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India in a Globalized World:¹ Maximizing Benefits and Minimizing Costs

Duvvuri Subbarao

The year 1991 was a watershed in India’s economic history when it made a decisive break from the past and shifted from a dirigiste regime of heavy protection, extensive controls and tight regulation to a more open, liberalized and market-oriented regime of economic management.

Motivation for the 1991 Reforms

The trigger for this radical shift, at any rate in popular perception, was the external payments crisis consequent on the first Gulf War, but that was just the proximate cause. The more substantive motivation for embracing wide-ranging structural reforms, going beyond merely stabilizing the external sector, was the realization that the economic philosophy that had guided India since Independence—self-sufficiency, protection and public sector dominance—had run its course. India needed to institute sweeping reforms in order to accelerate growth and reduce poverty.

According to the government’s discussion paper on economic reforms² published in July 1993, the objective of the reforms was:

. . . to bring about rapid and sustained improvement in the quality of life of the people of India. Central to this goal is the rapid growth in incomes and productive employment . . . The only durable solution to the curse of poverty is sustained growth of incomes and employment . . . Such growth requires investment: in farms, in roads, in irrigation, in industry, in power and, above all, in people. And this investment must be productive. Successful and sustained development depends on continuing increases in the productivity of our capital, our land and our labour.

Within a generation, the countries of East Asia have transformed themselves. China, Indonesia, Korea, Thailand and Malaysia today have living standards much above ours . . . What they have achieved, we must strive for.

Reforms in the Nineties

The early big-bang reforms straddled a wide canvas. Industrial licencing was dismantled, save for a few exceptions; it was accompanied by a government policy for reducing the ‘commanding heights’ role of the public sector. Import restrictions were largely removed and tariff and non-tariff barriers were sharply scaled down. Following the steep two-step devaluation of the rupee, heavy management of the exchange rate gradually yielded to a market-determined exchange rate while the foreign investment regime was substantially eased.

Recognizing that it was the fiscal profligacy of the eighties that was at the heart of the external payments crisis, the government vowed to adhere to fiscal responsibility by reducing the fiscal deficit by two percentage points of GDP and laying out a road map for further consolidation. The fiscal reforms catalysed monetary reforms, including the dismantling of the administered interest rate and credit allocation system towards a market-based system. These were accompanied by financial sector reforms aimed at the development of deep, wide and vibrant financial markets. Significantly, the banking sector was opened up to new private sector players to enhance competition.

Post 1991, those early reforms were widened and deepened, to give a market orientation to most sectors and dimensions of economic activity, substantially relieving India from the tag of ‘the most closed and heavily controlled economy in the world’. Over the years, the agenda shifted gradually, if also logically, from first generation reforms, having to do mostly with product markets, which are largely within the control of the Central government, to second generation reforms centred in factor markets, where progress depends on the active cooperation, if also explicit involvement, of states, as exemplified most recently by the implementation of the Goods and Services Tax (GST).

Reforms—Unique Indian Context

Implementing economic reforms is politically difficult, always and everywhere. India was no exception. Its reforms were criticized for being hesitant, cautious and slow. That may well have been the case. But they were also arguably unique inasmuch as they were negotiated through a vigorous, if also noisy, democracy, and through the complex labyrinth of India’s federal structure where narrow regional interests clashed with collective economic virtue, and short-term political compulsions often militated against the national optimal. This may have slowed the process but it ensured that the reforms were robust and that the benefits were widely disbursed. That, at any rate, was the hope and expectation.

Democracy, in this sense, was, and remains, both India’s strength and weakness as far as reforms are concerned. The democratic process ensured that a plurality of opinion informed the content and process of reforms even if it meant contentious, and even vexatious, debates and difficult compromises. Some people hold that India reformed by stealth. This is far from the truth. Except for market-sensitive reforms like devaluation of the currency, all other reforms were implemented in the best traditions of the sunshine law.

Globalization at the Heart of India’s Reforms

One consequence, admittedly intended, of the economic reforms, even those centred in domestic sectors, was to integrate India with the global economy. For example, industrial delicensing or de-reservation of products for the small industry sector, even though domestic in content, was aimed at enabling the Indian industry to compete in the world. With the forces of globalization blowing hard and strong through the eighties, India surmised that staying out of globalization was no longer an option; on the other hand, the dazzling experience of the East Asian tigers (Hong Kong, Korea, Singapore and Taiwan) showed the rewards of global integration. The early successes of China, which opened up over a decade ahead of us, eroded India’s export pessimism by demonstrating that even a large, continental-size economy can be nimble enough to compete in the world if it gets its act together.

