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Real Exchange Rate, Fiscal Deficits and Capital Flows: Refutation Again

Real Exchange Rate, Fiscal Deficits and Capital Flows: Refutation Again VIJAY JOSHI Deepak Lal, Suman Bery and Devendra Kumar Pant (hereafter LBP) claimed in an article in this journal that India sacrificed a substantial amount of growth in the decade of the 1990s as a consequence of accumulating foreign exchange reserves [Lal et al 2003]. In particular they claimed that if the reserves had been absorbed, India would have grown by anything up to 8.5 per cent per year, not the 5.8 per cent that actually occurred. I disputed this claim in Joshi (2004) and argued that in the same counterfactual scenario, India

Discussion

Real Exchange Rate,Fiscal Deficits and CapitalFlows: Refutation Again

VIJAY JOSHI

D
eepak Lal, Suman Bery and Devendra Kumar Pant (hereafter LBP) claimed in an article in this journal that India sacrificed a substantial amount of growth in the decade of the 1990s as a consequence of accumulating foreign exchange reserves [Lal et al 2003]. In particular they claimed that if the reserves had been absorbed, India would have grown by anything up to 8.5 per cent per year, not the 5.8 per cent that actually occurred. I disputed this claim in Joshi (2004) and argued that in the same counterfactual scenario, India’s growth rate would have been at most 6.2 per cent per year.1 John Williamson (2004), in his comment on Joshi and Sanyal (2004), concurred with the view that LBP had made an analytical mistake. In their reply, LBP have defended their original claim [Lal et al 2005]. In what follows, I shall make another (and final) attempt to show that their claim is based on false reasoning.2

I begin by dealing with a minor point. In Joshi (2004), I pointed out an illegitimate step in LBP’s procedures, which biased upwards their estimate of growth sacrificed. The error lay in measuring capital inflows as a proportion of GDP by taking capital inflows at current prices and GDP at constant prices. They have now corrected what they call this “computational error”, without however making any acknowledgement for its discovery. No matter, I am glad the correction has been made. It reduces their estimate of hypothetical annual average growth in the 1990s from 8.5 to 8.2 per cent.

The main point of contention between us is a different one. LBP continue to insist that their estimate of foregone growth of (8.2 – 5.8) = 2.4 per cent per year is correct, since the foregone increase in investment was much higher than the actual reserve accumulation. Their reasoning is that “the change in reserves does not equal the amount of inflows not absorbed as it also reflects the net absorption effects of domestic monetary and fiscal policy, which are also assumed to have changed as compared to the original configuration”.

This is a nonsensical argument. LBP compare an initial position of the economy (in the absence of inflows) with a final position after an exogenous capital inflow plus a fiscal and monetary expansion. But what is actually observed in the data of any year is only the final position. The observed data relate to the current account deficit that is generated by the joint action of the exogenous capital inflow, the expansionary policies and the policy of reserve accumulation. In the observed final position, using their notation, we have,

I – S = M – X = K + R – ΔNFA = B –ΔNFA,

where I is domestic investment, S is domestic saving, M and X are imports and exports respectively, (M – X) is the current account deficit, K is net capital inflows, R is remittances, K + R = B is total net inflows andΔNFA is the increase in foreign exchange reserves.3 The “net absorption effects of fiscal and monetary policy” are already included in the observed I, S, M and X. The only unexploited investment opportunity is represented by ΔNFA. If ΔNFA were absorbed, investment could rise to (I + ΔNFA) and the current account deficit would rise to [(M – X) + ΔNFA], covered by the continuing inflow (K + R). LBP argue instead that investment could rise to [I + (K + R)]. But that would require a wider current account deficit and hence a larger capital inflow than that available in the observed final position.4 It follows that, given their assumptions, LBP’s conclusion that the upper bound of foregone investment is (K + R) is logically invalid.5

The whole novelty of LBP’s claim was that India could have had an annual average growth rate of 8.2 per cent in the 1990s, i e, extra growth of 2.4 per cent per year, merely by absorbing the foreign exchange reserves that were accumulated. That claim was a central plank of their sensational indictment of India’s exchange rate policy during the decade. We see above that their claim is based on faulty logic and rests on assuming capital inflows significantly higher, and by a precise amount, than those actually observed. When that hidden assumption is made explicit, what they turn out to be saying is that growth could have been higher if capital inflows had been higher, a proposition of little interest. Consequently, their policy critique is also negated.

