Sailing past QE2

Indian Express, 11 November 2010

While most countries have criticised the US for trying to boost its economy through monetary easing, Prime Minister Manmohan Singh supported the move saying that the world will be better off if the US grows faster, and so will India. In taking this position India stands out as perhaps the only country that is not merely looking at short term considerations, but at the long term and wider implications of a prolonged world wide recession. However, this sentiment also reflects the strength and resilience that the floating rupee and large domestic consumption demand have given to the Indian economy.

Prospects for the US economy continue to look bleak. But there are limited intruments in the hands of policy makers. Since the US Fed has already pushed interest rates to zero, it cannot ease monetary policy by cutting interest rates any further. The potential for a fiscal stimulus is limited by the size of public debt and deficits. QE2, as it has come to be popularly known, is a second round of monetary easing by the US Federal Reserve, their monetary authority. It involves printing money in an attempt to put more money into the hands of people to encourage them to spend. The hope is that this will revive demand, and thus production. Large parts of the world, including China itself, have become dependent on the US consumer to generate demand. So if the easing does work and aggregate demand in the US goes up, and the US does grow faster, the world will, as Prime Minister Manmohan Singh said, be better off.

So what is worrying Germany, China and Brazil, and indeed the rest of the world? When the US Fed buys USD 600 billion worth of bonds, it will print money to pay for them. Economic theory suggests that when a country prints more money, its currency weakens. Dollars would flow to the entire world, including Europe, where interest rates will be higher than those in the US, and emerging economies like China, Brazil and India. Interest rates in Europe are already near zero. Germany expects that Euro will get stronger compared to the dollar, reducing the competitiveness of German exports, which counteracts the positive impact for Germany of stronger American demand.

The Chinese economy is dependent on exports as the engine of growth, and China has been pegging the Yuan tightly to the US dollar to keep Chinese exports cheap. China will have to fight harder to prevent the Yuan from appreciating. It will end up buying more reserves, and then face difficulties in controlling the excessive liquidity and potential for inflation.

Considering that India is one of the fastest growing economies in the world today, with high long run growth prospects, capital is likely to flow into India as well. To some extent, higher domestic growth in India coupled with low world demand has pushed up imports, and held back exports, thus creating a current account deficit. Higher capital inflows are financing our higher current account deficit. The rupee moves up and down to ensure that this is a perfect match. The current account deficit is now up to 3.7 percent of GDP. Some people worry that this might be a cause for concern, but as long as exports are growing slowly, and India is growing fast, and we are not paying for our imports by short term dollar denominated debt, this unlikely to be a serious issue.

Why does it matter that the Indian rupee is floating rather than pegged to the US dollar? Given the India is deeply engaged with the world both through trade and finance, India has a fairly open capital account, despite the large number of controls. Pegging the rupee to the US dollar would have meant importing US monetary policy. If India tried to hold an administered rupee-dollar rate fixed, and if the US eased monetary policy, India would be forced to buy dollars, thus inducing high rupee liquidity in the domestic market. In other words, if India tried to have a fixed exchange rate, QE in the US would directly induce QE in India.

This would have pushed up prices in the country. If India's focus is not on maintaining exchange rates, India can respond to inflationary pressures through raising rates, which the RBI has been doing. But India gets the flexibility to pursue low inflation only by giving up on interfering with the currency. Had a weak exchange rate been the objective of monetary policy, India would have had to cut rates in response to the US Fed's QE. That is China's predicament.

Further, India is willing to accept higher US growth even if it comes at the cost of rupee appreciation because India's exports are far more responsive to world demand, than to exchange rate movements. In the last one year the rupee has moved both up and down and exporters have learned to live with a volatile rupee. In the past, before 2007, when the rupee was tightly pegged to the US dollar, movements in the rupee dollar rate caused far more pain to Indian industry when compared with the attitude of the industry to rupee fluctuations today. In contrast, the Chinese economy is far more dependent on exports, and on the American consumer, as the engine of growth, since domestic consumption is barely 40 percent of GDP.

The impact of goverment stimuli worldwide is eroding. There is no sign of strong world growth. In this is situation, India is saying that the most important problem the world faces is getting back to high GDP growth, and not that of addressing the problems of central banks that have exchange rate inflexibility.

Exchange rate flexibility is the key to achieving autonomy of monetary policy. When RBI is not conflicted with trying to achieve a target exchange rate, RBI can turn around and look at the Indian economy and choose monetary policy decisions which are best suited to India. Prior to 2007, India did not have such autonomy. Today this has given India the ability to give priority to the world economy, and not have to sacrifice those for the sake of short term goals.

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