Reform debate

Deena Khatkhate's essays offer a perspective on monetary and financial sector reform in India and in East Asia and Latin America.

THE relative merits of government intervention vis-a-vis market-oriented reforms in less developed economies have been a topic of much debate. In the book under review, Deena Khatkhate engages in this debate, with the focus on the monetary and financial sectors.

The 27 essays in this volume were published (or written) between 1964 and 2006, most of them in academic journals such as Economic & Political Weekly and World Development. In these essays, Khatkhate, who held senior positions at the Reserve Bank of India (RBI) and the International Monetary Fund (IMF), provides his perspective on aspects of development in India and East Asian and Latin American countries.

The most important theme in this collection of essays is financial sector reforms in developing countries. During the 1950s and 1960s, the financial sectors of several developing countries were tightly controlled by their governments. Interest rates were maintained at relatively low levels; banks were required to set aside substantial shares of their deposits as reserves; and governments directed credit to specific sectors, with social and development objectives. In India, in the years after the nationalisation of major commercial banks in 1969, credit allocated to agriculture and small-scale industries was raised to 40 per cent of the total and there was a significant growth in rural banking.

However, starting in the 1970s, an alternative view emerged, which claimed that state control over the financial sector resulted only in financial repression and therefore the operation of the financial sector should be left entirely to market forces. Consequently, most developing countries began implementing financial liberalisation policies. In India, financial sector reforms, along with major reforms in other sectors, began in 1991.

East Asia and Latin America

Khatkhate is convinced that market-oriented reforms of financial sectors are a necessary step. However, sweeping, big-bang reforms will be a mistake, he points out. Liberalisation measures will be successful only if they are implemented on a gradual basis; also important are the timing and sequencing of the reform process. In particular, the opening up of the economy to free foreign capital movements (capital account liberalisation) is a measure that should be taken only towards the final stages of financial reforms, according to Khatkhate. Otherwise, with an open capital account, there will be large inflows and outflows of foreign capital, subjecting the economy to great vulnerabilities.

Argentina, Chile and Mexico are countries in which fast-paced financial sector reforms paved the way for financial crises. In these countries, the controls on interest rates and foreign capital movements were removed in the very early stages of the reform process. Further, in Argentina and Chile, the banking system was under the dominance of oligopolies, which appropriated a large share of the credit and thereby imposed further strains on the system. Compared with the Latin American experience, financial sector reforms in East Asia have been more gradual and more successful.

Despite their relatively successful financial reforms, East Asian economies did face a major financial crisis in 1997-98. Khatkhate points out that the real cause of the East Asian financial crisis was the inflow of short-term foreign capital into these countries.

The IMF failed to understand the nature of the crisis. The IMF conditions, which forced these countries to reduce government spending, raise interest rates, and slow down bank lending, only worsened the crisis. According to Khatkhate, the IMF's policy prescriptions in East Asia in 1997 were similar to its policy advice for Mexico in 1995 although the problems faced by the two economies were vastly different.

While the financial crisis was triggered by rising public sector debt in Mexico, the crisis in East Asia was on account of short-term foreign liabilities of the private sector. The crisis in East Asia abated only when steps were taken by the affected countries (Thailand and South Korea) themselves to regulate short-term capital flows.

Changing views

Khatkhate's views on markets vis-a-vis government intervention have undergone significant changes over the years, as he notes in the introduction. While he writes appreciatively of the role of government intervention in East Asia, he expresses distrust of state intervention in his later writings and argues for greater market-led reforms in India.

Thus, in an essay published in 2006, Khatkhate supports the view that the primary goal of a central bank's monetary policy should be to maintain the inflation rate within reasonable limits, rather than to stabilise output or employment. In another essay, Khatkhate argues that fiscal deficits resulting from increased government spending is the cause of the escalation of interest rates in India. In other words, increased public expenditure crowds out private investment (because of higher interest rate) and is therefore not desirable.

These arguments are highly debatable. They are built on the monetarist/new classical theory assumption that the economy, at its natural state, is always at full employment. Clearly, such an assumption is incongruous with the everyday realities of a country like India.

It is also surprising that Khatkhate underestimates the effects of short-term capital flows. He does not agree that the rise in interest rates in India could be a price paid for the country's increasingly open capital account. Given the perceived risks of investing in a Third World country, international investors would expect a higher (than the developed country average) interest rate in a country like India. If interest rates are lowered, these investors would withdraw from the country, triggering a financial crisis. That Khatkhate failed to recognise this possibility is indeed puzzling, for he himself had earlier attributed the East Asian financial crisis to liberalised capital movements.

The articles in this volume (the latest one was written in 2006) do not discuss the recent developments in the global and Indian economies. It will be interesting to revisit Khatkhate's conclusions in the context of the cataclysmic changes happening now in the international economy.

In recent times, India's banking and financial sectors have weathered major global crises quite remarkably, notably the worldwide financial meltdown in 2008. This has been attributed mainly to the continuing dominance of the public sector in India's banking system, the prudential regulations of the RBI, and the gradual nature of the financial sector liberalisation in the country. It must be noted here that there have been strong, continuous pressures to hasten the reform process in India.

In fact, during 2007-08, just months before the global financial crisis broke out, two government-appointed committees recommended a speedy transition to full capital account liberalisation in India. It is certain that if India's capital account were fully liberalised, the 2008 crisis would have had disastrous consequences for the country. Fortunately, there have been other forces that helped to moderate the pace of financial sector reforms in India. The RBI has been adopting a more cautious route to capital account reforms. Equally important has been the role of political discussion in the country, largely led by Left political parties, in pressuring the government to go slow on financial reforms.

At the same time, despite the gradual nature of Indian reforms, studies indicate that financial liberalisation in India has, so far, been hugely regressive in respect of widening the reach of the banking sector to the disadvantaged sections of the population and to sectors such as agriculture. Although India has not yet fully liberalised its capital account, there have been increasingly large inflows of foreign portfolio investments into the country in recent years. These short-term investments, exhibiting a high degree of volatility, contribute to the large fluctuations in commodity prices and exchange rates. It is the poor whose interests are hurt most by such price fluctuations.

No doubt, the current problems in the world's major economies have revived the Keynesian idea that governments can play a vital role in stabilising crisis-ridden economies. If anything, government intervention is more crucial in a country like India with its gigantic development challenges, including large reserves of unutilised labour and other resources. Therefore, there is a definite need for a rethink on the content, pace and even the very desirability of financial liberalisation in India. At the same time, the recent events in the Indian and global economies clearly show that there is no basis for the excessive faith in markets that is noticeable in Khatkhate's later writings.

The book under review also contains a number of interesting essays on India's political economy written at various points in time. In an article published immediately after the 1977 general elections, Khatkhate argues for greater decentralisation of power in India so that the distance between the electorate and the elected is reduced. In other essays, he laments the absence of a class of independently thinking intellectuals in India and writes about the many problems affecting the country's administrative machinery. He also argues, in an essay written in 1971, that brain drain provides a safety valve for the surplus numbers of university graduates in developing countries.

Even while disagreeing with some of his views, there is no denying that this collection of essays by Khatkhate provides a rewarding reading experience for both the academic and the lay reader.