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global economic crisis
january 10, 2009
EPW
 
Economic & Political
Weekly
32
Pvt d rpd tth c f 2018
 Arvind Subramanian
I am grateul to Josh Felman, Olivier Jeanne, Vijay Kelkar, Dani Rodrik and John Williamsonor helpul discussions. Arvind Subramanian (
asubramanian@ petersoninstitute.org
) is with the PetersonInstitute or International Economics,Washington DC.
Looking ahead, the bigmacroeconomic policy questionor India is whether or not itshould emphasise greatersel-insurance with a necessarily more cautious approach to capitalmarket integration. The seriousadverse impact o the currentcrisis should awaken India to theneed or eective sel-insurancein the uture. I sel-insurancebecomes an important policy objective, the government willneed to revisit its macroeconomicpolicy, including exchange ratemanagement and capital accountconvertibility.Sel-insurance calls or counter-cyclical policy – dampening owsand keeping the currency competitive – so that reserves canbe built up during good times.
T
his crisis is not over, by any means.Drawing lessons is thereore a littlepremature. The uture may yet sur-prise. With that caveat, policymakersshould be rattled enough by the crisis toattempt to draw lessons, albeit provisional/interim, rom it in thinking aboutpreventing and responding to the nextcrisis – the crisis o 2018.What has come as a genuine surprise isthe impact on India – on the
 fnancial
side– o this crisis compared with that o the Asian fnancial crisis (
 AFC
) o the late1990s. Stock prices have declined by nearly 40% and the exchange rate decline o about 25% would have been considerably greater but or intervention by the ReserveBank o India (
RBI
). This dierentialfnancial contagion has stemmed rom thesimple act that India has become muchmore integrated in international capitalmarkets. Net capital inows reached apeak o over 10% o the gross domesticproduct (
GDP
) compared with relatively negligible amounts leading up to the
 AFC
.India may still be relatively closed inpolicy terms but that has not deterred sub-stantial inows. In de acto terms, India isno longer a closed economy rom the pers-pective o fnancial integration.There was surprise on two scores. First,policymakers and market participantsunderestimated the extent o India’sfnancial integration: while they were ormust have been aware o cumulative non-resident investments in rupee assets, they did not ully grasp the magnitude o or-eign unding (liabilities) o Indian fnan-cial institutions and corporates, especially those that had borrowed abroad to fnancetheir mergers and acquisitions in the lastew years.Second, and perhaps more importantly,they assigned relatively low probabilitiesto the perect storm o oreign exchangepressures emanating rom so many ronts,all related to the fnancial crisis in indus-trial countries. Deleveraging led to non-resident ight rom rupee assets whiletightening credit markets abroad orcedIndian corporates to turn to the Indianbanking system or credit and or rollingover their oreign unding. In the ultimateanalysis, this sharply increased demandor oreign exchange – maniested in partand in the frst instance as a demand orcredit rom the Indian banking system –placed considerable pressure on the rupeeand the
RBI
’s oreign exchange reserves.What appeared to be a very comortablereserve position at the start o the crisis,seemed a little less robust in light o themagnitude o reversal o capital ows. Inthe event, the rupee depreciated by about20 to 25%
and
the
RBI
lost about $40 to 50billion in reserves over the space o two months.Looking ahead, the big macroeconomicpolicy question or India is the ollowing:in light o the crisis, should India’s strategy emphasise greater sel-insurance, with anecessarily more cautious approach tocapital market integration, or does thecrisis point to an even more enthusiasticembrace o oreign capital? There are alsoother questions relating to fscal and mon-etary policies as well as fnancial sectordevelopment that this article will address.
sf-iu
Sel-insurance is not a new idea or policy objective. Implicitly or overtly, and to var- ying degrees, the east Asian countriesmade sel-insurance an important policy objective ater the
 AFC
. But India did notdo so in the atermath o the
 AFC
becauseit was not seriously aected by it. In termso highlighting the importance o sel-insurance, this crisis has done (or shoulddo) to India what the
 AFC
did to the east Asian countries.While the impact o the crisis has beengreater than expected, it is undeniablethat India’s oreign exchange reserves,helped in limiting this impact. I India hadgone into the crisis with $100 billion oreven $150 billion o reserves instead o $300 billion, confdence would have been vastly more difcult to manage, in partbecause oreign exchange intervention
 