Globalization—Emerging Market Experience

Globalization comes with costs and benefits as indeed evidenced by the experience of virtually all emerging market economies across space and time. The Latin American countries were the first to break out of the low income trap and dependency syndrome by liberalizing their external sectors. But throwing caution to the wind cost them heavily in the form of several episodes of the Tequila crisis.³ The East Asian Miracle, riding on exporting value-added goods to the world to overcome the limitations of small home markets is a spectacular example of the positive side of globalization. On the other hand, the Asian financial crisis of the late nineties and the devastating toll it took on growth and welfare is a telling reminder of the pitfalls of misguided liberalization.

China’s astonishing success over the last two decades in turning itself into the ‘factory of the world’, which helped it accelerate growth and lift hundreds of millions out of poverty, is truly unprecedented. It is also a striking demonstration of the benefits of globalization. On the other hand, the growing stress in China in recent years arising from its efforts to rebalance the economy from external to internal demand, from investment to consumption, the rapid debt build-up and depletion of foreign exchange reserves are evidence of the challenges of coping with the vagaries of globalization.

India’s experience with globalization over the last twenty-five years is consistent with that of our peer emerging market economies. India experienced unprecedented growth acceleration in the first decade of the 2000s and clocked real output growth of nine plus per cent on average in the five-year period—2003–08.⁴ The India growth story was so persuasive that the country was on the verge of being christened the next miracle economy. There were many reasons for this remarkable performance—enhanced productivity, growing entrepreneurial spirit, rising domestic savings rate and improving financial intermediation. But underlying all of these factors was India’s deepening integration into the global economy manifesting the positives of globalization.

That sense of glory didn’t last long as the negative side of globalization caught up soon thereafter with the outbreak of the global financial crisis following the collapse of Lehman Brothers in September 2008. The crisis hit virtually every country in the world and India was no exception. There was dismay and disbelief over the setback in India. The financial sector in the rich world was in deep turmoil because of reckless risk-taking in pursuit of quick profits but Indian banks had no exposure to the toxic assets. There was also a global recession but that should have hit big exporters like China, Japan and Germany; not India whose exports are only a small proportion of GDP. So went the popular narrative.

So why did India get hit by the crisis? The reason was that by 2008, India was more integrated into the global economy than we consciously recognized. India’s two-way trade (merchandise exports plus imports), as a proportion to the gross domestic product (GDP) more than doubled over the previous decade: from about 20 per cent in 1998–99, the year of the Asian crisis, to over 40 per cent in 2008–09, the year of the global crisis. The deep trade integration was accompanied by an even deeper financial integration. Measured by the ratio of external transactions (total of all inflows and outflows in the current and capital accounts) to GDP, financial integration had more than doubled from 43 per cent in 1998–99 to 111 per cent in 2008–09. What this integration meant was that if global financial and economic conditions were in turmoil, India could not expect to remain an oasis of calm.⁵

International experience as noted above, including that of India’s, shows that the adverse effects of globalization arose mostly out of financial liberalization rather than trade liberalization. On balance, trade liberalization has benefited developing economies whereas financial liberalization has been a mixed bag. In any case, past experience makes the challenge of globalization obvious—maximize the benefits and minimize the costs.

Benefits of Globalization

The benefits of globalization are obvious enough. The competitive forces generated by globalization improve productivity while also allowing the economy to operate to its comparative advantage. The resultant higher exports and faster output growth make the economy more attractive to foreign investors thereby giving the domestic economy access to a more diversified and competitive resource base. At the same time, domestic investors can diversify their risk by investing abroad. While higher investment engendered by globalization will expand the production base and employment opportunities, access to better technology and management practices will potentially put the economy on a virtuous cycle.

Does this theory work in practice? In other words, has India benefited from globalization as predicted by theory? Some broad indicators will be instructive.

