The
overarching implication of the spate of financial
crises that have ravaged Asia, Russia and Latin America
is of course that the threat of deflation, driven
by a financial crisis is real. In fact, once integration
with globalised finance proceeds beyond a point, the
state of a country, as reflected by its GDP growth
or inflation rate, or even the size of its foreign
exchange reserves, need not be adequate to predict
an imminent crisis. East Asian economies had performed
very differently in the period immediately preceding
the crisis, and Brazil despite "qualifying"
for a $42 billion IMF package, could not stave off
the Real crisis. This has implications for economic
policy in a country like India. Principally, policy
in the current period should not be directed merely
at keeping investors, particularly financial investors
happy, but partly at insulating the system from external
shocks.
The second lesson is that a slump in export growth
in economies which are increasingly more integrated
into the world trading system is a major danger signal.
This makes the collapse in India's exports in recent
quarters a reason not merely to proceed with caution,
but in fact to even retract on elements of liberalisation
that exceed the requirements set by her membership
in the WTO. It could of course be argued that India's
poor export performance is more related to the slowing
of world trade growth than was true of the East Asian
economies, and that the crisis in East Asia itself
has played a role in undermining India's export competitiveness.
But these arguments only go to prove that the world
economic scenario currently is least propitious from
the point of view of launching on an accelerated pace
of external reform.
Since the slowing of export growth and a widening
of the trade and current account deficits are importants
catalyst for a collapse of investor confidence, they
call for measures to insulate the system against a
currency crisis as well. This makes the task of exchange
rate management extremely difficult. With the introduction
of the unified exchange rate system, the only means
by which the Reserve Bank of India can influence the
exchange rate is through open market operations. In
periods when large portfolio and debt inflows result
in a tendency in the market for the rupee to appreciate,
the RBI is forced through open market purchases to
acquire large volumes of foreign exchange and increase
the size of its reserves. This is exactly what happened
during the mid-1990s. Those reserves once accumulated
are however difficult to run down, since they are
an important determinant of the confidence in the
rupee. As the East Asian experience indicates, a reserve
amounting $25-30 billion is small change if there
is a run on the rupee because of a loss of confidence
which can arise from a number of factors. This makes
burgeoning reserves acquired often at high interest
rates and parked as short term funds at extremely
low interest, a partial indicator of economic strength.
Being unable to run down reserves without affecting
confidence implies that an effort to respond to the
loss of competitiveness in the wake of the massive
depreciation of the currencies of competitors from
East Asia, by managing a depreciation of the rupee,
is near impossible. Once the RBI, through dollar sales
allows the rupee to depreciate in value, expectations
of a further depreciation arise, since the extent
of devaluation need to restore competitiveness is
indeed large. Even though India has not yet opted
for capital account convertibility, there are a number
of ways in which speculators can operate on the basis
of such expectation. Exporters can choose to delay
the repatriation of their export proceeds. Non-residents
and foreign institutional investors can hold back
on making new deposits and investments as well as
repatriate part of their current holdings to forestall
losses or capture gains in the wake of a depreciation.
And authorised dealers can make short-term (even overnight)
acquisitions of the dollar in the hope of booking
profits. This is precisely what happened in late 1998
when the RBI chose to experiment with a dose of managed
devaluation. The net result of this danger is that
while India's exports languish, the rupee remains
relatively strong, with periods of even real, effective
appreciation.
One implication of this experience is that India
just cannot contemplate any further liberalisation
of its exchange rate regime. What it possibly needs
to do is tighten controls, through a higher rate of
capital gains taxation, than the prevalent 10 per
cent, on early repatriation of funds invested in the
stock market by non-residents and foreign institutional
investors. This need not imply much more inflexibility,
but it would mean greater instruments in the hands
of the RBI to control the level of the exchange rate
to some extent. It also means that there would be
some control on capital inflows as much as outflows,
the necessity of which has been emphasised by the
Southeast Asian experience.
