XVI CUB Shri V Narayan Memorial Lecture by Dr T V Somanathan, IAS, Finance Secretary, Govt of India
Architecture is a scientific discipline. The word architecture evokes a sense of planning, order and form. There are many styles of architecture—Victorian, Mughal, Chinese, Chettinad, Gothic and so on. Each has some distinct and identifiable features, which most common people and certainly connoisseurs can identify. From approximately 1944, there was a certain pattern of economic arrangements, which could reasonably be termed an economic architecture. There were the three blocks of economies in the world: the first world that had the market or capitalist countries; the second world, which had the communist countries; and then the third world, which had countries like India, that were generally poor, either under colonialism or recently decolonised. The first world’s institutional structure was also the one that the third world willy-nilly had to conform to or be part of. We were not actually the ones designing our architecture.
The Bank and the Fund
In that architecture, there were the so-called Bretton Woods twins, which were the World Bank or The International Bank for Reconstruction and Development, and The International Monetary Fund (IMF) known colloquially as the Bank and the Fund. These were the first creations post the World War, though they were created slightly before the end of the Second World War.
Apart from these two, there were several other powerful, well-funded, UN specialised agencies such as the UNICEF, UNESCO, The Food and Agriculture Organization (FAO), the World Health Organization (WHO) and so on. But there was a difference. In the Bank and the Fund, the governance structure was not ‘one country, one vote.’ It was one dollar of share capital and one vote, which is similar to that of a private sector company. In the other UN specialized agencies, it was one country, one vote.
So in the Bank and the Fund, the richer countries had bigger shareholdings and hence a bigger say. The disadvantage of this structure was that the third world’s views were not given due importance. The advantage was that the first world countries funded these organisations amply, because they were confident of their ability to control the organizations they funded. Quite naturally, the western donor countries were much more comfortable with the Bank and the Fund and also with UNESCO, UNICEF, WHO and FAO.
The funding levels of these two sets of agencies, though they were approximately on par initially, diverged enormously over the years. While these two became very powerful, the other UN specialised agencies were continuously strapped for budgets. It is all very well for someone to say that I want to be an equal member of an organization. It is sometimes more useful to be an unequal member of a stronger organization.
The Role of GATT/WTO
The third important element in the global economic architecture was initially known as the General Agreement on Tariffs and Trade (GATT), which later was converted in 1995 into the World Trade Organization (WTO). In fact, during the Bretton Woods conference, it was agreed to create the World Trade Organization. It was supposed to be one of the three institutions that was to be created in 1944. But sufficient agreement was not reached on the shape of the WTO and it was created nearly 50 years later in 1995.
The GATT resulted in a steady reduction of tariffs across many countries between 1994 and the creation of the WTO. Customs duties on imports fell in a secular manner between 1945 and 1995 and fell even further after the creation of the WTO.
The three organizations—the World Bank, the IMF and GATT or later, the WTO—had a largely common set of beliefs on the methods by which developing countries should develop.
Some of these elements were known as the Washington Consensus and these included that a) countries should have free trade with little or no tariff barriers; b) there should be free flow of capital across national boundaries; c) there should be flexible exchange rates; d) there should be a market or market driven economy in all of these countries; and that would be the best way forward for development.
In some cases, these beliefs were held more strongly than warranted by either theoretical foundations or empirical evidence. In some cases, they were sound prescriptions. Thus, they were a mix of some very well-established sound prescriptions of universal application and some which are more debatable.
However, the strength of the institutions which backed the Washington consensus meant that many countries in the developing world did follow the advice and prescriptions, albeit to a greater or lesser degree without necessarily having to test each of those principles for their actual correctness or relevance in the circumstances of each of those countries.
Apart from these global institutions, there were regional institutions of considerable importance, such as the European Economic Community, as it was known then and which later became the European Union. Similarly, there were institutions like the CFA franc in Western Africa, which was anchored by France. They had a currency union between the French franc and the CFA franc. The CFA franc was tied at a specific parity to the French franc.
So effectively these countries were running a French franc currency area and so they didn’t have control over the monetary policy. Their interest rates were decided in Paris for most of the ex-French West Africa. Similarly, there was an Organization of African Unity that became the African Union. However, many of these regional institutions, with the exception of the European Union, lacked longevity and influence.
India in Bretton Woods
The founding of the Bretton Woods institutions roughly coincided with the peak of India’s struggle for Independence. The gap between their founding and Indian independence was about three years. It is not known to many people that India was a participant in the Bretton Woods conference in Bretton Woods, New Hampshire and British India was represented by Shri K Shanmugam Chetty. So we were there, even though we were not independent.
