India and the Global Recovery: Key Policy Challenges
At the Federation of Indian Chambers of Commerce and Industry (FICCI)
New Delhi, December 2, 2010
As prepared for delivery
It is my great pleasure to be here today, and I wish to thank FICCI for hosting this event. I am honored to be a part of such a distinguished panel, with Chief Economic Adviser Basu, Chairman Nilekani, and Governor Reddy.
Since my last visit to India—about three years ago—the world has suffered the worst financial crisis since the 1930s. India has weathered the crisis remarkably well, thanks in large part to sound macroeconomic and financial policies. Now, India’s growth is amongst the highest in the world—making it a driving force of the global recovery.
India has traveled a remarkable distance over the last generation. Rapid growth has lifted hundreds of millions out of poverty. And innovation has put India in the vanguard of technologically advanced nations. India has truly become an economic superpower. The time has come for India—and Asia more generally—to play its rightful role in the global framework of economic governance.
I look forward to exploring these themes with you. To set the stage for today’s discussion, I’ll speak briefly now on three topics: the state of the global recovery, progress in reforming the financial sector, and international policy cooperation.
The global recovery is moving along, but it is fragile and uneven. In the advanced economies, high unemployment, weak household balance sheets and sluggish credit growth are holding back private demand. The outlook is very different in many emerging and developing economies, where strong internal demand and a rebound in global trade have powered a robust recovery—especially in Asia, with China and India in the lead.
The recovery remains subject to significant downside risks. Renewed turbulence in sovereign debt markets could spill over to the real economy and across regions. Investor sentiment in Europe is particularly precarious. I am hopeful that as investors gain a deeper appreciation of the bold steps being taken to address fiscal and financial vulnerabilities, the situation will stabilize. The IMF stands ready to support our members in whichever way suits them best.
Another possible risk is new shortfalls in bank capital, which would add further pressure on public finances and could trigger a renewed loss of market confidence. And finally, a breakdown in global cooperation could undermine the recovery.
What are the policy priorities today?
In the advanced economies, the fragility of the recovery calls for policies to remain as supportive as possible. If growth in these economies stalls—especially in the U.S., which still accounts for a quarter of the global economy—the consequences for the rest of the world could be very serious.
Because public debt in the advanced economies is so high, the burden of this support falls on monetary policy. And because interest rates are already very low, less conventional measures may also be needed. In the U.S, for example, the Fed recently announced a $600 billion program of quantitative easing. It aims to prevent damaging deflation and support the recovery. Of course, the Fed’s actions carry implications for the global economy—and I will address the issue of capital flows shortly. This is why it is so important to have a collaborative approach to rebalancing the global economy.
At the same time, the advanced economies must make faster progress in repairing the financial sector and household balance sheets. Structural reforms to make labor, product and service markets are also critical—especially in Europe.
Restoring confidence in the long-term sustainability of public finances is clearly a top priority. Public debt in the advanced economies is projected to reach a staggering 110 percent of GDP on average by 2015, up about 35 percentage points since the crisis. Credible medium-term plans for fiscal consolidation are needed urgently to reassure markets.
Indeed, one of the principal lessons of the crisis is the value of fiscal space for being able to cushion the economic impact of a crisis. This is why India’s commitment to ambitious medium-term deficit and debt reduction targets is so important.
Let me turn now to one of the major policy challenges facing the emerging economies: the surge of capital inflows.
On the whole, capital flows are beneficial to receiving economies—especially when driven by growth prospects, rather than short-term cyclical factors. In India, as in other rapidly growing emerging economies, foreign capital has helped top up domestic savings and promote financial market development. Now, as India seeks $1 trillion to finance critical infrastructure projects, foreign capital may prove even more useful.
But capital inflows can bring policy challenges. When they come in too fast—exceeding the absorptive capacity of the economy—they can have disruptive effects. These could include too-rapid appreciation of the exchange rate, and credit and asset price bubbles.
Financial stability must be guarded carefully in the face of such inflows. India did this very well in the run-up to the crisis—which spared it the disaster that struck less vigilant nations. In this context, we should recognize the tremendous contribution made by Governor Reddy and by the RBI more generally. Just one example is the early introduction of countercyclical macroprudential measures—which other countries are only now recognizing as an essential instrument for protecting financial stability.
Today, India is once again receiving strong capital inflows—more than $50 billion over the last year, or 4 percent of GDP. And while other countries facing surging capital inflows cry foul, India has neither undertaken massive intervention, nor further tightened its existing system of capital controls—in fact the limits on foreign investment in long-term debt were recently increased.
In my view, this approach is the right one. As noted by Prime Minister Singh at the Seoul Summit, “even as we try to avoid a destabilizing surge in volatile capital inflows, there is a strong case for supporting long-term flows to stimulate investment, especially in infrastructure.” He also pointed out that recycling surplus savings into investment helps address developmental imbalances. I am confident that with India’s strong track record of vigilance, capital flows can be put to good use without sacrificing financial stability.
