Economist Michael Spence gave a clear endorsement of India’s financial sector policies in a recent meeting with this newspaper, when he argued that developing countries would do well to maintain some capital controls, try to actively manage the exchange rate and ensure that the banking sector is domestically owned to a large extent.
Spence won the 2001 Nobel Prize in economics and is the head of the Commission on Growth and Development, a group that includes heavy hitters such as Robert Solow, Robert Rubin, Zhou Xiaochuan and Montek Singh Ahluwalia. In a new report on post-crisis growth in developing countries, the commission says that two ingredients on the standard growth recipe that need to be reconsidered are financial reform and export promotion.
Similar views were evident all around during an international research conference on challenges to central banking in the context of the financial crisis, which was organized by the Reserve Bank of India last week. It was clear to anybody in the audience that the old consensus has cracked, as important names from central banking, academia and the International Monetary Fund asked tough questions about the risks from a lightly regulated financial sector and the need to use short-term capital controls to manage economies such as India.
This is not unexpected. Given the central role played by the financial sector in the economic crisis, it is also natural that there has been a lot of healthy debate about how fast and to what extent a government should open up the financial sector. “The lightly and incompletely regulated model that was influential in many Western countries is fundamentally flawed and in need of change,” says the growth commission in its new report.
This newspaper was a votary of cautious financial reform even when it was fashionable to lash out at the Indian central bank in 2007 and 2008 for its conservatism. But there is also little doubt in our minds that India needs a larger and deeper financial sector to oil its growth engines. The real debate should be about the pace of change to an open financial sector and capital account, rather than the direction of change itself.
India does not need to tighten capital controls right now because we are in a different phase of the business cycle compared with the boom years: Asset prices are still not in bubble territory, there is still excess capacity in the economy and the exchange rate is not appreciating. However, a country is well advised to keep some types of capital out when its economy shows signs of overheating.
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