This year, we mark the 75th year of India’s independence and it’s also approximately 78 years since the start of what can be termed the post-WWII economic architecture. The architecture established then, remained largely intact for over six decades. It was strengthened by the collapse of the Soviet Union in 1991 and the subsequent admission of erstwhile communist countries into that architecture. It was further strengthened by the admission of the People’s Republic of China which was not even a member of the United Nations for the first 40 to 50 years of its existence, but it was admitted later.
Success Leads to Overconfidence
In 1995, China became a member of the WTO. Viewed from its results till the turn of the century, that is till 2000, one could consider the post-war economic architecture largely to be a success, because many countries moved from poverty to prosperity; others moved from dire poverty to less poverty. The proportion of poor people in the world declined dramatically. A large numerical share of that decline was in China and India. But there was a decline in many other countries too. Some countries, however, have worsened between the 1940s and now but they are very few.
The confidence that was generated by the fall of the Soviet Union and the admission of China into the international trade and currency systems, instead of generating more confidence, led to a level of overconfidence. The western regulators and central banks, among others, started to deregulate much further. This philosophy received a big jolt in 2008 when we had the global financial crisis. It showed up the weaknesses of the extreme deregulation version of the post-war economic architecture.
It led to a re-examination of that architecture but it did not fundamentally change it. Nobody felt that the architecture was fundamentally flawed. It looked like there were a few excesses here and there.
IMF’s Change in Thinking
The other thing that happened during the aftermath of the global financial crisis was a change in the thinking of the IMF. Till then, when countries ran into serious economic problems, they were the major advocates of austerity.
Whether by coincidence or not, when Europe in 2011 to 2013, faced severe economic problems and when there was a chance of Greece dropping out of the Eurozone and when Italy and Portugal were also in serious trouble, in terms of their ability to service their debts, the IMF, which is traditionally headed by somebody from the European Union, changed its philosophy and did not advocate austerity as the solution.
Then we had a series of other events between 2008 and 2012. There was an unprecedented level of monetary expansion. Creation of money was given a new term—Quantitative Easing (QE). The labelling changed but it was typically what old textbooks would have called, creating money or injecting money supply. When this massive expansion happened, it seemed to settle things down. A lot of things calmed down and the crisis receded. The worst was over and a lot of new things started, including startups and crypto.
Free Trade gets Trumped
By 2016, another set of challenges emerged. The US began to retaliate under new political leadership, against what it saw as manipulation of world trade rules by China and therefore, it imposed measures, which were in classic WTO terms could be called protectionist. I am not making any value judgment on the correctness or wrongness of their action. The United States, which was the prime mover of free trade and in whose country, the so-called Washington consensus used to reside, began to impose unilateral trade restrictions on imports from China. Then came the completely unexpected exogenous event, which was Covid. It brought trade to a screeching halt across countries and exposed the risks of highly decentralized supply chains that had enabled and expanded free trade post-WTO. Optimization of costs became possible because of low tariffs and free trade system. It brought consumer prices down for a lot of people including citizens of India. Many things have not changed much in spite of inflation thanks to the supply systems which are extremely efficient. But they depend on continuation of free trade, open markets, free-flowing shipping lanes and air traffic and so on.
Covid Shows the Mirror to the World
What Covid did is to show the world that all of these are man-made devices and that they can collapse. They all collapsed at the same time. There were no ships and factories were not working. People didn’t have even toilet paper.
When Covid ended, things began to perhaps recover but it had done the damage. It had damaged the belief that this is the ideal system; that there is one country in the world, which is the global manufacturing hub and everybody else supplies components to that hub and everything gets shipped from that hub to everywhere else. This hub-and-spoke model and the free flow of capital that it enabled began to suddenly seem not so optimal and that it was vulnerable. Then came the other one—the Russo-Ukraine war, which happened in late February 2022.
The Covid, Galwan and Russia-Ukraine war have created profound effects on the way the government of India has to manage its finances. The war and the western reaction to it have again upset a lot of widely held assumptions about how the global economy functions.
Western countries for centuries have been a bastion of property rights. Confiscation, expropriation and nationalisation without adequate compensation were all roundly condemned. It was always emphasised that there is a need for due legal process before any such thing happens and it cannot arbitrarily be taken.
Confiscation and expropriation were known features of communist states and not of capitalist states. Yet today, confiscation of movable and immovable properties of some persons, of certain nationalities happened in those countries without legislation and without following the principles of natural justice, which used to be held as self-evident.