Above all, India needs to think of alternative means
of pushing out exports then merely relying on the
(price) exchange rate mechanism as a driver of export
growth. This means that the export strategy should
be strategic in nature, and provide special incentives
to those areas of export growth which have either
the most potential for employment generation or which
imply a significant increase in domestic value added.
External vulnerability of this kind has implications
for macroeconomic and monetary management as well.
If the central bank is saddled with large increases
in its foreign assets, money supply can be controlled
only by a process of sterilisation involving a reduction
in central bank credit. The principal area in which
such reduction occurs is with regard to central bank
credit to the government. This has two implications.
First, it substantially increases the fiscal vulnerability
of the state, reducing its capability (as shown in
the first section of this paper) to stimulate growth,
sustain welfare measures like subsidies and increase
outlays on the social sectors like health, education
and those aiming to meet the basic needs of the population.
Secondly, with the State caught in a fiscal wrench,
the only means of macroeconomic management is monetary
policy. Here, however, the fiscal crunch forces the
government to turn to the open market for even the
minimum volume of borrowings it undertakes. In periods
when demand for credit from the private sector is
also high, as was the case during the mid 1990s industrial
boom, this leads to high interest rates. It is only
when a recession induced reduction in the private
sector's demand for credit eases monetary stringency
that the government can manoeuvre interest rates downwards,
as has happened recently.
This situation where a reduction in interest rates
is a means of stimulating recovery, but where recovery
inevitably leads to higher interest rates, reduces
the efficacy of monetary policy as means to stimulate
growth. Given the higher reliance of employment-intensive
small industries in particular on bank credit rather
than other means of raising capital, it is important
to ensure that monetary policy does not become a constraint
on productive activity. While this does not mean that
interest rates must be completely administered, it
does suggest that as far as possible the monetary
and credit policy of the government should be designed
towards the expansion of production and employment.
There is a perception that external vulnerability
is essentially a consequence of dependence on purely
financial flows, but that flows of foreign direct
investment help improve the balance of payments situation.
This is based on the presumption that FDI flows are
of the relocative kind, in whose case there is a virtuous
nexus between such inflows and exports. However, import
liberalisation and the liberalisation of foreign investment
regulation in economies with home markets of a significant
size inevitably encourages FDI directed at the domestic
market. In fact, in India liberalisation has encouraged
three kinds of FDI flows. First, is a set of flows
by transnationals who already control assets in the
domestic economy who, in the wake of liberalisation
permitting a higher share of foreign equity in foreign
controlled rupee companies, choose to enhance their
equity stake with relatively small dollar investments.
These small investments substantially increase their
ability to repatriate dividends from future profits.
Second, investments by foreign firms which virtually
purchase large domestic market shares by fully or
partially acquiring domestic firms that dominate particular
markets. The acquisition of Parle Exports, which dominated
the soft drinks market, by Coca Cola and the partial
acquisition of the Malhotra's blade empire are instances
of these. Finally, there is a large inflow into the
non-tradable, infrastructural sector, attracted by
special concessions, including guaranteed returns,
offered by the government for such investments.
It should be clear that in all these cases the initial
inflow of investment would be followed by large and
persistent outflows on account of imports, royalties,
technical fees and dividends, with adverse balance
of payments consequences. With the rush for purchase
of East Asian assets rendered cheap by deflated prices
and depreciated currencies, which we have discussed
above, it is even more unlikely that relocative FDI
geared to export production would flow to countries
like India. Hence rather than liberalise FDI policy
across the board, the government should seek to provide
special incentives for FDI which uses the country
as a location for world market production and discourage
flows that bring little by way of technology but are
costly in foreign exchange terms.
These features of global and domestic trade scenario
implies that despite new trends in FDI, post-reform
Indian economic growth is accompanied by persisting
external vulnerability. The significance of this phenomenon,
however, is not that there is no option but succumb
to this heightened vulnerability and hope for the
best, but to work out a national economic policy that
takes this vulnerability into account. Reduced manoeuvrability
does by no means imply no manoeuvrability at all.
However, reduced vulnerability does imply that the
kind of developmental agenda that was worked out in
the immediate post-War years is no longer adequate.
