Copy with care

Financial Express, 19 June 2008

In India today, it is fashionable to suggest that India should do Chinese-style exchange rate policy on the grounds that this will induce Chinese-style growth in India. There are three problems with this proposition. First, there are many important elements of the Chinese growth advantage - the contribution of exchange rate policy is small at best. Second, there is no switch inside the central bank which can be thrown to achieve Chinese-style exchange rate policy. A full reckoning of the cost and complexity of setting up that configuration must be put on the table. Third, Chinese exchange rate policy is breaking down.

How important is exchange rate policy in explaining the gap between Chinese and Indian growth?

It is important for us in India to closely study the Chinese growth miracle. Six critical components of that experience can be identified, which differ from India:

  1. When their economic reforms started, China was near universal literacy, while we are still far from this.
  2. China has sound law and order, in contrast with the banditry that afflicts a third of India.
  3. China has no trade unions, in contrast with the difficulties faced by Indian firms.
  4. China has high quality roads, railways, ports and airports; in all four areas, India is lagging far behind.
  5. China has near-zero tariffs, in contrast with India which is still quite protectionist.
  6. China had a one-child policy, which led to a compression of the demographic transition into a short period.

In my mind, these six factors are an adequate explanation of the difference of 350 basis points between India's 7.5% trend growth rate and China's 11% trend growth. The sixth element - the one child policy - is neither desirable nor feasible in India. The other five elements are entirely desirable and feasible for us. I am quite convinced that if India achieved full literacy, established universal law and order, undertook far reaching reforms to labour law, built Chinese-quality infrastructure and got tariffs to near zero, then trend growth would go up from 7.5% to 11%.

What about exchange rate undervaluation? "Undervaluation" is a slippery concept and it is hard to get a fix on when an exchange rate is undervalued. A simple thumb rule that I follow is: how hard is the central bank working in order to manipulate the currency market? If we think in this fashion, Chinese market manipulation on the currency market really only took off in 2003. In other words, currency manipulation was not prominent in the 25 years of dramatic growth in China, from 1978 till 2003. This helps us see that currency manipulation was not a critical feature of the Chinese growth miracle.

How expensive is the Chinese exchange rate policy?

Advocates of undervaluation then shift ground and say it is worth taking their favoured medicine even though the evidence on its usefulness is weak, since it does not hurt. It is claimed that there is a switch within the central bank, and by throwing this switch a program of currency market manipulation can be undertaken, through which exchange rate distortions can be achieved.

This is far from true. The Chinese effort on exchange rate undervaluation has involved numerous elements. Financial sector policy has been highly distorted in supporting this policy. NPAs of near 100% of GDP have been built up. Households have been defrauded by giving them low or negative real rates of interest on bank deposits, while giving banks a near-monopoly on financial intermediation. The Chinese central bank has a program of `targeted' issuance of sterilisation bonds where one by one, banks are picked up and told to buy a stated quantity of sterilisation bonds at a stated price.

For each $1 trillion of reserves invested in US government bonds, a 10% drop in the US dollar meant a transfer of $100 billion to the US government. Reforms of PSUs involved withdrawing a cradle-to-grave welfare system for millions of workers: this gave the frightened workers a strong incentive to save in preparing for old age, and thus depressed consumption. The one-child policy gave parents fewer children to spend money on, and fears about old age which required high saving.

Before we embark on Chinese-style undervaluation, we need to take in the full costs of this strategy. India is on the path to building sound institutions, in the context of an open democracy and free press, and aspires to become a mature market economy. All the elements of the Chinese strategy are antithetic to this goal.

How sustainable is the Chinese exchange rate policy?

Finally, it is important to see that the undervaluation strategy works for only a short period; it does not work for the long run. The Chinese undervaluation strategy was in full play from 2003 to 2006. From 2007 onwards, it has been breaking down. The yuan has been appreciating at an average rate of 5% a year. Monetary policy has been very lax; inflation of near 9% has sprung up. Yuan appreciation with high inflation is ending up giving the feared real appreciation anyway. But along the way, financial sector policy and monetary policy has been distorted with long-term harmful consequences.

Back up to Ajay Shah's 2008 media page
Back up to Ajay Shah's home page