question.

The UPA is bound to interpret a victory as vindication of its current policies, which would seal the fate of reforms for another five years.

The NDA is more likely to return to the reforms it had vigorously promoted during its previous stint.

But alas, the NDA's prime ministerial candidate LK Advani, who lacks the moderation of his predecessor when it comes to Hindu-Muslim relations, leads it.

Authors

Arvind Panagariya

Publication: BBC.com

The G-20 Summit and Global Trade: Restore Credit and Resist Protectionism

Arvind Panagariya — Sat, 14 Mar 2009 12:00:00 -0400

The Group of Twenty (G-20) major nations accounting for 90% of the world's gross domestic product, 80% of its trade and two-thirds of its population will meet in London beginning April 2, 2009. They plan to discuss the cooperative steps necessary to bring the current economic crisis to a speedy end. If history is any guide, measures to roll back creeping protection and move the process of trade liberalization forward ought to be high on their agenda.

The Smoot-Hawley Tariffs Act of June 1930, which quadrupled the then-effective tax rate on several thousand imported items to 60% and brought swift retaliatory response from the major U.S. trading partners, accelerated the spiraling down of trade flows worldwide.

According to the State Department, between 1929 and 1932, the U.S. exports to, and imports from, Europe fell 67% and 71%, respectively. This rapid decline contributed to the deepening of the economic depression.

The lessons of the Smoot-Hawley tariffs have not been lost on the policymakers around the world in the midst of the current crisis. They recognize that international trade today accounts for a much larger proportion of the GDP than at the beginning of the Great Depression in virtually all nations. The likely damage to their economies from a trade war aimed at securing domestic markets exclusively for domestic producers is many times what it would have been in the 1930s. Unsurprisingly, despite shrinking demand across the board, no trade war has broken out and few observers suggest that it is likely to break out in the future.

Nevertheless, international trade has been rapidly shrinking in the wake of the U.S. financial crisis and protectionist measures are creeping into the national economies. Both developments pose a threat to faster recovery and long-term growth prospects. The G-20 must address them head on when they meet in London.

There is no doubt that a key factor behind declining trade is the declining demand around the world. Therefore, a part of the solution to the revival of trade lies in the revival of the economies themselves. But trade has been impacted disproportionately more than the GDP.

For instance, the U.S., which declined 6.2% in GDP terms during October-December 2008, saw its exports and imports plunge 23.6% and 16%, respectively, during the same period. The decline in trade has been much sharper in many emerging market economies. India and China, which managed to register GDP growth rates of 5.3% and 2%, respectively, saw their trade flows shrink at double-digit rates during October-December 2008. Other Asian countries, including Japan, South Korea, Thailand, Taiwan and Singapore, have suffered much worse fates.

A key factor behind the spectacular decline in trade flows has been the breakdown of trade credit. Once a firm has an export order, it needs credit to finance the production and sale until it receives payment from the buyer. The bank that offers such credit may require the firm to obtain insurance cover for the loan in case of nonpayment. The importer faces the risk of nondelivery.

In all likelihood, the general breakdown of credit markets has asymmetrically impacted international trade transactions. With the exporter and importer located in two different countries, information asymmetries and the resulting distrust are deeper. The complex organization of production activity whereby components and raw materials for any product are imported from a number of different countries has made matters worse: A breakdown of credit markets at any link in the chain can adversely impact the entire chain. The G-20 must assign a high priority to restoring the provision of trade credit.

The major nations meeting in London must also take steps to arrest the creeping protectionism. Though the WTO rules have provided considerable restraint on the deployment of protectionist measures to shore up domestic market for one's own producers, protection has risen through two channels.

First, stimulus packages have had an element of subsidy to domestic firms that violates the WTO rules and serves as a protectionist measure. For example, the subsidy element in the credit to the U.S. auto industry helps GM and Chrysler at the expense of auto imports and violates the WTO rules in goods trade. Likewise, the vast bailout packages to the U.S. and European banks are on shaky grounds under the WTO rules on trade in services.

Second, countries have resorted to protectionist measures using the flexibility available to them within the WTO rules. A prime example of this is the "Buy American" provision of the U.S. stimulus package. True, the Government Procurement Agreement is confined largely to industrial countries and allows the U.S. to discriminate against nonsignatory countries like India and Brazil. But this only encourages these latter countries to retaliate by raising their own tariffs on the goods the U.S. exports to them.

As long as the applied levels of these tariffs are below the bound levels to which they have committed at the WTO, the countries are legally permitted to raise them. In addition, the countries also have recourse to anti-dumping and related measures to retaliate. In London, G-20 must strive to avoid the use of both WTO legal and WTO illegal measures that try to divert demand toward domestic producers. Such diversion, when pursued by all, will yield no net gain in demand to any single nation. Instead, reduced trade will slow down recovery and also result in the loss of the gains associated with international trade.

Finally, the obvious must be stated. At least some concrete steps to move the Doha negotiations forward rather than just an expression of commitment to its eventual completion must be taken. By appearing ambivalent to the Doha Round, the Obama administration strengthens the existing impression that its commitment to worldwide free trade is at best weak. This in turn emboldens countries to resort to demand-diverting protectionist measures with greater callousness and contributes to the delay in recovery.

Authors

Arvind Panagariya

Publication: Forbes.com

India's Financial Secret Weapon

Arvind Panagariya — Thu, 29 Jan 2009 09:23:32 -0500

Editor's Note: Originally thought to be immune to effects from the U.S. economic slowdown, many emerging economies have been hard hit. However, India has escaped the worst of the financial crisis, but how long can it last? In an article in Foreign Policy Magazine, Arvind Panagariya examines ways in which the Indian economy has not remained entirely immune to the tremors in the world economy.

Although it may now seem a lifetime ago, it has only been a few months since the so-called "decoupling" hypothesis dominated media coverage of the global economy. The dominant view held that emerging markets were growing independently of the United States and therefore were immune to a U.S.-born economic slowdown. Yet the second half of 2008 was not kind to this hypothesis. Indeed, the orthodox view that countries must prosper and perish together in today's interconnected world has returned with vengeance.

In the immediate aftermath of the fall of Lehman Brothers and the takeover of AIG, countries such as South Korea, Mexico, Brazil, and even normally well-governed Singapore found their internationally exposed banking systems in shambles. The U.S. Federal Reserve was forced to open $30 billion worth of swap lines of credit to these countries' central banks. South Korea had to even put together a megapackage worth $130 billion to rescue its banks in October 2008.

But one emerging economy managed to defy the trend. More than four months after the fall of Lehman, India's banks remain in sound financial condition. They have required no bailouts or recapitalization. The country's economy is expected to grow at a rate of 7 percent this year. Although this figure represents a nontrivial 2 percent decrease from its five-year average, it is hardly the disaster one would predict going by the gloomy news and forecasts for the U.S. economy. How did India manage to beat the odds?

One key reason is its tight regulation of banks and external capital transactions, largely the result of the sound management and foresight of one man: Yaga Venugopal Reddy, the former governor of the Reserve Bank of India (RBI).

