Dancing with the Giants

Indian Express, 23 Sept 2006

India and China constitute barely 5 percent and 2 percent of world GDP, respectively, in current dollar terms. At current growth rates it would be half a century before they are amongst the world's largest economies. Yet, an enormous amount of attention is now being bestowed upon India and China by the world. Is this baseless hype, or is there is a strong justification for the interest in these two giants?

First, India and China may be small in dollar terms but are amongst the world's largest economies in terms of purchasing power parity, wherein a rupee currently gets valued at 1/8 of a dollar because of the goods that it can buy, rather than 1/45 th of a dollar. Using this measure India is the fourth largest economy in the world, after the US, Japan and China. Second, China and India account for 37.5 percent of the world's population which are rapidly doubling their per capita incomes. And, this population is a source of consumption demand, financial savings, skilled labour, migration and pollution. And third, the growth of China and India constitute the biggest ever surprise and major new development for the world economy.

Last week, the IMF-World Bank Annual Meeting, held in Singapore included a program of seminars attended by policy makers, academics and officials. These seminars discussed the current questions in development economics facing the world today. The reason for the focus on the "Giants" (as India and China were termed) became clear. It was primarily about other countries asking what it means for them. The main question being asked was: what does the emergence of India and China mean for the global economic environment facing other countries? Can low income countries hope to do well on low labour cost products, now that India and China are supplying those? Will middle income countries continue to get investment flows or will all these get sucked away by India and China? Will the rich countries lose jobs as the BPO industry in India grows larger? Will carbon emissions by India and China tip the world into global warming? Will 'global financial imbalances' -- jargon for the United States large domestic and foreign borrowing from developing countries, especially China -- play out smoothly? These are the big questions in the global economy today - and they are all connected with India and China.

In international trade, China and India are already seen as Giants. Trade integration of the Giants with the world, with East Asia and in relation to Latin America and Africa is going to grow. The only question was how fast or slow. In international finance, China is the seventh largest holder of foreign direct investment, with 4.1 percent of the world's total. China and India hold the second and the fifth largest foreign exchange reserves respectively, and are now turning into important sources of FDI for other countries. One of the biggest concerns appears to be : how would the financial sectors of China and India integrate with the world?

Larry Summers, Former US secretary of Treaury, said that financial integration of China and India is bound to happen in five to ten years. It will be driven by fundamental forces such as growing trade, investment and capital flows. And, it would happen regardless of what the policy makers in these countries want. What policy makers control is only the ease or pain with which this takes place.

Summers's major lesson for India is : greater currency flexibility will make India's path towards financial integration with the global economy smoother and prevent a wrenching and forced adjustment. His understanding clearly differs from the CAC-2 report, which has recommended reduced currency flexibility.

Larry Summers predicted that the next decade would witness an appreciation of the real exchange rates of the two countries. This would happen regardless of what the RBI and the People's Bank of China might want. It will happen because of the rapid growth in these countries. The US dollar is likely to decline in real terms with rising US current account deficits. As the pressure mounts exchange rates in India and China will be more flexible than they are today because of the difficulties of managing domestic monetary policy when exchange rates are being manipulated. In the event of external shocks and diverse growth rates of trading partners, it will not be optimal to hand over control of monetary policy to other countries. Greater flexibility in the exchange rate will allow more autonomy of monetary policy.

These developments, according to Larry Summers, will not be policy choices. They will be driven by fundamental forces. What policy choices will be able to determine is the smoothness with which the adjustment to this destination takes place. It will determine the path that each country would follow towards this inevitable destination.

One central lesson from international monetary history, Summers pointed out, is that the incidence of countries leaving fixed exchange rate schemes too late is at least 10 times as common, and has had 10 times as serious consequences, as countries leavings fixed exchange rate schemes too early. If the exit from a fixed exchange rate system is a forced move, and is easily justified, then the country has waited too long.

The policy advice for India and China from the seminar was clear: one important enabler for opening up the capital account is greater currency flexibility. Governor Zhao, governor of the People's Bank of China, who also spoke at the same session, said that China was going to move towards capital account convertiblity and was committed to greater currency flexibility.

Ever since the release of the CAC-2 report debate in India has focussed on whether we want convertibility or not. Some analysts seem to think we have a choice of not integrating financially with the world. Such an approach appears naive in the context of the global picture and where India and China stand. The Reserve Bank of India has made no commitment towards convertibility unlike Governor Zhao . It makes much more sense for the RBI to make a similar public commitment and then focus on the task of how to smoothen the path towards this destination.

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