Real GDP growth accelerated from 5.6 per cent per annum during the eighties to 6.9 per cent per annum in the post-reform period (1992–2016). Acceleration in per capita income was even more striking, rising as it did from 3.2 per cent per annum in the eighties to 5.1 per cent during 1992–2016. Underlying these broad parameters was a host of macroeconomic indicators—savings and investment rates, tax base and tax buoyancy, fiscal and current account deficits, credit growth and financial intermediation—all of which showed significant improvement consequent on reforms.⁶

How much of this improvement in the overall macroeconomic situation is due to India’s integration with the global economy? Put another way, could similar results have been obtained if reforms were restricted to the domestic sector? It is difficult to give a precise answer in the absence of a counterfactual. But the reality is that domestic and external sector reforms are two sides of the same coin; it is difficult to reform on one side without reforming on the other side as well.

Costs of Globalization

Just as with benefits, the costs of globalization too are obvious enough but difficult to estimate in quantitative terms. With globalization, India’s macroeconomic fortunes get linked to the vagaries of global forces. Entire industries can die because of import competition causing extensive job losses and destruction of regional economies. A case in point is the large steel imports that flooded Indian markets in the last two years forcing several factories to shut down, resulting in a huge negative multiplier effect. Similarly, exports can suddenly lose established markets because of abrupt and unforeseen supply–demand imbalances or innovation of new products and processes. Exports are also subject to periodic threats of protectionism as is the case presently.

While the volatility associated with trade integration can take a formidable toll, volatility arising from financial integration can be even more unforgiving. Capital flows, in particular, are notoriously fickle, subject to sharp surges, sudden stops and abrupt reversals, all of which can impair macroeconomic and financial stability, erode competiveness and hurt growth and welfare.

Volatile capital flows have been a common and recurrent feature of India’s macroeconomic experience over the last ten years. In the years immediately preceding the crisis (2003–08) when the India growth story was on a roll and the world was experiencing the so-called Great Moderation, foreign capital inflows into India surged beyond its absorptive capacity. The result was a sharp appreciation of the rupee out of line with fundamentals and the threat of an asset price bubble and financial instability. The Reserve Bank of India (RBI) had to intervene in the market to prevent undue appreciation of the rupee.

That story changed abruptly with the outbreak of the global financial crisis in 2008 when, unnerved by the turmoil in the advanced economy financial markets, capital fled emerging markets to the safe haven of the US, giving India the reverse problems. The rupee depreciated steeply, inflation pressures intensified and fiscal pressures were exacerbated. This time round, the RBI had to intervene in the market to sell dollars in order to prevent volatility in the exchange rate.

The same story was repeated during the so-called Taper Tantrum triggered by a statement in May 2013 by Ben Bernanke, then chairman of the US Federal Reserve, that they were considering gradually tapering their asset purchase programme, popularly known as ‘quantitative easing’. That the Federal Reserve would unwind its unconventional monetary policy once financial markets started stabilizing was known from the beginning. Nevertheless, global financial markets were shaken by the Bernanke statement setting off the Taper Tantrum.

Amidst the ensuing fear and panic, emerging markets, including India, experienced capital flight. The rupee tumbled, depreciating by as much as 17 per cent in just a little over three months, forcing the RBI once again to mount a fierce exchange rate defence.⁷

Managing exchange rate volatility caused by capital flow volatility is always a complex and costly challenge. Emerging market economies have tried a variety of options—capital controls, foreign exchange intervention and, on occasion, even monetary policy. But experience showed that no option is benign.

On capital controls, for example, there are always questions about what type of controls, when and indeed whether they will be effective. Similarly, when it comes to foreign exchange intervention, a central bank is concerned about maintaining its credibility since a failed defence of the exchange rate can be worse than no defence at all. If the exchange rate does not correct in spite of intervention, the central bank runs the risk of hitting a tipping point when it forfeits market confidence and the exchange rate goes into a free fall. This explains why central banks are always anxious to ensure that they have sufficient ammunition by way of foreign exchange reserves to counter any threat to exchange rate stability.

Global Cooperation to Manage Globalization

Volatile capital flows are a characteristic of globalization—in particular, a consequence of spillover from the advanced economy central bank policies into emerging market economies. Quite understandably, this is a contentious issue that has regularly figured in international meetings such as those of the IMF and the G20.

