FDI

What is FDI?Foreign Direct Investment is the investment which is done in productive assets and participation in the management of the company as the stake holders by a company which is based in one country, into a company based in another country. Recently the cabinet said OK for 51% FDI in multi-brand retail sector & 100% FDI in single brand. Foreign Investment in India is governed by the FDI policy announced by the Government of India and the provision of the Foreign Exchange Management Act (FEMA) 1999. RBI also issues notifications which contains the Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000 and had been amended many times. The Ministry of Commerce and Industry, Government of India is the nodal agency for motoring and reviewing the FDI policy on continued basis.

Ways of investment?The investing company may make its overseas investment in a number of ways - Joint Ventures, merger, Franchising, Sourcing of Supplies from small-scale sector, Cash and Carry whole sale trading, Non-Store Formats, Strategic Licensing Agreements, either by setting up a subsidiary or associate company in the foreign country, by acquiring shares of an overseas company.The foreign retail chains will need to make very expensive real estate investments which may or may not be feasible in the long run.

Who are the target group for FDI?The people who prefer going to shopping malls instead of kirana shops constitute not a sizable percentage and who belong to affluent, upper middle and middle class. As such there is no immediate threat to the kirana shops or small venders, as they have their own share of customers with whom they share a special relationship.

Why only India?India has a population of nearly 1.2 billion, and many countries feel it as most alluring and thriving retail destination. Liberalization of trade policy and loosening of barriers and restrictions to the foreign investment in the retail sector of India, have made the FDI in retail sector quite easy and smooth. India being a signatory to World Trade Organisations General Agreement on Trade in Services, which include wholesale and retailing services, had to open up the retail trade sector to foreign investment. In 1997, FDI in cash and carry (wholesale) with 100 percent ownership was allowed under the Government approval route. It was brought under the automatic route in 2006. 51 percent investment in a single brand retail outlet was also permitted in 2006. India being an open economy with skilled workforces and good growth prospects tend to attract larger amounts of foreign direct investment among other growing and emerging markets.Advantages of FDI:1. There would be increase in revenue to the state exchequer in the form of taxes2. Counties which have shortage of funds for developmental activities would find it beneficial if they go for FDI thereby improving the country's "shunned sectors" -- infrastructure and logistics. So in order to grow faster and compete with the other countries foreign investment would turn out to be very fruitful.3. There would be increase in employment opportunities4. All multi brand products are available under one roof and there would be greater range and variety of products for sale and increased consumer choice5. Competitive spirit and good managerial skills would be introduced in the country6. Festival discounts would be available to the people7. Many under developed and developing countries will be benefited with the introduction of FDI.8. Best corporate and management practices would be introduced in the country9. Better usage and utilization of natural resources10. Helps in bridging infrastructural gaps (especially rural infrastructure) and technological hiccups.11. