India and the global finance-What next?

Almost six months after their last get-together in London in early April, the heads of government of the G-20 countries will meet again in Pittsburgh in the United States in late September.

They will presumably return to the quartet of issues that has progressively engaged them since they first met as a group in Washington in November 2008.

These issues are: macroeconomic coordination, global imbalances and resumption of global growth; global financial reform (including reform of the IMF and the multilateral development banks); strengthening the global trading system and avoiding protection; and burden-sharing in fighting global warming, primarily by capping the growth in the stock of green-house gases in the atmosphere.

Looking at the agenda as a whole, one would have to conclude that progress since April has been somewhat underwhelming, largely because of political constraints in the advanced countries.

Profound differences of views persist between the major blocs on the appropriate fiscal/monetary mix, reflecting different traditions and capacities.

In the absence of such co-ordination, exchange rates are likely to take on the main burden of adjustment, raising risks of protection, primarily directed at the emerging markets.

Banking systems in both Europe and the United States, while now better capitalised, remain dependent on exceptional liquidity support, even as the cleansing of toxic assets from their balance sheets remains unresolved, inhibiting the flow of credit.

The US administration shows little or no appetite for deep engagement in multilateral trade negotiations, although the political window for action in the US, India and Brazil is hauntingly narrow. On preparation for the Copenhagen meeting in December, the less said the better.

But my main theme this month is the second topic listed above, the evolution of the global financial order. India has dual, linked interests in this topic.

On the one hand, it has the opportunity, if it wishes to exercise it, to be an active player in G-20 debates on this issue (as was done, for example, by Rakesh Mohan as deputy governor earlier this year).

The second challenge is to equip the domestic financial system to deal with the next phase in global finance, whatever that may turn out to
be.

It is in this second context that the JRD Tata Memorial lecture delivered by the Governor of the RBI, Dr D Subbarao, at the end of July is of interest. In that speech, available on the RBI website, the Governor ponders on some of the issues and lessons that he draws from the turmoil of the last two years.

The four issues he chooses to address are the role of global imbalances; coordination of fiscal and monetary policies; inflation targeting; and the relationship between the financial sector, the real economy and growth.

Given his courteous and civil personality, the broad conclusions Dr Subbarao draws are moderate and sensible.

As with all central bank heads, however, the interest is in the nuance, so it is worth examining his views in some detail.

Readers of these columns may be aware that there has been a battle royal raging on the source and importance of the global imbalances that developed in the second half of this decade.

The common measure of such imbalances is the absolute size of current account surpluses and deficits of the major countries. While the surpluses moved around over this period, the major deficit country throughout was the United States, leading many non-US commentators (particularly, but not only the Chinese) to lay blame on America's domestic policies.

By contrast, the US has portrayed itself as the balancing force in a world otherwise likely to have been plunged into deflation by the mercantilist policies of the surplus countries.

A close reading of Dr Subbarao's text suggests that he inclines more to the 'savings glut' interpretation. He rightly notes that the links between the imbalances and the financial crisis is 'interesting although not obvious'; he also rightly notes that India did not contribute to global imbalances (a fact which gives us a certain moral authority in contributing to the debate).

His summing up is, in my view, realistic and wise: 'global imbalances have been, are, and will continue to be inevitable.'

On this score, then, the future may not be very different from the past.

Dr Subbarao draws similarly cautious conclusions on the prospects for prompt fiscal adjustment in the advanced countries, with the implication, as he puts it, that 'monetary policy will have to be conducted in a regime of large and continuing structural deficits' for some time to come in the advanced countries.

In the language of economists, 'fiscal dominance' and public debt management are likely to drive monetary policy much more in the future than in the past.

On inflation targeting Dr Subbarao endorses past RBI rejection of this doctrine (even in the lower-key version of a 'low-inflation objective' as suggested by the Raghuram Rajan report), adding the newer global concerns with addressing unsustainable trends in asset markets; while on the role of finance he is clear that finance is desirable only to the extent that it supports development of the real sector.

So far, then, so good. But what conclusions should one draw on how Dr Subbarao might steer the RBI in preparing for India's future engagement with global finance?

Dr Subbarao is silent on the future evolution of the global exchange rate system, and what that implies for India. The combination of slow growth, global imbalances and structural fiscal deficits in the advanced countries is quite likely to lead to fundamental shifts in real exchange rates between emerging markets and rich countries.

Greater flexibility in nominal rates would facilitate such adjustment. Second, there is bound to be the relocation of major financial institutions to Asia where the world's growth and savings will be centred. Does India want to opt out of this wave?

Or will we encourage our financial institutions to go abroad as we have our corporations? Finally, while we remain concerned by asset bubbles, I understand that the Chinese are drawing the opposite conclusion, namely that inflation alone should be the preoccupation of monetary policy. Dr Subbarao is in for interesting times. We need to wish him luck.