Freezing of Currency Reserves
Another feature of the recent economic changes has been the unilateral freezing of foreign currency reserves of certain countries. That in turn, in certain cases, has created a risk of those countries defaulting on their sovereign bonds. You have a country which is a borrower in sovereign bonds. It is solvent, willing to repay its bonds but it is not allowed access to the currency it needs to repay those bonds. Therefore, it could technically be in default and if it is in default, there are serious consequences to defaulting on a bond, especially a sovereign bond.
None of these actions are based on any UN resolutions. I am not criticizing the decisions of any of these countries. They were taken in exceptional circumstances and it is quite normal. Let us accept that. But they should now realise that it is quite normal for other countries also to act in their own best national interests.
When it comes to a crisis, long held principles are sometimes not followed. It is no longer sufficient to assume the prevalence of a particular architecture or of a particular set of rules or ways in which the global economy functions.
We need to rethink our own policies, for example, on the composition and location of our foreign exchange reserves or the desirability of issuing dollar bonds by the government of India. There are multiple views on these but the point is, one has to think afresh. After all, it’s a new world. It’s not the world that we thought we lived in.
So, with all this, what is the situation today? Let me pick a few points selectively.
The China-Russia Factor
China and Russia have de-facto formed a new economic block among them. There’s a lot of Russo-Chinese or Sino-Russian trade. Most of it is not denominated in US dollars. It is largely Yuan denominated and some of it is Rouble denominated.
The US and Western Europe are closer to each other, than they have been for decades. They are systematically detaching their economies from Russia and to a lesser extent from China. The US-Western Europe block is trying to pull away from the China-Russia bloc. Earlier in the WTO era, everybody was trying to trade with everybody else, as much as possible, whatever was the cheapest. That’s not the case now.
The economy of Europe is certain to suffer. Potential damage from their self-imposed withdrawal of energy sources from Russian oil and gas will be damaging in the long run. They will recover but it will definitely take a long time because their huge dependence on Russian oil and gas cannot be solved overnight. The solutions involved are costlier purchases from more distant countries than Russia.
The economy of Russia is also certain to suffer because of the sanctions that have been imposed on them. Meanwhile, Brexit has weakened, at least numerically, the European Union and it has perhaps weakened Britain as well though. Again there are two views on whether it has weakened or strengthen them.
Less Talk in WTO
Free trade agreements are becoming much more prominent than the WTO negotiations. A lot of trade discussions happen between two sets of countries or between two countries and much less gets done in the WTO. Now, as a matter of principle, the multilateral WTO system is better because it gives you optimal results and doesn’t result in trade diversion.
What do I mean by trade diversion? If India enters into an economic free trade agreement with one country X, then any trade from that country becomes cheaper. But some other country Y may be more efficient at producing that product. Because I don’t have a free trade agreement, I end up buying from the more inefficient country. This is called trade diversion.
WTO enables trade creation and not trade diversion. Whatever is done, is done for everybody, but bilateral and these kinds of group arrangements do result in some suboptimal trade arrangements, though it may be better than not having an agreement at all.
The other feature of the present situation is the classic case of balance of payments crisis like the one we see in today’s Sri Lanka. But in this crisis, the role of the IMF has declined. The role of two countries—China and India in Sri Lanka’s economic crisis and its resolution as of today—has been greater than that of the IMF. I’m not saying that it’s a good thing but just observing that it has changed. The multilateral institutions that were the pillars of the 1944 order are not driving this particular crisis. It is something that we can see easily.
Therefore I would argue that what we have today is difficult to call an architecture. At best, it has the architectural look of an old locality in an old city, with a mix of structures of different ages, vintages and appearances. At worst, it has the chaotic architectural features of a slum. So it is this architecture that we are dealing with today. We actually have a lot of confusion in the global economic structure.
India Stands to Gain
But such chaos has benefits, particularly for a country, like India. So in the earlier architecture, India was not in the premier league. It was a second class citizen, without a permanent seat in the UN Security Council and classified as a borrower country, rather than an investing or lender country. India was peripheral to global decision-making. There is little to lose and much to gain for us, from the emerging architecture or lack of it.
Even if India does not do anything spectacular, even if we simply continue with our existing normal functionality and dysfunctionality that India has displayed consistently for the last 10 to 15 years, our relative position is almost certain to improve. If we continue growing at six to seven percent a year, we will be way ahead of many countries globally and our position will continue to improve substantially in this new system. We have to only ensure that we don’t do anything very bad and score self-defeating goals. We will improve, because others are worsening.
The Solar Alliance
Second and more positively, we have an opportunity to shape the emerging architecture now. A small but significant aspect is in the founding of the international solar alliance. Solar energy is going to be one of the key energy sources of the future. 100 years from now, it may be more important than oil. The international solar alliance is the first international organisation headquartered in India. It’s not a government of India organization.
