The Hindu Business Line : Inflation is likely to remain high in the near term

Capital account convertibility should be an important policy goal and the sooner it is achieved the better. But nevertheless you have to move towards that goal carefully.

DR MANSOOR DAILAMI, MANAGER, INTERNATIONAL FINANCE, DEVELOPMENT PROSPECTS GROUP, WORLD BANK.

Dr Mansoor Dailami, Manager, International Finance, Development Prospects Group, World Bank, has been with the Bank for over two decades and is an expert on infrastructure development and finance, emerging bond markets, and emerging corporate finance. He was the lead author of the World Bank's Global Development Finance Report 2007, which tracks capital flow, both official and private, across the world. In Chennai recently to release the report, he spoke to Business Line on a range of issues confronting both the global and Indian economies.

Excerpts from the interview:

While some attribute the spike in crude prices to rising demand in India and China, others, especially the OPEC, blame the speculators. What in your opinion are the reasons behind the spurt?

There has been a combination of factors. I think the underlying factors are demand and supply. Demand from developing countries as whole, and not just from India and China, has been increasing because of high economic growth. There has been under-investment in the oil sector for a number of years. Production from OPEC countries has not increased much. In fact, it has declined in Mexico, and there have been some problems in Russia and Nigeria.

Also, the demand-supply balance in the market has become very sensitive to political events.

The devaluating dollar against major currencies has also to some extent affected oil prices, because historically the dollar and oil prices have had an inverse relationship.

There has been some evidence of speculation, but if you look at the trend in the New York or Chicago Mercantile Exchange it hasn't been unusual compared to the past. There is also the cyclical pattern in oil consumption, with demand increasing generally in summer. There is also the under-investment in the refinery side of the oil sector. So I feel that it's the combination of all these factors coming together.

Inflation, especially food and commodities, is another issue which has been hogging the headlines the world over. Why are these prices on the uptrend globally?

When it comes to commodities there is the cyclical factor. Prices tend to go up when there is a global economic boom. The 2003-07 period was one of significant global economic growth. Combined with that were the high liquidity in the global markets and low interest rates which contributed to high commodity prices. These are the cyclical components.

Underlying these cyclical factors were the structural factors, such as high growth in developing countries, especially in recent times.

In India an inflation rate of over 5 per cent is seen as being politically unacceptable. So for the central bank there is this tension of balancing growth and inflation. How do you think the central bank should grapple with this? Should it sacrifice growth in the short term to manage inflation?

I think this is a policy dilemma being faced by many other central banks around the world. To a large extent it has become a global phenomenon. We really are at the stage of the global business cycle which is slowing down. But the inflationary momentum is picking up in a number of countries. Therefore it is a global problem. But nevertheless this global problem has to be addressed at the national level. Each country has to have its own policy responses.

Let's not forget that we went through similar growth versus high inflation dilemmas in the 1970s and 1980s. But finally when there was political determination to really address inflation, it was done in a collective way beginning in the 1980s.

Since then, we had a period of 10-15 years where inflation worldwide came down significantly. Countries such as Turkey and many in Latin America, where they had hyperinflation for many years, managed to bring inflation under control. So in the historical perspective we have really won the bigger battle but nevertheless inflation in the current context is definitely an issue that needs to be addressed.

We cannot have long-term sustainable growth with high inflation. Obviously different countries have different tolerance levels of inflation, it's something which cannot be defined.

In the Indian context, the RBI has been very active in controlling inflation. But again many of the underlying factors driving inflation are not from the domestic side but from the external side. And it's very difficult to believe that monetary policy by itself in the national context can combat inflation.

So in my view it is very important to analyse to what extent the inflation is internal demand driven, which can be handled by internal monetary and other policy measures, and to what extent it is globally generated, which will take more time to bring it under control.

So my suggestion is to have two-tiered approach. One is to have the appropriate monetary and policy measures to handle the internal factors and the other is to handle the external factors/the global dynamics which are going to take sometime to work themselves out.

What is the near-term outlook on global inflation? Where do you see prices heading in the next one year?

I think we are already seeing some signs of easing of the commodity prices, part of it is because of the seasonal nature of these commodities. Part of it is also because of the medium-term cycle of the market, liquidity in the markets and financial conditions. But I think the longer-term factors are going to be with us.

So my prediction is inflation is going to remain high, but hopefully not in the current accelerated pace.

On capital account convertibility you have said in the past that without the requisite regulatory and institutional framework in place emerging economies would be putting themselves at risk. Do you think it is the right time for India to go ahead with capital account convertibility (CAC)?

I have been fortunate enough to be involved with the Indian economy over the last 10-15 years. It is delightful to see how India has come along over the years and addressed some of the policy issues in a gradual and conscious manner. I think this a feature of policy making in this country. I am aware of the institutional background. But I believe that CAC should be an important policy goal and the sooner it is achieved the better it would be. But nevertheless you have to move towards that goal in a very conscious and careful manner.

If you look at India's foreign exchange reserves they are at quite a comfortable level, covering more than a year's imports. But India's a very large economy with a vibrant corporate sector.

The financial sector too is large and vibrant, but not to the extent one expects of an economy of India's size. You need to develop a much deeper corporate bond market. This is important because with a developed bond market the corporate sector does not have to rely on the banking sector or the overseas market for funds.

But there are obviously concerns on the fiscal side. What is the level of fiscal deficit needed to prepare for CAC? There is no ready formula for this.

It is a decision to be made taking into account the benefits that CAC would provide. The main benefit is that it provides more assurance to investors, both domestic and foreign. And when you achieve CAC, it is a sign of confidence about the depth of your capital and financial markets, which the investor would take into account.