global economic crisis
Economic & Political
Weekly
 
EPW
january 10, 2009
33
could not have been deployed to thesame extent.So, one lesson seems to be that sel-insurance is a prudent and even necessary strategy to limit the impact o fnancialcrises. This would, o course, have tobe qualifed i international collectivearrangements – regional and multilateral– can provide liquidity during crises.There have been some encouraging devel-opments in the recent crisis: the Interna-tional Monetary Fund has now a quick disbursing acility and the
US
FederalR eserve provided dollar liquidity underswap arrangements with our emergingmarket countries. India should as a res-ponsible member o the internationalcommunity work hard towards buildingthese arrangements, but or the oreseea-ble uture, liquidity provision under themis unlikely to become a ull or adequatesubstitute or domestic sel-insurance.Moreover, the contrasting experience o China – which experienced limited fnan-cial contagion because o its staggeringly large oreign reserves – and the others,even those with large amounts o reserves(such as Russia, Brazil, Korea and India),must give pause. China’s relative immunity seems to lend support to a stronger v ersiono sel-insurance, a kind o Powell doctrineor fnancial crises: a fnancial crisis like war requires vast frepower to mount aneective response so that the battle is woneven beore it begins. I this is true, beingprepared or, or minimising the impact o,the next crisis requires large amounts o reserves, perhaps even more than Indiahad at the beginning o this crisis.So, what does Powellian sel-insuranceimply? In its most extreme orm, it impliesa counter-cyclical macroeconomic strategy o moderate/serious mercantilism with acountry aiming to run current accountsurpluses in order to accumulate reservessteadily and thereby also keeping its netoreign indebtedness manageably small.It certainly means avoiding currency appreciation.Two distinctions are necessary. First,sel-insurance and building-up reservesrelate to net ows but vulnerability tocrises depends on gross inows, in act ongross liabilities. India in this crisis hasound itsel somewhere between Koreaand China. China sel insured with a vengeance ($2 trillion o reserves) andrestricted capital inows. India and Koreahad broadly similar and lower levels o sel-insurance. India, however, had largerlevels o gross inows than China butsmaller than those o Korea.The second distinction is between mer-cantilism and the associated reliance on acompetitive exchange rate as developmentstrategy (on which there is a lot o debate)and mercantilism as counter-cyclicalmacroeconomic policy. A sel-insuranceobjective would argue or a certainapproach to the capital account and ex-change rate to accumulate reserves duringgood times, with these reserves beingused up during times o crisis.
Hw muh sf-iu?
This crisis will rekindle debate about howmuch is adequate sel-insurance. The oldrules, including the Guidotti rule that re-serves should be as much as debt allingdue within a year needs to be revisited. A starting point would be to ask: what arethe total gross oreign liabilities o allfnancial and corporates alling due with-in a 12 to 18 month period. The recentexperience suggests that any unding by Indian corporates in oreign capital markets(such as those o the Tatas or even Arcelor- Mittal) should be included in thinking o the optimal size o the war chest.The problem is that one cannot stopthere. In the recent crisis non-resident in- vestments in the equity market were alsoprone to sudden withdrawal. In act, inthe recent crisis, the reversal o these ows were as important as debt rollovers inputting pressures on the currency. It is notobvious why reserves should not cushionagainst this kind o sudden stop as well.To be sure, there is one dierence betweenoreign portolio investments in the domesticstock market and oreign currency de-nominated debt. Withdrawals o portolioinvestments have a sel-limiting aspect tothem: prices adjust to moderate outows.But the recent crisis shows that even i they are sel-limiting, the process can easily play itsel out enough to create signifcantpressures on the currency, especially i therehave been sizeable cumulative inows.One could go even urther. I there areno capital controls on residents, crisescould also lead to pressure on oreignexchange reserves rom residents eeingrupees directly or indirectly through tradechannels. O course, it is not possible orthe government to sel-insure against allthese sources o pressure on oreignexchange but prudence would require tak-ing a broader view o vulnerability tocrisis: vulnerability stems not just romoreign-denominated contractual liabili-ties (i e, debt instruments) but rom amuch broader class o capital ows.Two conclusions ollow: frst, eectivesel-insurance might require a la thePowell doctrine a sizeable war chest o re-serves. To change metaphors a little, onemight say that the Chinese experienceshows that one should not just save or therainy day but that to prepare or the delugeone should build nothing less than Noah’sark. Second, the size o the chest will de-pend directly on how much the country opens itsel to capital – gross capital –ows. The more open the capital account,the greater the likely deluge and the biggerthe required ark.Two clear reservations to a strategy o sel-insurance must be noted. First, thereis a allacy o composition issue. Mercan-tilism might work or a ew countries butmercantilism by all would lead to beggar-thy-neighbour outcomes and internationalrictions. The frst-best o course is thecreation o pooled liquidity at internation-al level that could be made easily andquickly available to some or many coun-tries in crisis. I that option is not seriously on the cards – and nothing about therecent crisis will engender confdence thatthat option is on the horizon – the pursuito sel-insurance by some or many coun-tries will be an unavoidable second-bestoption, and or countries such as Indiaeven a necessary option.The second reservation is at the country level. Sel-insurance and the associatedmercantilism protects against fnancialcontagion. But this strategy will also in-crease reliance on exports and oreignmarkets or sustaining growth. Export-to-
GDP
ratios will increase. A consequence o this is greater vulnerability to
trade
conta-gion. I the economies o the United States(
US
) and the European Union (
EU
) headinto recession, China is more susceptibleto a cyclical slowdown because o itsgreater reliance on exports. So, what a
 
