A Chinaman poser

For all the brouhaha over the G20 meet in London early this month, it is increasingly becoming clear that the answer for many of today’s problems
lie with the G2, US and China. It is in this context that two recent speeches by Zhou Xiaochuan, governor of the People’s Bank of China, are particularly noteworthy. The first, calling for a reduced role for the dollar and a new reserve currency, returns to a debate that is not entirely new. Many, including this columnist, have argued the dollar’s role as international reserve currency underpins many of our present problems. This is the first time, however, that China has come out officially in favour of a new reserve currency, hence the significance of Zhou’s speech. The second—rubbishing the western hypothesis that lays much of the blame for global imbalances on excess savings in Asia and the related issue of surplus and deficit countries—raises issues that have been much less debated. ‘Surpluses in emerging countries powered Western bubbles. When they burst the crisis struck the core of the global system,’ says an editorial in the London Financial Times, repeating the popular Western view. Zhou debunks this argument as well as the view that the savings ratio can be adjusted by simply adjusting exchange rates. According to him there are many factors underlying global savings imbalances. So it is inappropriate to link savings ratio only to exchange rate and to try and resolve long-term issues by a short-term exchange rate adjustment. He concedes the US cannot sustain the growth pattern of high consumption and low savings but believes it is not the right time to raise its savings ratio. Instead he argues the US needs to strike a balance between stimulating consumption and facilitating economic recovery. Meanwhile countries and international organisations must strengthen their cooperation and intensify the regulation of the international speculative capital flows, he says. The current financial crisis underscores the necessity of reinforcing regulation over international capital flows and enhancing their transparency. Global organisations should help developing countries establish a robust early-warning system and guard against predatory speculation. In case emerging markets experience temporary BOP difficulties, international aid should be swift, and conditionalities attached should be reduced. This would encourage countries to lower savings including foreign reserves and expand domestic demand. Appropriate measures should also be taken to channel more savings into developing countries and emerging markets. The flow of savings from emerging markets to the advanced economies is neither rational nor consistent with the idea of advanced economies increasing their domestic savings. However, the adjustment of savings ratios in Asian countries will not happen overnight. Savings in oil-producing countries are also likely to remain high so long as oil prices do not fall further. Therefore, global savings imbalance will remain for some time in the future. The top priority is, therefore, to facilitate the rational flow of savings and improve their allocation efficiency. One option is to redirect surplus savings to other developing countries and emerging markets.

Time to abandon monetarism

A theory can be proved by experiment, noted Einstein, and categorically added that no path leads from experiment to the birth of a theory! That was
then, in financially less complicated times. Fastforward to the here and now, and it’s plain that economic theories must sooner or later be confronted with empirical evidence, so as to be workable propositions and proper guidance for policy. Consider, for instance, monetary policy and the stance of the Reserve Bank of India when it comes to supply, availability and the cost of money in the domestic economy. Given that the inflation rate in terms of producer prices has hit record lows, the RBI needs to promptly reduce its policy rates and mandate lower cash reserve ratio for banks. The policy objective ought to be to purposefully bring down high real interest rates — approximately the nominal interest rate minus the inflation rate. The central bank does need to indicate lower cost of funds right across the board. It would shore up faltering growth momentum in the industrial economy and much beyond. And strong growth performance would arrest and reverse the overtly decpreciating value of the rupee. True, the RBI has substantially reduced its policy rates since October: the repo rate, the rate at which the RBI lends was reduced by as much as 400 basis points. It has been ‘cut’ from as much as 9% to 5%. In tandem, the reverse repo rate, the rate at which the RBI accepts deposits, has been reduced to 3.5%. The idea of course is to discourage ‘lazy banking’ and boost credit offtake. But given the unprecedented slowdown in the global economy and much deceleration domestically, what’s called for is sustained reduction in the policy rates, to policy induce growth. Specifically, what’s called for is a significant reduction in the repo rate, to signal easier interest rates. Also required is further reduction in the reverse repo rate and lower cash reserve requirements for banks. Sadly, the RBI has chosen to effect only a nominal 25 basis points reduction in both the repo and reverse repo rates. It is also true that the monetary transmission mechanism — the process by which policy-induced changes in the short-term nominal interest rate or nominal money stock affect real variables such as aggregate output and employment — is weak and quite under-developed here in India. It points at the need for sustained financial sector reforms, albeit “gradual” and staggered over a period so as to better manage the shortcomings and outright distortions in the policy setting.