Interestingly, India's central bank lacks the independence from government that the Federal Reserve enjoys. It is administratively subservient to the Finance Ministry. Yet, by sheer force of his personality, Reddy, who served as RBI governor from 2003 until the end of his term in September 2008, successfully resisted government pressure to deregulate banks and hastily open India to external capital account transactions. In contrast to former U.S. Federal Reserve Chairman Alan Greenspan who believed in the fundamental integrity of market agents, Reddy is reported to have held the view that if bankers were given the opportunity to sin, they would.

As a result, whereas banks and financial institutions around the world were massively lured into investing in assets and derivatives backed by U.S. subprime mortgages, banks and financial institutions in India were largely kept out of them. Under the watchful eye of Reddy, only $1 billion out of India's total banking assets of more than $500 billion slipped into toxic assets or related investments. When the crisis came and financial institutions around the world found themselves writing off almost $1 trillion in assets from their books, Indian banks had at most a few hiccups.

Nevertheless, the Indian economy has not remained entirely immune to the tremors in the world economy. Investment in toxic assets represents only one (albeit the most lethal) of the three ways that the crisis in the U.S. economy has infected the rest of the world. The other two are the withdrawal of investments by U.S. firms abroad and the sharp decline in U.S. demand for foreign goods and assets. India might not be able to escape these tremors quite so easily.

The drying up of liquidity within the United States led U.S. investors to withdraw their investments in the Indian economy at lightning speed. In October alone, India saw its foreign exchange reserves decline a staggering $39 billion, leading directly to a tightening of liquidity in India. These withdrawals also indirectly caused a precipitous fall in equity prices, adding to the liquidity crunch. Finally, Indian corporations, which had been able to borrow at attractive rates in the United States and other markets in the past, could no longer do so and returned to borrow in the domestic market.

The global fall in demand for Indian goods is also beginning to bite. India's merchandise exports tripled between 2002 and 2008. Even between April and September 2008, exports rose more than 30 percent over their level during the corresponding period of the previous year. But since October, exports have started to fall.

The story on the foreign investment front is similar. Between 2002 and 2007, annual direct foreign investment and portfolio investment together rose 10-fold from $6 billion to $62 billion. But between April 1 and Oct. 31 of 2008, this figure stands at $10 billion. The figure for the corresponding period in the previous year was $37 billion.

The Indian government has acted to unfreeze liquidity by aggressively cutting interest rates, the cash reserve ratio, and the statutory liquidity ratio. It has also announced fiscal stimulus in two stages, though on a much smaller scale than in many other countries. This is appropriate for two reasons: India already has a very large fiscal deficit on top of a massive debt-to-GDP ratio of more than 80 percent. Also, the forthcoming national elections, expected in May 2009, are bound to accelerate government spending independently of the stimulus package.

Can India's good fortune continue? The jury is still out on how the economy will perform in 2009 and beyond. Some pessimists see India returning to the 5 to 6 percent growth rate of the early 2000s. I do not share this view. Even with the global financial crisis, India is likely to sustain growth of 8 to 9 percent in the coming decade thanks to its top-class entrepreneurs, more competitive markets, high savings rate, and increasingly younger population. But as India toasts its continued economic success, it would be unwise to overlook the careful regulation of financial markets that at least partially protected it from the worst effects of the financial crisis.

Authors

Arvind Panagariya

Publication: Foreign Policy Magazine

Myths from Mumbai

Arvind Panagariya — Tue, 16 Dec 2008 12:00:00 -0500

Following the Mumbai terror attacks, politicians, pundits and the press have created many myths, confusions and falsehoods. These deserve to be exposed in favour of clearer thinking.

Myth 1: “When it comes to terrorism, India and Pakistan are now victims of a common enemy.”

President Asif Ali Zardari of Pakistan has expansively promoted this myth and many in the West and some in India embrace it. In an interview on CNN, Zardari said: “The state of Pakistan is of course not involved. We’re part of the victims.” A week later, he wrote in the New York Times: “Not only are the terrorists not linked to the government of Pakistan in any way, we are their targets and continue to be their victims.”

But this is a treacherous claim. True, Pakistan has been subject to several terrorist attacks recently including the one on the Marriott Hotel that killed more than 50 people three months ago. But India and Pakistan are not victims of the same terror groups. Pakistan suffers at the hands of the Taliban and Al-Qaeda groups whom it is now fighting on the Afghan border alongside the US. But Lashkar-e-Toiba (LeT) that sent terrorists to Mumbai recently and Jaish-e-Muhammad (JeM) that attacked the Parliament in 2001 do not terrorise Pakistani citizens.

Instead, they have had a history of receiving patronage from Pakistan’s intelligence agency, the ISI. It is only under intense international pressure that Pakistan has recently arrested the leaders of these outfits. The ease with which the Pakistani army was able to round them up testifies to the cozy relationship between the two.

Myth 2: “Pakistani government bears no responsibility for the recent Mumbai attacks.”

Zardari makes this claim calling the terrorists stateless actors. Indian and US officials have also avoided directly implicating the government of Pakistan in their statements. Yet, the statement is substantively false. For some time now, there has existed an “Army-ISI-Jihadi complex” in Pakistan whereby retired officials of the army and ISI routinely participate in terrorist-training camps that jihadi outfits such as LeT and JeM run. In turn, these outfits actively assist the ISI. Therefore, even if there was no official contact between the government and LeT specifically on the Mumbai attacks, the army and ISI bear responsibility in an essential way.

Myth 3: “A silver lining in the aftermath of the Mumbai attacks has been the absence of any retaliatory attacks and riots within India.”

Western observers frequently mention this. Taken literally, the statement is true. But its unstated implication that terrorist attacks in India are usually followed by retaliatory attacks and riots is entirely false. In recent years, India has been rocked by a series of terrorist attacks, originating both externally and internally. But in no case has there been a retaliatory attack by either Hindus or Muslims. Indeed, in the aftermath of the May 2008 bomb explosions in my own hometown, Jaipur, both Hindus and Muslims lined up at hospitals to donate blood for surviving victims. In a similar vein, following the recent Mumbai attacks, the government has been unable to find a single Muslim group willing to accept the bodies of nine Pakistani terrorists for burial in its graveyard. Those who raise the spectre of retaliatory actions following terrorist attacks confuse them with communal riots. While communal riots by definition divide Hindus and Muslims, terrorist attacks usually bring them together.

Myth 4: “All Muslims are not terrorists but all terrorists are Muslims.”

The falsehood of this statement is made obvious by the facts that a Tamil terrorist assassinated Prime Minister Rajiv Gandhi and Sikh guards, guided by Khalistani militants, shot Prime Minister Indira Gandhi. White supremacist groups have had their share of terrorist acts in the US. Even a more restrictive claim that “all transnational terrorists are Muslim” is false. In the ’70s, terrorist groups in different Latin American countries cooperated with one another as well as Palestinian, European and Japanese urban guerrilla groups. Nor is modern day transnational terrorism in Africa Muslim in character.

Myth 5: “India itself is to be blamed for the terror attacks because of its ill treatment of Muslims at home.”

In the immediate aftermath of the attacks, commentators in the Western media disproportionately focused on domestic ills as the principal source of terrorism facing India. Though strong signals of Pakistani involvement had begun to emerge within 24 hours of the attacks, some among these observers continued to cling to the idea that discrimination at home had led local Muslims to carry out the attacks. Others naively believed that outfits such as the LeT would not send terrorists if India did not discriminate against Muslims.