global economic crisis
january 10, 2009
EPW
 
Economic & Political
Weekly
34
country gains on the swings (protectionagainst fnancial contagion) it loses partly on the roundabouts (vulnerability totrade contagion). Policymakers willhave to trade o these benefts and costs.One argument, o course, is that thissusceptibility to a slowdown rom declin-ing  oreign demand can be oset by osetting policies to boost domesticdemand, which China has sought recourseto. But this requires a strong sovereignbalance sheet.
sv b sht
The one sae conclusion to draw rom thiscrisis is that there will be other crises o similar magnitude in the not-too-distantuture. True, it will probably not take thesame orm, but that there will be a crisis isinevitable. So, what other mitigating strat-egy apart rom sel-insurance on theexternal side can a country deploy?Crises such as these show that the lender/guarantor o last/ultimate resort is thegovernment. Governments have to takeover oten substantial amounts o privatesector liabilities in crises and governmentshave to implement counter-cyclical fscalpolicy during steep downturns. The
US
 demonstrated the ormer; and the Chinese with the huge fscal eort announced re-cently have implemented the latter. Indiahas, sadly, not been in a position to easily do either because its sovereign balancesheet is shaky (it has been noteworthy thatduring this crisis, the brunt o the burdeno providing macroeconomic stimulus hasbeen orced upon monetary policy becausefscal policy has been hamstrung by thestate o the public fnances).For the uture, thereore, India shouldaim or a balance sheet that is robust andsound enough to be able to increase publicliabilities by large amounts within a shortspace o time: say, up to 10%-20% o 
GDP
.The implication is that it is imperative tohave India’s debt, during the phase o rapid growth, to come down to levels rom which ramping up o the orders mentionedabove will be easible. This implies a debt-to-
GDP
ratio in good times o no greaterthan 30%-40% o 
GDP
. Medium-term fscalconsolidation involving a substantial re-duction o public sector indebtedness is anurgent task or the uture, once the crisishas passed (during the crisis, some fscalexpansion, taking advantage o oil pricedeclines, should not be ruled out).
F cpt
Beore the
 AFC
, the orthodoxy (Mark 
I
) was to aim or capital account liberalisa-tion. Ater that crisis, the revised ortho-doxy (Mark 
II
) was that countries that hadalready opened up to capital ows shouldnot reverse policies but that closed orsemi-open countries such as India shouldproceed cautiously on the path o capitalaccount opening especially short-termdebt ows. But one can detect the emer-gence o a new view that has not yet at-tained the status o orthodoxy (Mark 
III
)but is garnering more adherents. On this view, not only should those not already open be cautious but even countries thatare open should think o careul and pru-dent ways o managing, even dampening,inows through policy actions.In the last ew years, India has beenmoving rom Mark 
II
to Mark 
I
. It is unde-niable that this development – India’srapid integration in world capital markets– has been one o the principal reasons orthe surprisingly large magnitude o theimpact o the crisis on India.Does this impact necessitate a rethink o capital account convertibility? Whatshould India aim or?Capital account convertibility (
CAC
) hasbeen a hotly debated topic in India and thesubject o three ofcially-sponsoredreports: Tarapore
II
, Mistry and Rajan.One can argue that all o these need to berevisited in light o the crisis or one simplereason: none o them addressed directly the question o whether sel-insuranceagainst fnancial crises should be a macro-economic policy objective guiding
CAC
. Inother words, the issue here is not whetheroreign capital is good or bad or India’sgrowth rom a development perspective;rather, it is whether the introduction o asel-insurance objective into policy – argu-ably one o the lessons o this crisis orIndia – should alter in any way currentmacroeconomic policy toward
CAC
.What ollows assumes that sel-insurance should be an important utureobjective because that is one o the lessonso the crisis. I that is so, looking ahead,India aces three options.The frst option is to continue the cur-rent policy o continuing and acceleratingthe move toward
CAC
as argued in theMistry, and more guardedly in the RajanCommittee, report. It is a necessary conse-quence o pursuing this option that it would not allow or any serious sel-insurance and thereore would be basedon a relatively sanguine view about the vulnerability to sudden stops and theirconsequences. This view will necessarily lead to large and sharp swings in assetprices including exchange rates.
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and interest in public fnance and public policy are essential qualifcations.
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