Developing countries cannot return to a strategy of
making optimum use of "available" foreign
exchange earnings, through import-substitution strategies
of the kind that the Feldman-Mahalanobis model epitomised.
Such strategies attempted to control the rate of growth
and degree of diversification of consumption, on the
one hand, and reduce dependence on manufactured imports
in the long run, by utilising scarce foreign exchange
to create a capital goods sector, in general, and
a machine tools sector in particular.
However, the problem with that strategy was three-fold.
Firstly, it was really open only to developing countries
which in terms of size of the domestic market and
resource base were above a critical minimum. Secondly,
even in the case of these countries, since the growth
of manufactured goods production was determined by
the scale and quality requirements of the domestic
market, an increase in the ability to produce manufactures
was not necessarily accompanied by an increase in
the ability to keep pace with international innovations
and export manufactures, holding back the rate of
expansion of the system in the long run. Finally,
given the inequalities within the system and the growing
pressures from the well-to-do to obtain access to
product innovations that defined international lifestyles
to which they were inevitably exposed, the ability
of the State to restrict the rate of growth and degree
of diversification of consumption was increasingly
undermined. Neither the savings rate nor the import-intensity
of domestic productions stuck to the trajectory that
the strategy charted. Given the parameters within
which it operated and the concept of development that
it implicitly appropriated, import-substitution was
doomed to failure. Thus the alternative we need to
consider must go beyond the dirigisme characteristic
of "old-style import substitution", even
while retaining its principal objective, viz., that
of reducing external vulnerability. This is all the
more true since the nature of external vulnerability
appears transformed in a world dominated by fluid
finance capital.
This brings us to the first aspect of the alternative
strategy incorporating intervention: it must transcend
the dichotomy between production for the domestic
market and production for export. In its archetypal
form that dichotomy is reflected in arguments that
make a case for industrialisation based on the home
market because international inequality provides grounds
for 'export pessimism'. In the debate on the transition
to capitalism that led up to the industrial revolution,
one issue of contention was the relative roles of
purely 'internal' factors in the form of structural
change, as opposed to 'external' factors like the
effects of commercialisation and the growth of markets
in determining that transition. Whatever the merits
of those contending arguments with regard to the principal
determinant, one thing appears clear with hindsight.
Successful capitalist industrialisation cannot occur
in a context "insulated" from world markets,
but requires consciously engaging those markets as
part of the strategy of growth.
We use the term "engaging" advisedly. World
markets are not benign, autonomous forces that spur
efficient Third World industrialisation. On the contrary
they embody all the inequalities characteristic of
the world system. Engaging those markets involves
therefore using all the weaponry in the hands of a
developing country, including the power of its State,
the foundation that its home market provides, the
ability of its scientific and technical personnel
to override the domination implied in the control
of technology by a few transnational firms and the
advantages of the late entrant (varying from low wages
to a less codified legal framework), to prise open
those markets that inequality suggests are hermetically
sealed for them.
This brings us to our second point. A successful
growth strategy has to be based on an activist State.
There is no relationship between the existence of
an activist State and autarky or, for that matter,
insularity. One valid criticism of the import substitution
years in countries like India is that it neglected
exports. While exports cannot constitute a basis for
growth in a large developing country, in an interdependent
world one cannot finance the imports that accompany
the process of growth without an export thrust. It
is for this reason that all successful late industrialisers,
including the so-called NIEs, had pursued a "mercantilist"
export policy which emphasises pushing out exports
at whatever cost. Such a policy involves a continuous
restructuring of the production base of the system
in both quantitative and qualitative terms, which
requires both technology and investment. Investment
matters for two reasons: first, the larger the size
of investment the larger the share that can be devoted
to modernisation as opposed to 'expansion'; second,
since for any incremental capital output ratio, higher
investment implies higher growth, capacity expansion
proceeds at a pace that allows the incorporation of
new technology at the margin. For these and other
reasons, the rate of growth of manufacturing exports
of an economy is dependent on the investment ratio.