Shifting focus to the medium term, how best to achieve strong global growth?
Rebalancing global demand holds the key. In economies with excess external deficits, public and private saving must increase. And in economies with excess current account surpluses—including many in Asia—domestic demand needs to increase. Stronger financial safety nets and financial market development can promote this shift from external to internal demand. In many emerging economies—including China—currency appreciation is also an important part of the solution. Finally, structural reforms remain essential in all countries to raise productivity and boost growth.
Let me turn briefly now to financial sector reform.
A lot has already been done to achieve far-reaching reform of global banking regulation, through the Basel III accords. Yet we are far from having the type of supervision needed to actually implement such regulation. And at the end of the day, without intensive supervision, even the best rulebook in the world will be useless.
We also still have a long way to go on resolution, and how to handle problems related to institutions that are too big (or too important) to fail, moral hazard, and cross-border issues. Even more work is needed to develop frameworks to monitor risks related to how financial institutions, markets and the real economy interact—so called macro-prudential frameworks.
International policy cooperation
The last topic I’d like to address is international policy cooperation.
The crisis represented the first phase of a new approach to global economic governance. Concerted policy action across the globe helped avert a much greater economic—and ultimately human—disaster. The key lesson is that in today’s globalized economy, there are no domestic solutions to global problems.
We have now entered the second, more challenging phase of economic governance. Large and disruptive adjustments in exchange rates and capital flows are putting pressure on some countries. Talk of “currency wars” has raised the specter of beggar-thy-neighbor policies, which proved so devastating during the Great Depression.
But I remain optimistic that global cooperation will prevail in the end. Let me mention just two reasons for my optimism.
The first is that international cooperation is being cemented by historic advances in global economic governance.
The emergence of the G-20 has clearly changed the rules of the game, with countries accounting for 85 percent of the global economy now working together in a regular policy forum. And governance reforms at the international financial institutions have made them more legitimate. At the IMF, our members recently agreed to a shift in quota—or relative voting power—of over 6 percent to dynamic emerging and developing countries. Once this reform is in place, the IMF’s ten largest members will include Brazil, China, India and Russia. Asia more generally will get a major boost in voting share.
The second reason is that we now have a concrete mechanism for international policy cooperation—the G-20’s Mutual Assessment Process, or MAP. I should note that India serves as co-chair (with Canada) of the G-20 MAP Working Group, which plays a critical role in moving the process forward.
Through the MAP, the G-20 identifies the policies needed—by each country—to achieve strong, sustainable, and balanced growth. The MAP has also shown that global policy cooperation can deliver significant and tangible benefits. Under an “upside scenario” of strong policy implementation, we could have global GDP that is over $1 trillion higher over the next five years—with 30 million additional jobs and 33 million fewer people in poverty.
As we seek to strengthen the global framework for economic governance—making it more legitimate, more credible, and hence more effective—we look to the rising economic powers not only for their support, but also for their ideas. Let me mention just two powerful features of India’s success story that hold important lessons for other countries.
First, a focus on inclusive growth. In India, the goal is not simply for growth to be rapid, but for growth to also be inclusive—and improve the quality of life for all citizens. As India’s government seeks the best policies to achieve this dual goal, it is fortunate in having advisers like Professor Basu, who brings such strong academic credentials to his position as Chief Economic Adviser.
Second, technological advances. India’s meteoric rise in the services sector has been an inspiration to other countries. Clearly, India’s commitment to excellence in higher education has played a major role in this success. So too did the dismantling of the “license raj” in the early 1990s, which unleashed a powerful wave of creativity and entrepreneurial spirit.
These two features of the Indian growth miracle are coming together through the Unique Identification project, under the leadership of Chairman Nilekani. This project holds out great hope for making India’s social services—which provide a lifeline to hundreds of millions of vulnerable Indians—better able to reach those in need, and more cost-effective. The UID can also advance financial inclusion, which plays a critical role in supporting small businesses and in reducing poverty.
Let me summarize my key messages today.
To sustain the global recovery, we must do whatever it takes to support growth in the advanced economies. The downside risks of not doing so are simply too great—not just for these economies, but for the world as a whole.
This does not mean that efforts to resolve the legacy problems of the crisis can be put on the back burner. Public finances must be put on a sustainable footing, with credible medium-term consolidation plans. And financial sector repair and reform needs to move faster, so that financial institutions can support the recovery.
Finally, we must continue to deepen international policy cooperation. The crisis showed that by working together, we can all be better off. This is just as true for the recovery and beyond.
Underpinning this cooperation is a new, stronger framework of economic governance. The world looks to Asia to play its rightful role in global efforts—because with rising economic power comes rising responsibility to help resolve global economic challenges.
Ultimately, this deepening international engagement is in Asia’s own interest. Asia’s future lies in creating a framework that can deliver strong, balanced and sustainable global growth. And India, with its economic dynamism and strong democratic tradition, should play a leading role in these efforts.
Thank you for your kind attention.