But these observers largely rest their case on association: If discrimination against Muslims exists — and there is plenty of it — it must be responsible for Muslim terrorism. But this is wholly insufficient reasoning. For instance, listen to what LeT head Hafiz Saeed said at a rally in Karachi in 2000: “There can’t be any peace while India remains intact. Cut them, cut them — cut them so much that they kneel before you and ask for mercy.” Is this a man who will stop sending terrorists if India stopped discriminating against Muslims?

Likewise, those connecting domestic terrorism to discrimination must answer why despite its existence for decades, we have witnessed systematic bomb explosions by a Muslim terrorist group only over the last year? Why is it that

Dalits, who have suffered from discrimination even more than Muslims and are today worse off than them, have not resorted to similar terrorist attacks? And why is it that, according to at least tentative evidence, even Hindu groups have begun to engage in terrorist attacks? Connecting terrorism to discrimination by association may make one popular but it does not make for sound analysis or policy-making.

Myth 6: “No amount of intelligence, training and equipment can prevent determined terrorists from striking.”

Taken literally, this is true but in substance it is false. The US has successfully prevented attacks since 9/11. Given its more vulnerable borders and the limited appetite of its citizens for searches and security alerts, India’s task is more difficult. Nevertheless, significant reduction in attacks and the damage from them is possible. Multiple checkpoints equipped with bulk-cargo scanners can make terrorist entry difficult. Intelligence, especially at local levels, can help catch some terrorists before they attack. And better weaponry, protection devices and training can improve the chances of the security personnel subduing terrorists in case the latter succeed in attacking. The best need not be the enemy of the good.

Authors

Arvind Panagariya

Publication: Indian Express

The Economic Cost of the Mumbai Tragedy

Arvind Panagariya — Sat, 29 Nov 2008 12:00:00 -0500

With the highly proficient National Security Guard commandos having killed the last of the terrorists holed up in the Taj Hotel in Mumbai, the question on everyone’s mind is what effect the tragedy will have on the economy. Despite some clear differences between the Mumbai tragedy and the 9/11 New York calamity, the latter provides a good starting point for answering this question. The effects of the 9/11 events, now extensively studied and analyzed, may be considered at the local level on New York City and at the national level on the United States.

In the immediate aftermath of the 9/11 terrorist attacks, many analysts predicted significant permanent damage to the economy of the New York City. There is now virtual consensus, however, that the effects were smaller than initially predicted and were short-lived. A July 12, 2006, report by the Federal Reserve Bank of New York concluded that the economic effects of the terrorist attacks were sharp but short-lived and had largely disappeared by the end of 2002. According to the Federal Reserve report, New York City recovered from the 2001 recession--well under way at the time of the attacks--at least as fast as the rest of the country. Average incomes in the following four years rose faster for the city’s residents than the rest of the nation.

At the national level, the Sept. 11 tragedy had no measurable effect. A 2002 study authored by Gail Makinen and published by the Congressional Research Service, observed that the initial fears that the event would have serious adverse effects on aggregate demand proved wrong. At the time of the attacks, the economy was in the third consecutive quarter of contraction. By the fourth quarter, growth had resumed. This strongly suggests that any adverse effects of the attacks on aggregate demand were truly short-lived and small in magnitude.

Several factors suggest that the effects of the Mumbai attacks, though devastating for far too many families at the personal level, will be less significant than those of 9/11 attacks. To begin with, the 9/11 attacks were the first ever by foreign terrorists on U.S. soil. They were perhaps also far more dramatic and took many more lives. As such, they left a deep psychological impact on a vast number of Americans, especially in New York. The Mumbai attacks are also more heinous and dramatic--and wider in scope--than anything Mumbai has witnessed previously. Yet they are not entirely new to Mumbai. Psychologically, Mumbai and India are better prepared to deal with such tragedies than the U.S. was immediately following 9/11. This makes the prospects of Mumbai bouncing back rapidly substantially better.

Indeed, I was surprised to learn from my former Columbia student Catherine Delain, who has been on a visit to India for the last three weeks, that she could arrive at Mumbai at 5 a.m. by train from Vadodara immediately following the night of the massacre at Victoria Terminus station, and, within an hour, could also take the train from the Terminus to Aurangabad.

Catherine could observe the signs of the vast tragedy strewn all over in the station and yet found, to her astonishment, that the railway staff was out there going about their jobs as if it were a normal day! And of course, flights into and out of Mumbai never stopped during the 60-plus hours of the clean-up operation.

Equally reassuring was the effect on the stock market. Following 9/11, the stock market in New York had to be closed down for almost a week. When the market opened on Sept. 17, the Dow Jones index, which had closed at 9,605 on Sept. 10, fell to 8,920. In Mumbai, markets opened on Friday (Nov. 28, 2008), after just a one-day break--with the tragedy still in progress. A day earlier, markets in Singapore and elsewhere had reacted negatively, with the rupee declining in value. Yet, the Sensex on the Bombay Stock Exchange rose 0.7% on Friday, reaching a two-week peak.

One further favorable point for India is that the market shock has come at a time when the economy is otherwise healthy. Despite the slowdown in the world economy, the average annual growth rate in India during April 1-Sept. 30, 2008, the first two quarters of financial year 2008-09, has been 7.75%. This is predictably down from the average rate of 9% during the preceding five financial years, but still sufficiently high to absorb the shock without significant effect. Indeed, any negative effects of the terrorist attacks nationally are likely to be indistinguishable from, and overwhelmed by, those of the global slowdown.

The key question from the national standpoint is whether the episode will have an adverse effect on foreign investment (both direct and portfolio). Judging from the reactions of foreigners who narrowly escaped the attacks, as broadcast on various television channels, it does not appear that they are about to run away from India. Indeed, my former student Catherine did not change her plan to return from Aurangabad to Mumbai even though she did not know whether the terrorist threat would be eliminated by the time she arrived there. The effect on foreign investment is likely to be, at worst, small and temporary.

In all likelihood, the large part of the measurable economic costs of the attacks will consist of: the cost of restoring the damaged structures of Hotel Taj, Hotel Oberoi and Nariman House; lost income earnings of those who lost their lives; expenditures on the care of those injured and suffering traumas due to lost family members; and increased expenditures on anti-terrorist measures and security precautions at such places and events as airports, train and bus stations, international cricket games and the forthcoming Commonwealth Games. A slight temporary drop in tourist activity and foreign investment may also occur.

A worthwhile investment for the government will be to urgently create a substantial national anti-terrorism force with commando units placed in all major cities to ensure rapid action in case of future attacks. Those fighting terrorism need to be better trained than the terrorists. The authority to tackle the crises must also be shifted entirely from the state administrations, which are often ill prepared and also ill informed about their limitations, to the national government. The government must also greatly improve its intelligence gathering capability. Prevention is a better remedy than cure.

Authors

Arvind Panagariya

Publication: Forbes.com

Nano: The Car for the Common Man?

Arvind Panagariya — Thu, 25 Sep 2008 12:00:00 -0400

A set of weather events that individually give rise to only a mild to moderate storm turn deadly when they occur simultaneously. The result is what meteorologists call a "perfect" storm. The Singur tragedy is such a storm caused by confluence of an aggressive corporation, a zealous government and an opportunist politician.

