IMF and World Bank: Where do India's interests lie?

Business Standard, 20 September 2006

There has been much focus on the change in voting rights at the IMF. It is felt that India has "lost out" in this process. Careful thinking is called for, on India's engagement with the Fund and the Bank. Where do our interests lie?

At the end of World War II, John Maynard Keynes designed a world monetary system which involved pegged exchange rates. Every once in a while, a pegged exchange rate would get into trouble, as is their wont. To cope with these episodes of crisis, the IMF was invented. So every now and then, a speculative attack would take place, a country would be stripped of its reserves, the IMF would give a loan, the exchange rate would be adjusted, and the story would start all over again. This system lasted for a quarter century.

The remarkable development of recent decades is that one by one, the countries who matter have defected from this system. By the late 1970s, the industrial countries no longer needed the Fund: they had graduated to convertibility and flexible exchange rates.

The recipe of the Fund was then applied in the third world, where capital controls and pegged exchange rates were still found. But as trade grows, it becomes impossible to enforce capital controls. Just as a government can't tell a firm to not import steel from the cheapest vendor abroad, it can't tell the firm to not source debt from the cheapest lender abroad.

Some countries mishandled this inevitable capital account convertibility by having exchange rate rigidity. As Argentina, Korea, Thailand, etc. have demonstrated, central banks trading in currency markets has given spectacular BOP crises. These crises kept the IMF in business for a while. But poor countries are also learning sound monetary economics, and shifting to the consistent framework of floating rates + convertibility. When a country has a floating rate and convertibility, there are no currency crises and hence no role for the IMF.

Where do our interests lie? Our monetary policy framework is not consistent, and the possibility of a crisis remains with us. We need to set about building a consistent framework of monetary policy, involving (a) convertibility, (b) floating exchange rate and (c) a narrow inflation-targeting central bank. It is fully within our power to do this. Once we do this, India will no longer need the IMF to help on a rainy day.

The IMF has some top quality people, with remarkable knowledge on these issues. India can greatly benefit by tapping into this knowledge. Raghuram Rajan can be brought to the RBI and his predecessor, Ken Rogoff, can be invited to do consulting for the Ministry of Finance. Apart from this, India's best interests lie in having no engagement with the IMF, and letting it fade away.

What about the World Bank? The World Bank was originally created to assist reconstruction in Western Europe. In Robert McNamara's period (1968-1981), the bank reoriented itself from a focus on European reconstruction to issues of economic development in poor countries.

The World Bank earns a prosperous margin on largescale lending to countries such as India and China, where a huge chunk of the world's poor live. The operating profit from the lending operations of the World Bank is used to employ roughly 10,000 international civil servants.

The trouble with this scheme is that the two most important customers of the World Bank - India and China - no longer need loans from the Bank. India and China are perfectly able to access global private capital flows. More importantly, both countries have learned enough modern economics to achieve high growth rates, through which poverty reduction is happening at a smart pace.

An argument is made that while the World Bank does not matter for financing of projects in India, it can supply useful knowledge inputs alongside government projects. But in operationalising this, there is a large gap between the best minds in the World Bank and the day to day operations staff.

As an example, the World Bank was involved in India's Sarva Shiksha Abhiyan (SSA). This has not helped prevent the SSA from being plagued with the classic blunders of Indian public policy. The SSA, which is jocularly called the Sarkari Shiksha Abhiyan, constitutes an intensification of the old Indian approach of building more schools and hiring more teachers, without applying first principles of economics at thinking about the incentives of teachers. It was Pratham - and not the World Bank - which discovered that the children getting enrolled under the SSA are learning nothing. It is not clear that World Bank civil servants have value to add over Indian civil servants.

A considerable reorganisation would be required at the World Bank, to ensure that operations work is driven by the best minds in the world. Until this is done, it is not clear that there is a useful role for the World Bank in India.

In an international setting, there is a gulf between low growth countries and high growth countries like India and China. The poor countries with low GDP growth rates are afflicted by political problems, or what are now called problems of "nation building". The World Bank had once reinvented itself to shift focus away from European reconstruction to poverty reduction. It may be time for the World Bank to once again reinvent itself, to shift focus to nation building.

This would be in India's interest. We can achieve high GDP growth and eliminate domestic poverty, all by ourselves. But all around us, we have problems with dysfunctional states in Central Asia, Afghanistan, Pakistan, Nepal, Bangladesh, Burma and Sri Lanka. It is in India's best interests if the World Bank, and the international community, will work towards nation building in these countries.

But there is the question of financing. The World Bank earns an operating profit from largescale lending to India and China,and uses this money to run unprofitable programs elsewhere in the world. Such a financing structure is not in India's interest. Nation building in the poorest countries is a global public good - it is not clear why India and China should pay a disproportionate part of the cost. The expenses of the World Bank should be paid for by the 25 biggest countries of the world, with contributions in proportion to GDP.

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