Stop-start in currency flexibility harms economic growth
Business Standard, 6 January 2025
There was an age when the government controlled petroleum-product prices, and those prices were not updated regularly. World prices would go up and the Indian prices would not. The gap would become larger, the economic distortions would get worse, and the pressure would build up. And then, suddenly, prices would change by a lot. These big price changes were shocks to the economy. The policy community learned from those experiences: It is much better to dribble out the news as a large number of small price changes that happen every day. Some days, the price of petrol should go up, on other days it should go down, reflecting fluctuations of the world price. The price of petrol should not be fixed.
So it is with the exchange rate. It is possible to hold the exchange rate fixed for some time. But a gap opens up between the free-market price and the government-controlled price. This gap induces economic distortions and, in time, policymakers get the message. And then we get large moves of the exchange rate, which are even more disruptive than the flow of daily fluctuations of a free-market exchange rate.
The problem of high productivity firms
Let us dive into the mind of the firm. Every firm faces numerous fluctuating prices. The price of steel fluctuates, the price of natural gas fluctuates, the price of lithium-ion batteries fluctuates, the price of central processing units fluctuates, and the yen-rupee exchange rate fluctuates (even if the dollar-rupee is a government-controlled price). To be in business is to look at this landscape and figure out how to make money in this ever changing world.
Weak firms require an easy life. They want the government to give them a fixed environment where prices of steel, cement, petrol, dollar-rupee, etc. are locked in. It is argued that if the government does all this, the firms will learn to produce and export. From the viewpoint of Indian economic growth, there is no point in having such weak firms. The essence of economic development lies in the emergence of capable firms.
Isn’t exporting the ultimate path to economic success? Policymakers can get export growth for some time through subsidies, whether a production-linked incentive or a falsified exchange rate. But these “fake exports” are missing the point. Exporting is not the end: Capable firms with high productivity are the end. Exporting prowess is the thermometer where we get to read the capabilities of the firms. When firms fight fair and square to achieve exports, they achieve productivity. Fake exports is painting the tape, is falsifying the meaning of a statistical measure, is Goodhart's law in motion.
How does a firm learn to play in the complex world? It must have deep sources of competitive advantage. Price fluctuations knock out weak firms, which is a good thing for society. High-productivity firms are those that build organisational capability that copes with price fluctuations. Organisational capability never emerges quickly: It takes many years of purposive effort to get to high institutional capability within firms.
This shows us the connection between government-managed prices and economic development. When the government fixes the price of steel, it enfeebles the firms that make or buy steel, which do not learn how to build organisational capability to be high productivity firms. Weak firms that ought to have been destroyed by steel price fluctuations linger on in the landscape, using labour and capital in low productivity ways and driving up the price of labour and capital for high productivity firms.
Part of the story in high-productivity firms lies in their business model and organisational design, through which good firms are resilient to price fluctuations. A second part of the story lies outside: In the emergence of liquid and efficient derivatives markets. In a market economy, prices fluctuate all the time, and firms buy short-term protection using derivatives, which creates liquidity and capability in the financial system surrounding the derivatives industry. When a government shuts off price fluctuations (and, worse, when the government restricts derivatives trading), these capabilities are lost.
Spells of a managed exchange rate, followed by large changes, are thus the worst of all worlds. Those lull the firms into complacence: they take on more exchange-rate risk, and fail to develop organisational capability for the real world where exchange rates fluctuate. And then, inevitably, it always happens that the government is no longer able to control the price, a big price change then comes along. The firms — even the good firms! — lack the organisational capability to cope with price fluctuations and get hurt. The derivatives markets are feeble, they do not have GDP-sized numbers swirling in them, and are not able to supply protection on the scale required. You can’t buy flood insurance once the waters start rising: It takes decades for a capable insurance industry to develop. The firms respond in the political economy, lobbying the government to block price fluctuations, which reinforces the worst elements of the public-policy landscape.
Flexible exchange rates and economic growth
This reasoning shows us how government management of prices, in general, and the exchange rate, in particular, interfere with the main journey of economic growth. It is always tempting to achieve political objectives, or to support firms in genuine distress, by preventing the operations of markets. Practical people in firms faced with these questions, who tend to emphasise execution issues, often support ideas that harm Indian firms on a strategic scale.
One great milestone in the Indian journey was when the Reserve Bank of India (RBI) graduated from being “a temporary measure” of the British, to having a mandate of the inflation target of 4 per cent [EiE Ep68]. This part is now widely understood in the policy discourse: The single great contribution that the RBI can make for the Indian growth journey is to reliably deliver low and stable inflation, to rule out the possibility of an inflation crisis. Sometimes, the impossible trinity offers the temptation of a situation where exchange-rate objectives and inflation objectives can coincide. Policymakers must resist this temptation because reduces the credibility of the inflation target, and it sets us up for the stop-start of periods of currency management that harm economic growth.
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