Another example is India’s leadership in areas like unique identity and unique payment interface. These are technologies where we are ahead of even developed countries. A lot of developing countries are being advised on unique identity by the UIDAI. The UN agencies are taking the support of the Indian government in doing this in many developing countries. There will be many more things like this.
Need for Strong Domestic Economy
If India truly has to play a significant role in shaping the emerging global economy, then ironically, the most important challenge for us is domestic. We cannot shape the global order if we do not have a strong domestic economy. Paradoxically, our strength starts from here.
There are many steps which we need to take for our domestic economy to become strong. Gandhiji had talked about the role of drain inspectors. If I take such a view on Indian economy, I can dwell on a few of our weaknesses, so we can set them right. First and foremost, both state governments and central government need prudent and conservative fiscal policies. This is absolutely critical if we have to stay afloat and do well. We need to reduce our fiscal deficit, particularly at the central level. The Central deficit is much higher than at the state level.
We need to improve the quality of our public expenditure with a greater share for those aspects of public expenditure which promote growth. To do this, we will have to reform some of our poorly targeted subsidies such as those in electricity and fertilizer, without which we cannot improve the quality of our public expenditure. There are no quick fixes in this task. It will be difficult but it needs to be done and it calls for a lot of introspection.
We must have a tight control over public expenditure. The other way is to increase our tax revenue but nobody wants tax increases. Nobody wants any subsidy to be reduced and yet everybody wants fiscal deficit to be reduced. So, this is our trilemma which we face every day. This is a very difficult balancing act. The governments and the people inside governments need help from people in telling us how to solve this and coming up with workable solutions. The reduction of fiscal deficit is the single easiest way to increase the domestic savings rate. If you want India’s savings rate to go up, you need to cut the fiscal deficit.
Managing External Shocks
Second, we need to minimize the vulnerability of our economy to external shocks. This means, we need to avoid taking too much external debt, and especially debt denominated in foreign currencies. All kinds of external debt have consequences.
We may need to think about diversifying of foreign exchange reserves, including an increase in the share of our gold. Now, as an aside, Indians are often criticised for an apparently irrational attachment to gold but the Ukraine conflict and the various currency restrictions have shown the value of gold, which is not dependent on any sovereign; and which can be portably carried from one place to another. This perhaps gives us some sense of a deep civilizational experience as to why Indians have always wanted to keep a little bit of gold. I’m not making a plea for you to invest in gold. I am only talking about India’s gold reserves.
Third, we need to foster a strong domestic investment climate. We need to achieve the right balance in regulation, between preventing harm and promoting good. Regulation is always a tension between these two intentions. Too often, well-intentioned regulations have stifled innovation and growth. We have a long way to go in reducing compliance burden and we must reduce the harassment of businessmen for trivial mistakes or bonafide actions.
There is an assumption that the government and regulators will be unreasonable or maybe corrupt or both and there are enough examples to confirm some of these feelings. There is also an assumption that industry and investors will evade or cheat if they can. There are enough examples to confirm this assumption also. We need to get out of this trap. We look forward to practical suggestions from you on how we can rise above this.
Stay Away from Fashion
Fourth and last, India needs to exercise independence of mind in taking economic decisions. We need the courage to stay away or walk away from agreements that are not in our interest. Without harming others, we need to do what is in our interest. When India did not join the regional comprehensive economic partnership or RCEP, there was a lot of criticism that we are isolating ourselves from global trade. After two years, subsequent developments have shown that to be a wise decision.
Economics is a discipline which is subject to fleeting fashions. Massive fiscal stimuli were the fashion in 2020. India did not join that fashion. We had a restrained fiscal stimulus. Most of the relief measures were in the form of credit and monetary measures. We have emerged in reasonably good shape. Compared to most other countries, we have emerged in better shape. There was a lot of pressure on us to follow fashion. We need to resist fashion and assess things based on actual facts, circumstances, empirical evidence and the pros and cons. This has held us in good stead over the recent past. We will have to follow policies that work for our country and our circumstances.
My Wish List
To reach our potential, we need to improve in many dimensions. I would suggest that the future Indian economy should have ease of doing business of city-states like Singapore and Dubai; the financial, scientific and technical innovativeness of the US; the quality focus and work ethic of the Japanese; the manufacturing quality and process of the Germans; and the quality life of the Scandinavians. We need to do all this while preserving our unique strengths, including our cultural values and diversity, where every citizen is treated equally.
The old economic order is crumbling. India can become a global economic power only by having a powerful domestic economy and a peaceful and cohesive society.
(With kind courtesy—Sastra University and City Union Bank)