Development economics in the early years singled
out investment as the key to growth. In fact the group
of highly-distinguished development economists headed
by Arthur Lewis who authored the well-known Measures
document of the United Nations (1951) made raising
the investment ratio the cornerstone of their recommendations
for development in the underdeveloped countries. The
emphasis shifted only with the neo-classical critique
of the late sixties . It was the efficiency of resource
use, as emphasised by neo-classical writers, which
gradually came to occupy centre-stage; what mattered,
according to this perception then, is the economic
regime within which development took place, whether
or not this regime was conducive to the achievement
of efficiency of resource use. What a regime conducive
to such efficiency on the neo-classical argument would
do to the investment ratio was never discussed, a
reflection essentially of a shift of attention from
the macro to the micro issues underlying the development
process (and of course to a "marketist"
stance in this micro discussion). In short, the investment
ratio dropped out of the picture as a significant
phenomenon to concentrate attention upon.
More recently, however, a range of writings from
authors of rather widely differing persuasions has
argued that the successful cases of industrialisation
in East Asia was largely explained by an increase
in factor inputs into the production process, including
capital inputs in the form of high rates of capital
accumulation. That is, it is not greater efficiency
of resource use per se, but larger outlays of inputs
at a given level of efficiency that explains success.
At one level this argument is supported by evidence
on cross-country Total Factor Productivity (TFP) growth
estimates using purchasing power parity data, which
suggests that over 1970-85 "productivity"
in South Korea, Taiwan Province of China, Singapore
and Hong Kong grew much slower than Egypt, Pakistan
or even Bangladesh. However, the TFP index, favoured
normally by the World Bank, is based on assumptions
such as full employment of resources and perfect competition,
rendering it inadequate for real world analysis.
A more useful way of analysing the phenomenon is
to undertake cross-country correlations of investment
ratios, output growth rates and export growth rates.
An analysis based on twenty years (1968-88) data for
25 developing countries showed a close correlation
between output growth and the investment rate (or
the ratio of investment to income). Similarly there
was an extremely close relationship between output
growth and export growth. If it is investment which
drives output growth then the high correlation between
output growth and export growth must make itself visible
in terms of a high correlation between investment
ratio and export growth, which it does.
There are good theoretical reasons why a high investment
ratio ceteris paribus should give rise to a strong
export growth performance. International trade in
the different commodities grows, over any period,
at different rates. Given these growth rates in world
trade, the rate at which a particular underdeveloped
country's exports grow would depend to a very significant
extent upon its production-structure and the rate
at which this structure is changing. In particular
since the underdeveloped countries are, by and large,
saddled with production-structures specialising in
commodities with relatively stagnant world trade,
success on the export front depends crucially upon
the ability to transform the production-structure
rapidly in the direction of commodities where world
trade grows faster. And the rapidity of this transformation
is linked to the investment ratio: the higher the
investment ratio, the faster the transformation of
the production-structure and hence the greater the
ability to participate in the faster-growing end of
the world trade, i.e. the greater the rate of export
growth.
An activist State is needed not merely to raise investment
rates, but to coordinate the export thrust. The evidence
from east Asia suggests that such coordination was
crucial, because a mercantilist industrial policy
rather than market determined comparative advantage
was crucial in establishing a foothold in international
markets.
There is enough evidence that economies like South
Korea and Taiwan Province of China pursued similar
strategic and anticipatory industrial policies as
a run up to their competitive success. Hence, even
when a high investment rate is realised through the
agency of private entrepreneurs, the government needs
to ensure that an adequate share of such investment
is allocated to sectors selectively chosen as thrust
areas for exports and embodied in technologies and
plant scales that enhance international competitiveness.
During the import-substitution years when the thrust
of policy was to build a domestic industrial base
using the economic space provided by a protected market,
state policy was largely directed at regulating the
adverse consequences - in the form of concentration,
monopolistic pricing, uneconomic scales and a skewed
production pattern - of inadequate competition or
rivalry. Many of these problems are now being directly
dealt with by the "cutting edge" of international
competition in a more liberalised world. However,
openness and competition alone do not guarantee export
success, as a range of experiences have shown. Some
degree of intervention by the State seems necessary.