I conclude by reiterating that LBP’s claim that India’s growth could have been as high as 8.2 per cent per year in the 1990s, if foreign exchange reserves had been absorbed, is based on a simple but devastating analytical error. As argued in Joshi (2004) and Joshi and Sanyal (2004), the upper bound of growth was considerably lower. Foreign exchange reserves increased in the 1990s by 1.2 per cent of GDP per year. Hence the upper bound of foregone investment was also 1.2 per cent of GDP per year. On the assumption of an incremental net capital output ratio equal to that actually observed in the 1990s, viz 2.8, the foregone extra growth was 1.2/2.8 = 0.4 (approximately) per year. Thus, the upper bound of India’s growth was (5.8 + 0.4) = 6.2 per cent per year, and even less if we assume diminishing returns to capital accumulation.6,7 LBP have obfuscated the issue in Lal et al (2005). I shall desist from responding to any further obfuscating rejoinders on their part and leave it to discerning readers of this journal to judge who is right.8

EPW

Email: vijay.joshi@merton.ox.ac.uk

Notes

1 The argument in Joshi (2004) was repeated in

one of the sections of Joshi and Sanyal (2004).

In what follows, any references to the former

should be taken to include the latter.

2 There is also a substantive policy disagreement

between LBP and myself as regards India’s

past and future exchange rate policy. I have

Economic and Political Weekly February 4, 2006

nothing to add on this question beyond what is said in Joshi (2003), Joshi (2004) and Joshi and Sanyal (2004). The present article is not concerned with that substantive policy issue, which is a matter of judgment on which reasonable people can disagree. It focuses instead on a logical and conceptual error in LBP’s theoretical model, which invalidates their empirical results, including their startling claims about the consequences of India’s macroeconomic policies in the 1990s.

3 Note that LBP refer to (M – X) as the current account deficit; R is counted as a financing item. I shall adhere to their terminology below.

4 For investment to rise to I + (K + R), the current account deficit would have to widen to [(M – X) + K + R]. Assuming that ΔNFA is absorbed, this would require an extra capital inflow of (K + R – ΔNFA), over and above that observed in the annual data, which ex hypothesi constitutes the final position.

5 Note that LBP’s claim cannot be rescued by regarding the observed data as representative of the “initial” position rather than the final position. In this case, start with I – S = M – X = K + R – ΔNFA = B – ΔNFA in the initial position. Then their conclusion that if ΔNFA were absorbed, I would rise to [I + (K + R)] in the final position, would follow only on the assumptions that (a) there is a concurrent, exogenous expansionary policy thatincreases investment by precisely (K + R – ΔNFA), which when added to the ΔNFA absorbed, adds up to a total increase in investment of (K + R), and (b) additional capital inflows are forthcoming to cover the rise in the current account deficit of (K + R – ΔNFA). Plugging in LBP’s figures for the relevant variables, we can see that this hypothetical scenario requires that extra capital inflows would have been forthcoming to cover an increase in the average annual current account deficit of 3.8 per cent of GDP over the decade of the 1990s. In other words, LBP could get their conclusion only by making some highly artificial, unjustified, indeed bizarre assumptions, an example of “rubbish in, rubbish out”.

6 Another curious feature of the LBP results should be noted. According to their revised figures, foregone investment due to nonabsorption of foreign exchange inflows was 5 per cent of GDP per year and foregone growth was 2.4 per cent per year in the 1990s [Lal et al 2005, Appendix III, Table A-3, col 11 minus col 10 and Appendix III, Table A-2, col 10 minus col 8). This implies a hypothetical net incremental capital-output ratio of 5.0/2.4 =

2.1 (approximately), far below the actual incremental net capital-output ratio in the decade of 2.8. This implies an exogenous increase in the pace of technical progress that would, as if by magic, accompany the extra investment in the hypothetical scenario. LBP’s econometric black box needs opening up to the light of day!

7 In practice, the rise in investment and growth due to absorption of inflows would have been less than the upper bound, since consumption would have risen. Moreover, running down reserves would have increased the country’s vulnerability to currency crises and could even have reduced growth below that actually achieved.

8 I have little hope that LBP will gracefully admit that their logic was faulty. I therefore offer LBP another alternative. One distinguished economist has already confirmed the validity of my critique of LBP [Williamson 2004]. I would be happy to accept any other reputable economist, to be mutually agreed upon by LBP and myself, to act as an arbiter of the disagreement between us.

References

Joshi, V (2003): ‘India and the Impossible Trinity’, The World Economy, Vol 26, No 4, pp 555-83.

– (2004): ‘The Real Exchange Rate, Fiscal Deficits and Capital Flows: A Refutation’, Economic and Political Weekly, Vol 39, No 13, pp 1434-36.

Joshi, V and S Sanyal (2004): ‘Foreign Inflows and Macroeconomic Policy in India’, India Policy Forum 2004, Brookings Institution and NCAER, Washington and New Delhi.

Lal, D, S Bery and D Pant (2003): ‘The Real Exchange Rate, Fiscal Deficits and Capital Flows: India 1981-2000’, Economic and Political Weekly, Vol 38, No 47, pp 4965-76.

– (2005): ‘Real Exchange Rate, Fiscal Deficits and Capital Flows: Erratum and Addendum’, Vol 40, No 16, pp 1650-55.

Williamson, J (2004): ‘Comments’, India Policy Forum 2004, Brookings Institution and NCAER, Washington and New Delhi.

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