As the volatility settles in the financial markets after what Jerome Powell and Christine Lagarde communicated at this year’s Fed Kansas Jackson Hole Symposium, it is time to take a peek into the highbrow stuff presented at this symposium and see if it has any implications for India.
There are three important takeaways that should policymakers should take notice.
First, a study by Yueran Ma of Chicago Booth and Zimmermann of Leibniz Institute showed that a 100-bps tightening shock reduces R&D spending by 1-3 per cent, a venture capital investment decline by 25 per cent in the following 1-3 years and a patent-based innovation decline of 9 per cent over 2-4 years period.
These translates into output loss of 1 per cent and 0.5 per cent decline in total factor productivity growth over 5-years. The effects are percolated through demand channel (less profitable to innovate) and financial conditions (less funding for risk taking).
These findings may pose a challenge to conventional thinking that monetary policy cannot affect long-run growth and works best if it targets to keep inflation low and undertake counter-cyclical stabilization of output around its potential level.
However, the evidence is not compelling enough. The authors themselves caution against drawing inference that monetary policy should be more accommodative on an average if innovation is undersupplied. Technology waves arise due to more fundamental reasons. Further work, controlling for technology fixed effects, technology age effects and fiscal policy shocks may be needed to better understand the effect of monetary policy on innovations.
Despite the conflicting conclusions, there is strong evidence that more countercyclical monetary policy helps stabilise rate of innovations and supports higher growth, while financial instabilities work against it.
In fact, a study by Liu, Mian and Sufi shows that low interest rates spur innovations, and acknowledges that positive effects are generally seen limited to large superstar firms who are able to increase market concentration and so end up in long-run contractionary growth effects.
Global value chains
The second, relates to trade and global value chains (GVCs). Laura Alfaro and Davin Chor’s study points to the looming great relocation of GVCs from China to low-wage locations (Vietnam; Taiwan, Korea and India made “modest but still noticeable gains”) or nearshoring/ friendshoring (Mexico).
They also say that this great relocation is coming at a cost of higher unit value of imports that is likely to generate increased price and wage pressures in the US and a passthrough to consumer prices, indicating large static welfare losses.
Interestingly, they also present evidence that FDI relocation in Vietnam and Mexico has been significantly supported by Chinese outward FDI to circumvent higher US tariffs on Chinese imports. In contrast, Bank of England Deputy Governor, Ben Broadbent, in his speech pointed out that traditional GVCs rather than their relocation was driving the recent uptick in global trade. The recovery in traditional GVCs may bring down inflation in course of time but the monetary policy will need to stay restrictive.
Debt bubble
The third takeaway was from the paper by Serkan Arslanalp and Barry Eichengreen.
They focussed on the seemingly unsurmountable problem of exploding public debt that isn’t going to go away as primary surpluses of 3-5 per cent over an extended period that may be required are not political feasible. In years ahead, interest rate-growth rate differentials are likely to further move away from current favourable configurations and adverse debt dynamics are likely to come into play.
Running high inflation to reduce real debt or placing interest rate ceilings to return to financial repression to take care of high debt is no longer an option after financial liberalisation.
The retreat of official finance and growing share of private non-bank investors can subject emerging markets to vulnerabilities from diabolical loops and refinancing risks.
They make a clarion call to remove impediments to debt restructuring amid breakdown of the market, especially to restructure debt of countries whose debt has become unsustainable. Will we have a response at the forthcoming G20 summit?
Relevance for India
What is the relevance for these takeaways for India?
First there is insufficient case for premature easing of monetary policy. The hope that this will support innovations and growth is misplaced. Inflation differentials have again moved against India with disinflation in advanced economies. Our monetary policy is not at all tight in comparison with neutral rate even if withdrawal of accommodation may have been competed if real rates are compared with inflation expectations indicated in the latest policy.
A tighter monetary policy may be needed to deliver durable low inflation, especially if relative food price shock persists and starts generalising.
Second, the government should re-look at its GVC relocation policies along with its PLI component and rework to ensure that they are not inflationary or trade diverting in a dynamic sense.
One needs a hard evaluation of static welfare losses from relocations and sectoral import bans and juxtapose them with anticipated dynamic gains.
Lastly, the warning on exploding global public debt at the symposium should be a wake-up call for faster rule-based fiscal consolidation by regenerating primary surpluses that India did during 2003-04 to 2007-08.
The writer is Professor at IIM Kozhikode. He was Executive Director, RBI and MPC member. The views are personal