Until recently, it was a mystery why Tata Motors had chosen West Bengal, a state with a Marxist government, as the site for manufacturing Nano. Partial revelation of a tripartite agreement, signed by Tata Motors, West Bengal government and West Bengal Industrial Development Corporation (WBIDC) in March 2007, has now provided the explanation.

Seeking to maximise profits, Tata Motors went on to pit the states of West Bengal, Uttarakhand and Himachal Pradesh against one another when choosing the production site for Nano. The ensuing competition produced the most lucrative deal for the corporation. The West Bengal government not only agreed to award it prime location at Singur, a town just 30 miles northwest of Calcutta, it also sweetened the pot with subsidy on land, concessional power, a soft loan and gigantic tax breaks.

Under the tripartite agreement, WBIDC committed to acquiring 997 acres of land of which 650 acres would be for the Tatas for the mother plant and the rest for parts suppliers. WBIDC agreed to give land to the Tatas on a 90-year lease at the annual rent of just Rs 1 crore (Rs 15,380 per acre) the first five years with 25% increase every five years until 30 years.

Starting 31st year, the rent would rise to Rs 5 crore with 30% increase every 10 years until 60th year. From 61st to 90th year, the rent would remain fixed at Rs 20 crore. Parts suppliers have an even sweeter deal with the rent fixed at Rs 8,000 per acre for the first 45 years and Rs 16,000 per acre for the rest.

In addition, the government agreed to provide Tata Motors a twenty-year loan of Rs 200 crore at 1% interest. It is to also provide electricity to Tata Motors at the rate of Rs 3 per kWh. Tariff increase is limited to Re 0.25 per kWh once every five years. For several years, the Tatas will also receive effective exemption from value-added tax and central sales tax.

Against the backdrop of this aggressive pursuit of profits by Tata Motors, with a substantial cost falling on taxpayers and farmers, exhortations by the Tata Group leadership to India Inc to live up to their social responsibility ring hollow. The petition by the Tatas in the high court to keep confidential those parts of the tripartite agreement not yet made public also raises doubts about the group's commitment to transparency. The defence by the state industries minister in the assembly some months ago that the agreement is a "trade secret" is not credible.

Turning to the government, chief minister Buddhadeb Bhattacharjee is surely to be applauded for taking a leaf out of the Chinese experience and shedding his party's traditional hostility towards industrialists. Yet, the government cannot escape criticism, even condemnation, for its failure to recognise that democratic governments simply cannot do certain things that authoritarian governments can.

Although land acquisition by WBDIC was well within the law, its approach was heavy handed and lacked transparency. For instance, it sought signatures of farmers on the consent forms prior to even announcing the land price. It was also reluctant to offer information on how many farmers had signed consent forms and how many had not till long after the deadline for consent was past.

Under the antiquated Land Acquisition Act 1894, the government was required to set the price of land at the average of registration price in the preceding three years. On the surface, the government was generous and set the price at the highest registration price in the preceding year. But as is well known, in reality, a substantial payment on land sales in India is given in black so that the registration price substantially understates the true price.

Therefore, a significant element of expropriation in the acquisition price remained. Unsurprisingly, 30% of the farmers refused to sign consent forms and did not accept the payment. Instead, they took their case in the public domain where Mamata Banerjee eagerly awaited to champion their cause.

Though Tata is now poised to move Nano to Karnataka, a fairer and efficient solution would be for the corporation to make a financial contribution towards compensating all farmers at the true market price prevailing at the time of acquisition. Any difference not covered by this contribution may be borne by West Bengal taxpayers. As long as the financial contribution made by Tata Motors is below what it would cost to move the project to Karnataka, it will benefit from the deal. As for Mamata Banerjee, she should recognise that under the existing law, her farmers could do a lot worse.

From the long-run perspective, defunct Land Acquisition Act, 1894 must be overhauled. According to published reports, privately negotiated outcomes, satisfactory to both industrialists and landowners, have been achieved in states such as Gujarat and Punjab. If this is confirmed upon closer examination, the central government must consider limiting the scope of land acquisition by states to public projects such as roads, railways, airports and ports.

States should be permitted to intervene on behalf of industrialists under only exceptional circumstances and after explicit permission from the central government. The interests of small landowners against forced purchases by powerful industrialists may be protected through NGO oversight and free legal assistance.

There also needs to be greater transparency in the provision of subsidies by the states to industrialists. When public money is involved, there should be no room for secret deals between the government and industrialists. Requirement of disclosure will also restrain states from competing for projects through wasteful subsidies.

This commentary was originally published under the title "El Nano: A Perfect Storm".

Authors

Arvind Panagariya

Publication: Economic Times

Doha: The Last Mile

Arvind Panagariya and Jagdish Bhagwati — Thu, 21 Aug 2008 12:00:00 -0400

The director general of the World Trade Organization, Pascal Lamy, minding the Doha Round negotiations that collapsed in Geneva on July 29, was in India last week and is in Washington this week.

A marathon runner who goes the distance in a 26-mile run, Mr. Lamy is not giving up when he is at the last mile. There are good reasons to predict that he will cross the finishing line.

At the outset, remember that every round has taken more to finish in recent memory than the previous one. The longest to date was the Uruguay Round, the last round of multilateral trade negotiations under the auspices of the General Agreement on Tariffs and Trade.

The Doha Round still has not exceeded significantly the Uruguay Round's duration; and we have more countries negotiating and face thorny issues that remain after eight rounds of trade liberalization.

Nor should we forget that no round has ever failed. They often break down, are often thought to be in intensive care where the pessimists predict that they will expire, and they come back like the proverbial cat and are concluded. Doha will be no exception.

When the Doha talks broke down at the Cancun Ministerial meeting of the WTO, the principal players from the European Union and America publicly broke into acrimony. The post-collapse atmospherics this time in Geneva were altogether more amiable.

At the same time, as Mr. Lamy has pointed out, the Geneva meeting successfully resolved the specifics of 17 difficult issues, leaving only three to be thrashed out, of which the major one was the conflict on agricultural protectionism between India and America. When one probes the matter in depth, one immediately sees that a political compromise is within reach.

Essentially, America was making an offer to cap her trade-distorting subsidies at $14.5 billion which, in fact, exceeded its current payout, which is likely to be $9 billion or less. America has 2 million farmers. India, which has nearly two-thirds of its population in the rural sector, has small subsistence farmers. Faced with competition from subsidized, often large farms, India's reaction has been exactly like that in the United States where nothing works up politicians and lobbyists more than the often-imagined, not even real, allegation that foreigners are subsidizing their products "unfairly." So, just as America, fearful of competition from China, introduced an unprecedented product-specific safeguard in its bilateral agreement of November 1999 and a special textile safeguard during the transition to freer trade in textiles, India wanted a Special Safeguard Mechanism. It was, however, excessive and unacceptable to America, which had virtually pioneered the practice.

The central problem therefore arose from the fact that the U.S. offer on trade-distorting subsidies was too low, prompting an unacceptable Indian demand for an over-cautious SSM. Evidently the solution lies in America capping the distorting subsidies at a minimum of the current payouts: nothing prevents it from spending more instead on non-distorting subsidies which do not affect output (and hence trade) but which are given, for instance, for environmental improvements and for raising poultry and cattle in an ethically-acceptable fashion. In return, India could surely agree to a serious downscaling of the SSM.