I have no doubt that with CAC the cost of capital for the Indian corporate sector would come down. It would be much easier for Indian banks to access international markets, the global inter-bank market. But then you do need to tread very carefully and have the requisite safeguards in place. Whether India is ready for CAC, it is difficult to say.

There is tremendous potential in the corporate sector and if this has to be tapped and utilised fully you need to give corporates here greater access to international capital markets not just in accessing finance and investing outside the country but also having the whole mechanism of hedging and risk management. These come through when you have CAC.

One of the findings of the `Global Development Finance Report of 2008' is the rise of private flows and the decline of official development assistance (ODA), what are the reasons for this?

Well ODA in 2007 was about $103.7 billion, in 2005 it was $107 billion. But if you look at the history of ODA you observe a spike in 2005 and 2006, partly because of the significant debt relief, particularly to Nigeria and Iraq. And that was pretty much confined to those two years. As the debt relief tapered off, ODA has come down to its long-term trend. So if you exclude debt relief you will see that the ODA has not come down.

On the other hand, you have many developing countries that in the past have relied on ODA but today have access to private capital markets. In the context of some low-income countries - in Africa - even in 2007 it was quite interesting to see that countries such as Ghana, Gabon and some banks in Nigeria could issue global bonds. And these bonds were extremely well received.

Therefore, the private market has shown the ability to price and to take the risk of low-income countries. Part of that interest from the private capital market in low-income countries' debt papers is because of the fact that debt relief has reduced the extent of debt in those countries quite significantly. Therefore from a creditors' point of view these countries are considered to be more credit worthy. But again the growth in these countries, which has been quite high, has also been a contributory factor.

But coming to ODA we have been making this point that there have been pledges made in the Montreal consensus of 2002, and we have made it clear in the GDF report that donor countries should affirm those pledges, particularly as we are now in the process of reviewing the Montreal consensus. In fact right now this is being done by the UN office of official development finance, and I participated in some of the discussions sometime ago in New York in the General Assembly.

conference of major heads of states on this issue is planned in Doha in November 2008, which would review the implementation of the Montreal consensus and see to what extent the goals and commitments have been achieved.

What are your views on the Michael Spence Commission's findings? Is there a growing realisation in mainstream thinking that the `Washington consensus' is breaking down?

I think the Commission's finding is a major development which is going to have a significant impact on the whole development discourse because it has taken quite some time to bring all the experts on growth together and study this from a long-term perspective. Therefore it's a major development.

The `Washington consensus' has already been reviewed, revised and reconsidered for many years now, much before this Commission was formed. So I don't think the Growth Commission's objective was to knock down the Washington consensus. This consensus unfortunately got a bad rap maybe because people thought that it was just a set of proposals coming out of the Bretton Woods institutions. What's important to recognise is that markets by themselves cannot solve all the problems. To a large extent the whole liberalisation that we have experienced in the 1990s under the so-called `liberal orthodoxy', whether it was in developed or developing countries, to move away from certain government controls, unnecessary regulations. These have contributed significantly to the current growth, probably more in India than any other country.

But if you look at the larger picture what you really need is a kind of partnership between the public and private sectors. And this partnership should not be confined only to the infrastructure sector but also in the overall economic management and growth process.

I think from that point of view the Growth Commission has hopefully helped resolve this ongoing debate on the role of the state. There is a legitimate role for state in the overall economic management and the overall growth.

You were in India in the summer of 1991 when there was a major crisis in the economy and the new Government, under the then Finance Minister, Dr Manmohan Singh, ushered in the era of reforms. Can you share some of your experiences from that time when policymaking in India underwent some radical changes?

For me personally observing how India succeeded in reforming from those particularly difficult days of 1991 to today, when the growth is around 8-9 per cent, has probably been one of the most joyful occasions. It confirms the fact that when you do take the right policy measures and when you put in place the right institutional framework, you move ahead. Good policies pay off even in a country as politically complex as India where there are a lot of people who have said in the past that there is no way the country can grow beyond the `Hindu rate of growth (3-3.5 per cent). At that time I had the firm conviction that India could grow at a higher rate. If you put in place the right policies, address the infrastructure bottlenecks you could lift the country to a higher plateau of growth and I am very happy to see that has been achieved.

India has its own way of policymaking which is obviously embedded in the political and cultural aspects of the country. But, at the same time, India, having proved to the world that despite its political and cultural complexities, can grow at a higher rate. India should be proud of its recent economic achievements and should tell the rest of the world that good policies do pay off.

They are many countries which are sceptical of change, sceptical of reform, and that's quite natural. India can be a role model to such countries. Reform is not just about political consensus, more than anything else it is a question of conviction and confidence.

Before reforms, the entire regulatory framework in India was set up to save one dollar of imports than to earn one dollar in exports.

When you change that frame of reference it's much easier earn a dollar from exports than to save one dollar from imports. It is very heartening to see exports were close to $160 billion last year. The exports just from the IT industry today are higher than the total exports in 1991.

So the future of India is very bright: given the human capital talent, given the political stability, given the institutional framework, given the democratic framework, which are very much ingrained in the system, and given the vibrant corporate culture.

So the time has arrived for India to articulate its achievements, not just within the country, which is already happening in the form of the continuous debate on these issues in the media and in academic circles.

Compared to 1991 the image of India in the world has changed significantly and I can see that. Back in 1991 foreign investors were very wary to invest in India but today they are competing with each other to enter India. They are much more open to invest directly, to use India as a hub to export to other countries, and to have collaboration with Indian companies, etc.

For India, the next challenge is to manage the process of globalisation. At the same time it should also aim to influence the debate on globalisation at the global stage.