The consistent refrain of emerging markets at these meetings would be that the unconventional monetary policies of advanced economies are taking a heavy toll on their economies and that advanced economies must factor in this spillover impact in formulating their domestic policies. They argue that these cross-border capital flows are a consequence of globalization—maintaining open borders for trade and finance. Both sides, advanced and emerging economies, benefit from globalization and so they also must share the costs of globalization; it is unfair to leave the entire burden of adjustment to emerging markets.

Advanced economies, led by the United States, have largely been dismissive of these grievances. Their main response would be that their policies are driven entirely by the need to stimulate their domestic economies, and the argument that it is a cover for deliberately debasing their currencies for export advantage is vacuous. They would not deny the existence of the spillover impact but would argue that such spillover is an inevitable by-product of their policy effort to revive their domestic economies. Moreover, the argument goes, revival of advanced economies is an international public good inasmuch as emerging markets too benefit from such revival through increased demand for their exports. Their response would typically end with advice to emerging markets that they should set their own houses in order to cope with the forces of globalization rather than find a scapegoat in the domestic policies of advanced economies.

This has largely been a dialogue of the deaf. Global problems require global coordination; but in a world divided by nation states, there is no constituency of the global optimal. Consequently, emerging markets have had to fall back on their efforts to manage the negative impact of globalization, especially the macroeconomic instability caused by volatile capital flows. India has been in the forefront of putting across the case of all emerging market economies.⁸

Managing the Costs and Benefits of Globalization—India’s Agenda

The above synopsis defines the task clearly: what should India do to maximize the benefit-cost ratio of globalization. Here is a five-point template in that regard.

• Keep the fiscal and current account deficits in check: Both in 1991 when we had a severe balance of payments crisis and in 2013 when we had a near crisis, the root cause was the ‘twin deficit’ problem—unrestrained fiscal profligacy spilling over into the external sector⁹ pushing the current account deficit beyond sustainable limits. On the fiscal side, it is becoming increasingly clear that it is not enough if the Central government puts its fiscal house in order but the states too must do so, because what matters for macroeconomic purposes is the combined deficit of the general government.
• Maintain macroeconomic stability: The objective is to manage the basic macro parameters—interest rate, inflation rate and exchange rate—in such a way as to drive rapid and sustained growth consistent with low and steady inflation. This requires, in particular, managing the ‘impossible trinity’ which asserts that a country cannot simultaneously maintain all three policy goals of free capital flows, a fixed exchange rate and an independent monetary policy.¹⁰ As an emerging economy steadily integrating with the world, India should manage the impossibly trinity flexibly and predictably to preserve macroeconomic stability.
• Keep financial stability always on the radar screen: A big lesson of the global financial crisis was that financial instability anywhere was a threat to financial stability everywhere. The crisis held out many other lessons as well. Steady growth and macroeconomic stability does not guarantee financial stability; indeed an extended period of stability can itself sow the seeds of instability. Moreover, the financial system can contain pressure for longer than we think possible and as a result, when the inevitable implosion takes place, it can be quite disastrous, even catastrophic. The challenge for regulators is to ensure that the systemic risk is within acceptable limits without choking growth and innovation.
• Improve productivity: The importance of improving productivity in order to be competitive in the world is obvious and India’s agenda in this regard is huge—improve education and health outcomes, reduce gender gaps, improve skills and infrastructure and most of all create an environment and establish a regulatory framework that fosters innovation.
• Improve ease of doing business: One of the prime motivations for globalization is to attract foreign investment. The frustration and harassment that investors face in implementing projects in India is now the stuff of folklore. While India has now improved its rank to 100 out of 189 countries in the World Bank’s ranking by way of ‘ease of doing business’, it still has a long way to go in making the country an attractive place for doing business. Empirical evidence shows that countries gain as much as one percentage point of growth when they move up fifty places in the ease of doing business ranking. Here again the agenda is huge and obvious; the challenge lies in implementation.

Globalization—a Double-Edged Sword

Globalization is a double-edged sword. It offers immense opportunities but also poses harsh challenges, making it tempting for emerging markets to believe that they would be better off withdrawing from globalization. That would be throwing away the baby with the bathwater—exactly the wrong response. Managing globalization boils down to keeping borders largely open for flows of goods and services, and keeping borders only cautiously open for financial flows. The challenge for India, as indeed for all emerging economies, is to manage this balance in such a way as to maximize the benefit-cost ratio.