This solution is not politically impossible. It requires America to move away further from distorting subsidies, and substituting them with non-distorting subsidies, a move that is surely possible even in a presidential-election year since total farm support can be maintained while its composition changes in a pro-trade direction.

Actually, there is a glimmer that America might be able to do just this. Thus, Reuters recently quoted the U.S. Agriculture Secretary, Ed Schafer, as saying that if the Doha talks were to get back on track, other countries would have to "pay" for American subsidy cuts by increased access to their markets. And that "if we have free access to rest of the world, maybe we can talk about reducing [our] cap a little bit."

The grudging nature of this statement leaves an opening, especially when one remembers that some opening of developing-country agricultural markets already is in the agreed agenda.

The compromise, while doable, is above the pay grade of the trade ministers. Fortunately, both the prime minister of India and President Bush are for freer trade and are keen on the Doha deal.

For India, it also would please many in the Congress who have uncritically accepted the line that India alone is responsible for the collapse of the Doha talks, thus easing the Congress's acceptance of the much-delayed nuclear deal.

For Mr. Bush, staggering under the collapse of his Pakistan strategy, a genuine multilateral triumph founded on collaboration between two great democracies would be an important part of his legacy. Can the two leaders pull it off? We believe they can.

Authors

Arvind Panagariya
Jagdish Bhagwati

Publication: The New York Sun

India Policy Forum 2008/09 - Volume 5: Editors' Summary

Suman Bery, Barry P. Bosworth and Arvind Panagariya — Tue, 01 Jul 2008 13:54:00 -0400

The fifth issue of the India Policy Forum, edited by Suman Bery, Barry Bosworth and Arvind Panagariya, includes papers on India’s financial sector, including capital account liberalization, currency appreciation and capital reserves, as well as growth and employment in Indian manufacturing and the impact of private education. The editors' summary appears below, and you can purchase a printed copy, or access individual articles by clicking on the following links:

Download the 2008 India Policy Forum conference agenda »
Download India Policy Forum 2008-2009 - Volume 5 »
Purchase a printed copy of India Policy Forum 2008 - Volume 5 »

Download individual articles:

Some New Perspectives on India's Approach to Capital Account Liberalization, by Eswar Prasad
The Cost of Holding Excess Reserves: Evidence from India, by Abhijit Sen Gupta
Big Reforms But Small Payoffs: Explaining the Weak Record of Growth and Employment in Indian Manufacturing, by Poonam Gupta, Rana Hasan, and Utsav Kumar
What Explains India's Real Appreciation?, by Renu Kohli and Sudip Mohapatra
Private Schooling in India: A New Educational Landscape, by Sonalde Desai, Amaresh Dubey, Reeve Vanneman, and Rukmini Banerji

EDITORS' SUMMARY

The fifth annual conference of the India Policy Forum was held on July 15 and 16 of 2008 in New Delhi. This issue of the journal contains the papers and discussion presented at the conference. A total of five papers were presented. The first paper examines the growth of private schools in India and their influence on school quality. It is an extension of recent issues of this journal that have evaluated the performance of India’s education system. The second paper addresses a major question of why the growth of manufacturing output and employment in India has been disappointingly low. The final three papers share a common focus on India’s external financial relations. The third paper analyzes the process of capital account liberalization and the integration of India’s financial institutions into the global financial system. The fourth paper measures the evolution of prices in the nontradable and tradable sectors of the Indian economy and seeks explanations for the rise in the relative price of nontradables. The last paper addresses the issue of the adequacy of India’s current foreign exchange reserves.

Private Schooling in India: A New Educational Landscape

Although the growth of private schooling in India is ubiquitous even in rural areas, the contours and implications of this change remain poorly understood, partially due to data limitations. Official statistics often underestimate private school enrollment and our understanding of the effectiveness of private education in India is also limited. If we assume that parents know what is best for their children and that what is beneficial privately is also beneficial socially, their decision progressively to opt for private schools would suggest the superiority of the latter over public schools.

In their paper, Sonalde Desai, Amaresh Dubey, Reeve Vanneman, and Rukmini Banerji point out, however, that this is not a foregone conclusion. The vast body of research on school quality, especially that relating to the United States, suggests that much of the observed difference in school outcomes results from differences in parental background and levels of parental involvement with children going to different schools. In the Indian context, one runs the additional risk that many private schools are poorly endowed with resources, unrecognized (lack accreditation), and have untrained teachers. A proper empirical examination is essential to arrive at an informed assessment.

The authors use data generated from a new survey, the India Human Development Survey 2005 (IHDS), jointly conducted by researchers from the University of Maryland and the National Council of Applied Economic Research. These data allow them to explore some of the links between private school growth and school quality in India. They begin by providing a description of public and private schools in India as well as some of the considerations that guide parents in selecting private schools. They then examine whether private school enrollment is associated with superior student performance and whether this relationship is concentrated in certain sections of the population.

The IHDS data show considerably higher private school enrollment, particularly in rural areas, than documented in other studies. The authors place private school enrollment (including in schools receiving grants-in-aid from the government) among children aged 6–14 years at 58 percent in urban and 24 percent in rural areas. Private school enrollment is particularly high in India’s most populous state, Uttar Pradesh. In terms of outcomes, based on specially designed reading and arithmetic tests administered to children aged 8–11 years, those in private schools exhibit better reading and basic arithmetic skills than their counterparts in government schools.

But since these children also come from higher income households and have parents who are better educated and more motivated to invest in their children’s education, it is important to control for selectivity bias. The paper utilizes a variety of techniques (including multivariate regression, switching regression, and family fixed effects) to examine the relationship between private school enrollment and children’s reading and arithmetic skills. While no model is able to completely eliminate possible biases—there is a different source of bias left in each case—taken together, the results strongly indicate that private school enrollment is associated with higher achievements in reading and arithmetic skills. The magnitude of the gain from private school enrollment varies from one-fourth to one-third standard deviation of the scores.

The paper also distinguishes the relative magnitudes of the benefits from private schooling to children with rich versus poor economic backgrounds. It finds that the benefits to private school enrollment for children from lower economic strata are far greater than those for children from upper economic strata; at upper income levels, the difference between private and government school narrows considerably. This seems plausible since at upper income levels, students are likely to have better access to alternative educational resources including well-educated parents.

While the results of the paper point to positive benefits from private schools, especially for the underprivileged, the authors emphasize that their analysis does not imply that private schooling is the elixir that will cure the woes of primary education for children from poor families. They argue that both empirical results based on the IHDS data and theoretical considerations point to the need for caution.

Empirically, the paper finds that while private school students perform better than their counterparts in government schools, these effects are modest in comparison to other factors influencing the outcomes. For example, the results show substantial inter-state variation in the scores of both government and private school students. Controlling for parental characteristics, government school students in states as diverse as Kerala, Himachal Pradesh, Chhattisgarh, and West Bengal perform at a higher level than private school students in many other states. More importantly, the private school advantage seems to be concentrated in states such as Bihar, Uttar Pradesh, Uttarakhand (formerly Uttranchal), and Madhya Pradesh—states known for poorly functioning public institutions as well as high rates of poverty or low per capita incomes.