But that intervention has now to take on a new form,
with the emphasis on matching microeconomic investment
decision-making with a coordinated or "planned"
export thrust.
An important instrument in realising the objectives
of this new form of intervention is monetary policy.
The evidence seems to suggest that interest rate differentials
and are a useful instrument for realising an export
thrust of the kind described above. This automatically
suggests that financial liberalisation of a kind that
does not permit such differentials, and weak banking
systems in which such policies can be misused need
to be reformed, with the imposition of capital adequacy
norms and transparent procedures. Such policies also
imply some degree of sequencing of any process of
"liberalisation" aimed at dismantling structures
characteristic of the earlier import-substituting
strategy. Industrial liberalisation (of licensing
laws, output controls and direct price controls) must
take precedence over trade liberalisation, and both
of them over the liberalisation of the financial sector.
For all these reasons, coordination by the government
is crucial.
Activism of this kind has as its corollary two features.
First, an activist State pursuing a mercantilist growth
strategy should be in a position to discipline its
industrial class. Second, activism requires the mobilisation
of adequate resources by the State to sustain that
strategy. The need to discipline the industrial class
arises because, even while departing from the detailed
physical controls characteristic of the import substitution
years, the strategy being elaborated here requires
a substantial degree of strategic targeting and coordination
by the State. Through incentives, on the one hand,
and measures to enforce compliance, on the other,
the government must be in a position to influence
investment decision-making at a microeconomic level.
Based on the segment of the world market that is being
targeted, the coordinating agency should be able to
influence the choice of product, technology, scale
of production and price.
Needless to say, imposing such discipline requires
the backing of other sections of society, which defines
the third prong of an alternative strategy. Social
support for a strong State is most often won in a
situation where land reforms have dismantled structures
that provide the base for a collusive elite. The vital
necessity of land reforms is underscored by the fact
that even the successful east Asian capitalist economies
owe their success inter alia to the post-war land
reforms that they had.
But land reforms are needed not merely as an instrument
of mobilising political support. A thrust towards
land redistribution and greater social expenditures
in the rural areas which are best undertaken under
the aegis of directly elected decentralised governing
bodies (e.g. the panchayats in India), is essential
also for widening the home market immediately, ensuring
a rapid increase in agricultural output (as has happened
in West Bengal, India, for example), and increasing
the potential for direct and indirect employment generation.
To that end land reforms would have to be accompanied
by investments in the agricultural sector - in irrigation
and water management and other kinds of rural infrastructure
- that permit an acceleration of industrial growth.
This would not only broaden the base of development
but also create decision making structures through
devolution that are crucial for generating the strength
and the accountability needed to make the State capable
of functioning as a disciplining force.
Globalisation is fundamentally a centralising tendency,
drawing disparate economies and sectors into the vortex
of a world controlled by a few decision makers. It
also replicates this centralisation in economies which
it integrates into the world system, creating strong
domestic interests that support the case for an open
economy and a marketist strategy. The suggestion that
the nation state is no more a meaningful category
comes from those who find in an "integrationist"
strategy greater economic benefit than from any strategy
of reserving domestic space for domestic interests,
so that some forces that advocated protection and
state intervention in the 1950s, now support a liberal
economic regime. The problem however is such a regime
marginalises the disadvantaged, who constitute a majority
in most developing countries - a majority which because
of centralisation cannot make the case that the attenuation
of the nation state challenges their already meagre
standards of living. This however offers an opportunity
to forces seeking an alternative to blind marketism.
They constitute the social base which can legitimise
the effort to reckon with the adverse consequences
of globalisation. This implies that political and
economic decision-making needs to be decentralised
so that segments who believe that there must be an
alternative to unbridled marketism can find a voice.
It also means that any alternative strategy must immediately
address their basic needs so as to consolidate their
support for that alternative.
