A few years ago, the World Economic Forum at Davos came up with an intriguing suggestion—countries should appoint national risk officers and develop risk-management systems to help them navigate through a turbulent world.
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Risk management is central to most private sector activity. But governments do not seem to have an explicit strategy to manage risks. In fact, the very concept of risk seems to be absent in most policy discussions and documents, where everything is said and written with an air of oracular certitude.
Most sophisticated investors know that risk and return tend to move in tandem. You can get a consistently higher return on your portfolio only if you are prepared to take higher risks. Also, the prices of assets with higher risk tend to be more volatile than the prices of safe assets, so you need to have a good strategy to manage risk.
Is that also true of national economies? Does a country that aspires to grow its economy at a faster pace have to necessarily take more risks? Does high economic growth also tend to be more volatile? Should governments then have a clear strategy on how to manage the extra risks that seem to inevitably accompany growth accelerations?
Not much thought is usually given to these questions. Two recent developments are worth noting. The first is a brief debate between two respected mandarins on the role of risk in policy choices, and the second is data on how countries whose assets were once believed to be inherently risky bets are now growing faster, but with lower volatility than the erstwhile safe bets.
The Reserve Bank of India (RBI) does these days slip in terms such as tail risk into its policy statements and use fan charts to depict its range of forecasts, but the annual budget statement of the government is yet to do that. The recent debate between the two mandarins is welcome because it involves a clear attempt to introduce the concept of risk into a policy debate.
Former RBI governor Y.V. Reddy began the discussion in the 11 June issue of Economic and Political Weekly. He was commenting on an article by Planning Commission deputy chairman Montek Singh Ahluwalia, on the prospects and policy challenges in the 12th Plan. Reddy complained that the Plan does not discuss the “risks to the economy and economic agents”.
“Experience shows that at high levels of economic growth there is vulnerability to shocks,” wrote Reddy. Some of the risks identified by him were higher inflation, volatile capital flows because of global instability, the prospects of a further bout of financial instability and the risks faced by farmers as they move from cereal cultivation to commercialized agriculture.
In his reply in the same issue of the journal, Ahluwalia accepts that the new Five-year Plan will face several risks. He then charts out a few policy dilemmas. “We can consciously choose a strategy which entails a lower level of risk and therefore possibly lower reward…or we can aim at a higher reward strategy combined with conscious measures of risk management, to be able to deal with unfavourable outcomes should be arise,” wrote Ahluwalia.
Ahluwalia goes on to say that there is a close link between the strategy chosen and the level of risk. For example, India needs about $1 trillion to build infrastructure over the next five years. The ambitious investment plan cannot be completely funded by domestic savings. To make it possible for large amounts of foreign capital to come into infrastructure projects, India needs to accept a higher current account deficit and hence a higher exposure to global economic shocks. Such trade-offs are evident in other policy choices as well, though they are rarely brought to public notice.
What the debate between Reddy and Ahluwalia missed is that the relation between risk and return is not always stable, especially when it comes to comparisons between countries or groups of countries. For example, most equity market strategists used to assume that equities in certain parts of the world would bounce around more than equities in the more advanced countries. After the global financial crisis, emerging markets (EMs) have grown faster than developed markets (DMs), but with lower volatility.
As Alan Taylor noted in the Financial Times recently: “A central macroeconomic indicator, gross domestic product growth and its volatility, speaks to the reversal of fortune. Circa 1970, EMs exhibited high mean and high variance relative to DMs; but after 1980 this risk-reward combination evaporated as EMs suffered a lost decade. But from the 1990s EM growth picked up and volatility moderated; DM growth slowed and, after the crisis, volatility spiked.” So the more important question is not how fast an economy is growing, but how much faster it is growing than its potential.
Niranjan Rajadhyaksha is executive editor of Mint. Your comments are welcome at email@example.com