These results suggest that before a blanket embrace of private schooling, it may be worthwhile to understand why some government schools function well and others do not. Blaming teacher absence is superficially appealing, but theoretical considerations suggest that the complete story may be more complex. If the classroom environment in private schools is favorably impacted by the demands made by paying middle-class parents, a voucher program that brings a large number of poorer parents to the schools may dilute this effect. But this argument would seem to be undermined by the fact that the authors themselves find the private school effect to be significant in poor states with many students coming from poor families.

Nevertheless, the authors are correct in noting that it will be useful to further examine the processes that give rise to different classroom environments as between government and private schools before jumping to wholesale voucher programs leading to privatization of education. We must know, for example, whether children from poor households in private schools benefit because their parents are able to prevent teachers from resorting to physical punishment. And if so, would this benefit be diluted when vouchers rather than parents pay for the tuition? Can we devise mechanisms to ensure that government school teachers do not resort to discriminatory behavior when dealing with students from poor families? To date, the discourse on the benefits of private schooling in a developing country context has focused on teacher absence, lack of accountability, and lower costs of private schooling. While these are important issues, perhaps future research could try to shed additional light on other processes that establish different environments in private and public schools.

Big Reforms But Small Payoffs: Explaining the Weak Record of Growth and Employment in Indian Manufacturing

The promotion of manufacturing, particularly for export, has been a key pillar of the growth strategy employed by many successful developing countries, especially those with abundant labor. India’s recent experience is puzzling on two accounts. While India’s economy has grown rapidly over the last two decades the growth momentum has not been based on manufacturing. Rather the main contributor to growth has been the services sector. Second, the relatively lackluster performance of Indian manufacturing cannot be ascribed to a lack of policy initiatives. India introduced substantial product market reforms in its manufacturing sector starting in the mid-1980s, but the sector has never taken off as it did in other high-growth countries. Moreover, insofar as subsectors within manufacturing have performed well, these have been the relatively capital or skill-intensive industries, not the labor-intensive ones as would be expected for a labor abundant country like India.

One of the main components of reforms in India was the liberalization of the industrial licensing regime, or “delicensing.” Under the Industries Development and Regulation Act of 1951, every investor over a very small size needed to obtain a license before establishing an industrial plant, adding a new product line to an existing plant, substantially expanding output, or changing a plant’s location.

Over time, many economists and policymakers began to view the licensing regime as generating inefficiencies and rigidities that were holding back Indian industry. The process of delicensing started in 1985 with the dismantling of industrial licensing requirements for a group of manufacturing industries. Delicensing reforms accelerated in 1991, and by the late 1990s, virtually all industries had been delicensed. Large payoffs were expected in the form of higher growth and employment generation with this policy reform.

However, the payoffs to date have been limited. It could be argued that a lag between the announcement and implementation of the policy, and also a lag between implementation and the payoffs may be responsible. However, as many as 20 years have passed since the first batch of industries was delicensed, and the last batch of industries was delicensed almost a decade ago; the view that payoffs would occur with a lag is no longer easy to sustain.

What then could be the reasons for the rather lackluster performance of the industrial sector? The following factors are usually cited: (a) strict labor laws have hindered growth, especially of labor-intensive industries; (b) infrastructure bottlenecks have prevented industries from taking advantage of the reforms; and (c) credit constraints due to weaknesses in the financial sector may be holding back small- and medium-sized firms from expanding. More recently, two other factors have also been raised. First, it has been pointed out that the evolution of Indian industry may be influenced by path dependence or hysteresis so that despite the reforms of the mid-1980s and the early 1990s the relative profitability of capital and skill-intensive activities remains higher than that of labor-intensive activities. Second, the major reform initiatives undertaken so far—focused mainly on product market reforms—have been national ones. However, the working of product markets in a federal democracy such as India is influenced not only by regulations enacted by the Central Government, but also by those enacted by individual state governments. Moreover, much of the authority on administration and enforcement of regulation also rests with state governments. Accordingly, it has been pointed out that regulatory and administrative bottlenecks at the state level may be blunting the impact of reforms undertaken at the central level.

Using the Annual Survey of Industries (ASI) data at the three-digit level for major Indian states over the period 1980–2004, the paper by Gupta, Hasan, and Kumar analyzes the effects of delicensing reforms on the performance of what in India is called registered manufacturing. (The portion of manufacturing in the so-called unorganized sector is not covered by the ASI data and is therefore not analyzed in the paper; however, this component was also unlikely to have been affected by the licensing controls when these were in effect.) The paper utilizes variations in industry and state characteristics in order to identify how factors such as labor regulations, product market regulations, availability of physical infrastructure, and financial sector development may have influenced the impact of delicensing on industrial performance.

The main findings of the paper are as follows:

1. The impact of delicensing has been highly uneven across industries. Industries that are labor intensive, use unskilled labor, depend on infrastructure, or are energy dependent have experienced smaller gains from reforms.

2. Regulation at the state level matters. States with less competitive product market regulations have experienced slower growth in the industrial sector post-delicensing, as compared to states with competitive product market regulations. States with relatively inflexible labor regulations experience slower growth of labor-intensive industries and slower employment growth.

3. Infrastructure availability and financial sector development are important determinants of the benefits that accrued to states from reforms.

If supportive regulatory conditions prevailed and infrastructure availability allowed it, businesses responded by expanding their capacity and grew; thus hysteresis does not seem to matter. The authors acknowledge that their approach is subject to a few caveats. Several other major reforms have been introduced that impact Indian manufacturing, including reductions in barriers to trade and the dismantling of the policy of reserving particular industries for production by small-scale enterprises. These are not systematically examined and might interact with the impact of delicensing. Second, the neglect of the unorganized sector noted above means that the interactions between the “registered” and the “unorganized” sectors in adjusting to policy change is not systematically explored. Finally, regulations can affect firms and industries in many different ways. For example, they may create incentives for firms to operate in the informal sector, stay relatively small, or adopt particular types of techniques. While the analysis of aggregate data can shed (indirect) light on some of these effects, a more complete analysis would require the use of a microbased approach utilizing plant-level data.

The authors conclude that the agenda of reforms to promote manufacturing is not yet complete. Areas for additional action include further reform of labor market regulations; improvement of the business environment; provision of infrastructure and further development of the financial sector. In addition, in a federal democracy like India, reforms at the Center (especially those related to labor) need to be complemented by reforms at the state level.

Some New Perspectives on India's Approach to Capital Account Liberalization

Capital account liberalization remains a highly contentious issue. Proponents argue that rising cross-border flows of financial capital allow for a more efficient allocation of financial resources across countries and also permit countries to share their country-specific income risk more efficiently. Detractors have blamed capital account liberalization as being the root cause of the financial crises experienced by many emerging market countries. Their case has been strengthened by the lack of clear evidence of the presumed benefits of financial globalization. This debate has again become topical as many emerging market economies and even some low-income countries are coping with volatile capital inflows, with major economies like China and India contemplating further opening of their capital accounts.

A common argument in the literature in favor of openness from the viewpoint of the developing economies has been that access to foreign capital helps increase domestic investment beyond domestic saving. The recent literature has revived another older argument emphasizing the indirect benefits of openness to foreign capital, including the development of domestic financial markets, enhanced discipline on macroeconomic policies, and improvements in corporate governance.