Thus an alternative growth strategy does involve
economic "reforms", though not of the kind
dictated by the Fund and the Bank to all developing
countries. The objective of the reforms must be to
widen the home market, to provide the broadest possible
basis for development through appropriate structural
change. But broadening of the market without a stimulus
for its expansion can be counterproductive. And a
State faced with macroeconomic disequilibria is hardly
in a position to provide that stimulus. This implies
that macroeconomic disequilibrium reflected in high
budget deficits, has to be corrected through direct
taxation and a reduction in inessential expenditure.
Through greater discipline in tax-enforcement, changes
in tax laws, removing certain kinds of exemptions,
and an adjustment of rates for top income brackets,
the revenue from income taxation should increase.
With greater resort to direct taxation, the tendency
towards garnering revenue from indirect taxes and
administered price-hikes would have been reversed
which itself would be an anti-inflationary measure.
Even so however it is also necessary in addition to
protect the poor from the effects of such inflation
as would occur. And this is best done through an extension
of the public distribution system, both geographically
into the rural areas as well as in terms of its commodity
coverage. To keep the strain on the exchequer of such
an extension of the public distribution system within
reasonable limits, there should be an adjustment in
the targeting of this system, towards the poor.
The other component of macroeconomic disequilibrium
which plagues developing countries like India, viz.
the deficit on the current account of the balance
of payments, is dealt with more directly in the strategy
being proposed. The growth of income and exports here
are not made dependent on the pursuit of an open economic
regime, but are a fallout of the activism of the State.
This implies that the combination of selective but
stringent import controls and an export thrust itself
provides the basis for a correction of balance of
payments disequilibria. Further, growth in a broad-based
development strategy is not dependent on access to
international finance, but uses the foothold offered
in part by the home market. This implies that even
the direct link between growth and vulnerability,
or dependence on 'hot money' flows is snapped, achieving
the principal objective of the alternative traverse.
The important feature of this package is that its
focus on the expansion on the domestic market implies
emphasising employment generation and the provision
of adequate and sustainable livelihoods to the population.
This is especially important not only because of the
obvious welfare and equity implications, but because,
in the absence of such development, the political
and social tensions unleashed by the inequalising
effects of globalisation are likely to become very
difficult to contain.
Thus a package of policies of this kind would not
merely help accelerate growth with some attention
to equity, but would break the nexus between even
a minimal rate of growth and an acceleration of dependence
on foreign finance. Any access to finance would essentially
serve to raise the rate of growth beyond that critical
minimum, which is not subject to the uncertainties
that the external vulnerability stemming from dependence
on international capital generates. It is thus that
the "opportunity" offered by the rise to
dominance of finance capital can be used by a developing
country to engage international markets. That is the
virtuous circle that commends itself in the new environment
is one in which an effort by an activist State to
engage international markets for goods and services
provides it with the foundations needed to engage
international capital markets and use them as one
more weapon to further prise open unequal international
markets.
December 26, 2001.
1) The neo-classical critique
was elaborated among other places in Little, Scitovsky
and Scott [1970].
2) See, for example, Krugman 1994; Akyuz and Gore
1994; Singh 1995.
3) Young 1994.
4) See Patnaik & Chandrasekhar 1996.
5) For example, Vice-Minister Ojmi of Japan's Ministry
of International Trade and Industry is reported to
have summed up Japan's industrial policy perspective
as follows: "The MITI decided to establish in
Japan industries which require intensive employment
of capital and technology, industries that in consideration
of comparative cost of production should be the most
inappropriate for Japan, industries such as steel,
oil-refining, petrochemicals, automobiles, aircraft,
industrial machinery of all sorts, and electronics,
including electronic computers. From a short run static
viewpoint, encouragement of such industries would
seem to conflict with economic rationalism. But, from
a long-range viewpoint, these are precisely the industries
where income elasticity of demand is high, technological
progress is rapid, and labour productivity rises fast."
Quoted in Singh [1995].
6) Wade 1991, Amsden 1989.
7) This point is now recognised even by mainstream
political economists such as Dani Rodrik (1999) who
have pointed out that a general political movement
against globalisation may be the result of not taking
into account more seriously, the social consequences
of globalisation. |