In his paper, “Some New Perspectives on India’s Approach to Capital Account Liberalization,” Eswar S. Prasad argues that a major complication in considering capital account convertibility is that economies with weak initial conditions in certain dimensions experience worse outcomes from their integration into international financial markets in terms of both lower benefits and higher risks. For countries below these “threshold” conditions, the benefit–risk tradeoff becomes complicated and a one-shot approach to capital account liberalization may be risky and counter-productive. This perspective points to a difficult tension faced by low and middle-income countries that want to use financial openness as a catalyst for the indirect benefits mentioned above.

The author, nevertheless, maintains that the practical reality is that emerging market countries are being forced to adapt to rising financial globalization. In his view, capital controls are being rendered increasingly ineffective by the rising sophistication of international investors, the sheer quantity of money flowing across national borders, and the increasing number of channels (especially expanding trade flows) for the evasion of these controls. Hence, concludes the author, emerging market economies like China and India are perforce grappling with the new realities of financial globalization, wherein capital controls are losing their potency as a policy instrument (or at least as an instrument that creates more room for monetary and other macro policies). Against this background, the author provides a critical analysis of India’s approach to capital account liberalization through the lens of the promised indirect benefits from such liberalization. In recent years, the Reserve Bank of India (RBI) has taken what it calls a calibrated approach to capital account liberalization, with certain types of flows and particular classes of economic agents being prioritized in the process of liberalization. The result of these policies is that, in terms of overall de facto financial integration, India has come a long way, experiencing significant volumes of inflows and outflows. Although foreign investment flows crossed 6 percent of GDP in 2007–08, in the author’s view the flows are modest, placing India at the low end of the distribution of de facto financial integration measures in an international comparison across emerging market economies.

The RBI’s cautious and calibrated approach to capital account liberalization has resulted in a preponderance of FDI and portfolio liabilities in India’s stock of gross external liabilities. The author agrees that this is a favorable outcome in terms of improving the benefit–risk tradeoff of financial openness and has reduced India’s vulnerability to balance of payments crises. But he goes on to argue that the limited degree of openness has, nevertheless, hindered the indirect benefits that may accrue from financial integration, particularly in terms of broad financial sector development.

Against the backdrop of recent global financial turmoil, the author sees merit in a high level of caution in further opening the capital account. He states, however, that excessive caution may be holding back financial sector reforms and reducing the independence and effectiveness of monetary policy. He goes on to argue that increasing de facto openness of the capital account implies that maintaining capital controls perpetuates some distortions without the actual benefit in terms of reducing inflows. Flows of different forms are ultimately fungible and it is increasingly difficult, given the rising sophistication of investors and financial markets, to bottle up specific types of flows. In the author’s view, rising de facto openness in tandem with de jure controls may lead to the worst combination of outcomes—new complications to domestic macroeconomic management from volatile capital flows with far fewer indirect benefits from financial openness.

The author takes the view that a more reasonable policy approach would be to accept rising financial openness as a reality and to manage, rather than resist (or even try to reverse), the process of fully liberalizing capital account transactions. Dealing with and benefiting from the reality of an open capital account will require improvements in other policies—especially in monetary, fiscal, and financial sector regulations. This approach could in fact substantially improve the indirect benefits to be gleaned from integration into international financial markets.

In terms of specific steps, the author suggests that this may be a good time to allow foreign investors to invest in government bonds as an instrument of improving the liquidity and depth of this market. A deep and well-functioning government bond market can serve as a benchmark for pricing corporate bonds, which could in turn allow that market to develop. By providing an additional source of debt financing, it would create some room for the government to reduce the financing burden it currently imposes on banks through the statutory liquidity ratio—the requirement that banks hold a certain portion of their deposits in government bonds.

The author also recommends an “opportunistic approach” to liberalization whereby outflows are liberalized during a period of surging inflows. He suggests that if undertaken in a controlled manner, it could generate a variety of collateral benefits—sterilization of inflows, securities market development, and international portfolio diversification for households. The RBI has recently adopted such an approach by raising ceilings on external commercial borrowings in order to compensate for capital outflows. According to the author, these are steps in the right direction. But one potential problem he sees is that when taken in isolation rather than as part of a broader and well articulated capital account liberalization agenda, these measures are subject to reversal and unlikely to be very productive.

Despite this enthusiasm for capital account liberalization, the author goes on to suggest that none of this implies that the remaining capital controls should be dropped at one fell swoop. What it does imply is that there are some subtle risks and welfare consequences that can arise from holding monetary and exchange rate policies as well as financial sector reforms hostage to the notion that the capital account should be kept relatively restricted for as long as possible. It may seem reasonable to maintain whatever capital controls still exist in order to get at least some protection from the vagaries of international capital flows. However, in the author’s view, not only this is an unrealistic proposition, it could detract from many of the potential indirect benefits of financial integration. He sees steady progress toward a more open capital account as the most pragmatic policy strategy for India.

What Explains India's Real Appreciation?

India’s rapidly evolving economic landscape during the past two decades has elicited broad discussion of how changing economic factors will influence the future of India’s growth and prosperity. Often overlooked in the discussion are the effects of India’s changing economic structure on relative price dynamics, which have consequential effects on the allocation of resources in the economy. A host of recent developments would likely induce a change in relative prices, including the shift in economic policies beginning in 1991, the acceleration in economic growth, a rapid increase in exports, and rising per capita incomes and productivity growth. Taken together, these factors amount to the “catch-up” process that typically leads to an increase in the relative price of nontradables in developing economies.

In their paper, Renu Kohli and Sudip Mohapatra trace relative price developments in a two-sector, two-good (tradable and nontradable) framework for the Indian economy over the period 1980–2006. In line with their a priori expectations, the ratio of nontradable to tradable prices, also called the internal real exchange rate, rises consistently over the past one-and-a-half decades. Their empirical analysis confirms that this rise, or real appreciation, is driven by both demand and supply factors. A later section uses the results of the study to illuminate the evolution of past macroeconomic policies. Finally, using India’s recent robust economic performance as a guide, the paper concludes with a discussion on an appropriate macroeconomic policy mix for the future.

The authors construct the relative price of nontradables from the national accounts statistics using the degree of participation in trade as a criterion for classifying the economy into traded and nontraded sectors; the tradable– nontradable price series are derived as respective deflators for the two sectors. They find that the tradable and nontradable sectors are characterized by divergent inflation rates with the relative price of nontradables accelerating after 1991; on average, the difference exceeds 1 percentage point per year during 1991–2006. There are two competing explanations for such a divergent acceleration in prices: (a) the Balassa–Samuelson hypothesis posits that real exchange rates tend to appreciate as countries develop and (b) other demand-side explanations originate from changes in government spending and/or a shift in consumer preferences toward services (nontradable) as incomes rise. The preliminary analysis presented in the paper indicates a role for both factors in explaining the real exchange rate appreciation. A puzzle posed by the data, however, is the increase in the relative price of nontradables in conjunction with an expansion of the tradable sector, which suggests an offsetting role might have been played by economic reforms like import liberalization and exchange rate correction, leading to the emergence of new tradables through an increase in competitiveness.

The paper examines the determinants of this divergence in an integrated framework, exploring the role of both demand and supply side determinants. The relative price of nontradables is modeled as a function of the labor productivity growth gap between the tradable and nontradable sectors, real government expenditure as a share of gross domestic product, real per capita income, and a measure of import tariffs. The labor productivity growth gap and the import tariff rates capture the supply-side influences due to technological change (the Balassa–Samuelson effect) and the impact of trade liberalization, which accelerated after 1991. The fiscal and income growth variables summarize the demand side impact upon relative prices. The regression results reveal a significant influence of both demand and supply factors. A percentage point rise in the relative price of nontradables is associated with a 5 percent increase in the labor productivity growth gap, a 4 percent increase in per capita income growth, and a 3 percent increase in fiscal growth; the estimated impact of a fall in import prices upon the relative nontradables’ inflation rate is 0.04. The results are robust to a number of sensitivity checks, including different estimation methods, stability, specification, omission, and inclusion of variables as well as alternate definitions of the variables.

A decomposition of the relative price change over the sample period indicates that demand factors accounted for almost three-fourths of the average relative price increase over the sample period. In contrast, the supply-side influence stemming from the labor productivity growth differential between the two sectors accounted for only 35 percent of the mean of the dependent variable. Noting the rapid decline in import tariffs after 1991, the authors argue that this result underscores the role of convergence in tradable prices and its contribution to the divergence in sectoral inflation rates in liberalizing economies.

Kohli and Mohapatra link their results to macroeconomic policy by tracing the past evolution of exchange rate and fiscal policies in India. They argue that the fiscal expansion of the 1980s ending in the 1991 crisis led to a rise in the inflation rate of the nontradable sector, while the exchange rate policy favored steady depreciation in order to retain competitiveness and boost growth. Noting India’s recent and potential economic performance, its buoyant exports, and strong per capita income growth, they observe that the pressures upon real exchange rate appreciation, internal as well as external, are likely to continue—and indeed, accelerate—in the future. Under the circumstances, an appropriate macroeconomic policy mix would be to continue with the gradual increase in exchange rate flexibility so as to absorb the equilibrium shifts in the economy. This could be complemented with fiscal consolidation to offset competitiveness losses arising from the nominal and real exchange rate appreciation.

The Cost of Holding Excess Reserves: Evidence from India

Finally, the paper raises a number of critical data issues, not the least of which is the absence of a services price index in India. The implicit price series developed in the paper strongly suggests an understatement of generalized inflation through the current inflation indicator, the wholesale price index (WPI), which can be misleading. It also identifies gaps in the data on sectoral employment shares, emphasizing the need for sufficiently disaggregated information to enable fruitful analysis and informed policymaking.

The Asian financial crisis of 1997–98 served as a startling revelation to emerging economies of the drawbacks of financial integration. Neither the International Monetary Fund nor reliance on more flexible exchange rate regimes succeeded in preventing—or indeed, adequately combating—such a systemic crisis. Moreover, even countries practicing sound macroeconomic policies realized they were not immune to such crises as they can be hit by contagion and financial panic from other countries, regardless of their proximity. As a result, many countries have decided that they need to protect themselves against a speculative currency attack, and further, that the key to self-protection is the accumulation of substantial holdings of liquid foreign exchange. Over the past decade, developing countries, and particularly those in East and South Asia, have greatly expanded their foreign currency reserves. By the middle of 2008, the reserves of China, South Korea, Russia, and India alone amounted to over US$2.85 trillion. In the case of India, reserve accumulation has increased five-fold since 2001–02.

The security that results from high reserves does come at a price, however. The magnitude of reserves being held combined with the fact that most reserves are held as low-yield government bonds suggests that the opportunity cost of reserve holdings can be substantial. In his paper, Abhijit Sen Gupta employs a new empirical methodology to evaluate the factors influencing the demand for international reserves in emerging markets, and he estimates the costs incurred in the process for India in particular. Sen Gupta argues that the traditional analysis of the costs of reserve holdings, which considers a single adequacy measure (namely, import cover), does not reflect the multitude of factors influencing demand for international reserves in a financially integrated world. In addition to the desire to meet potential imbalances in current account financing, a central bank may also hold reserves to defuse a potential speculative run on its currency or to cover its short-term debt obligations.

The author first introduces a simple empirical model to highlight the principal determinants of reserve holding in emerging countries. Using the results of this model, one can create an “international norm” of reserve holding, and thereby calculate a measure of “excess reserves” which is the difference between actual reserve holdings and this international norm. Next, Sen Gupta provides a brief discussion of the history of reserve accumulation in India. As the bulk of India’s reserves are held in the form of highly liquid securities or deposits with foreign central banks and international organizations, the real return on these assets in recent years has been largely negative. In the final section, Sen Gupta estimates the cost of holding reserves in India by considering three alternative uses of the resources currently held in excess of the international norm described earlier.

The empirical section of the paper employs a sample of 167 countries over the period 1980–2005 and a regression framework that identifies the principal determinants of cross-country variation in the level of international reserves. In this context, reserves are defined as total reserves minus the country’s holdings of gold. The dependent variable is this measure of reserves scaled by Gross Domestic Product (GDP). The results of this regression accord well with the a priori expectations. The log of per capita GDP and a proxy for trade openness (measured as the ratio of imports to GDP) both record positive and significant coefficients for reserve holding, implying that richer countries and more open countries tend to have higher reserves. In addition, the regression results reveal that countries with less flexible exchange rate regimes and more capital account openness tend to accumulate greater reserves.

Next, the author uses the above framework for the period 1998–2005 to predict the demand for international reserves for various emerging countries. The difference between actual reserves and the reserve level predicted by the equation is interpreted as a measure of excess reserves. As illustrations of his results, Sen Gupta finds that by 2005, Indonesia, Philippines, and Argentina had reserves close to the amount predicted by the model, while Brazil’s reserve accumulation fill significantly short of the predicted value. In contrast, China, India, Korea, Russia, and Malaysia all exhibit significantly more reserves than what could be interpreted as an “international norm.”

In his discussion of India’s experience in reserve accumulation, Sen Gupta identifies several distinct episodes of significant reserve buildup in India: April 1993 to July 1995, November 2001 to May 2004, and November 2006 to February 2008. These three episodes account for more than US$ 220 billion worth of India’s current stock of reserve accumulation of US$ 300 billion. In each of these episodes, the author discusses the role that both the government and the Reserve Bank of India (RBI) played in the decision to accumulate reserves. Sen Gupta estimates that by the end of 2007, India had more than US$ 58 billion of excess reserves. In order to impute the costs of holding these excess reserves, he considers three alternative uses of the resources: financing physical investment, reducing the private sector’s external commercial borrowing, and lowering public sector debt. The cost is substantial across all specifications, both in terms of actual income foregone and as a percentage of GDP. The author estimates the annual cost of keeping excess reserves in the form of low-yielding bonds rather than employing the resources to increase the physical capital of the economy to be approximately 1.6 percent of GDP. Alternatively, if the resources were instead used to reduce private sector external commercial borrowing or public sector debt, India could gain more than 0.23 percent of GDP.

Authors

Publication: The Brookings Institution and National Council of Applied Economic Research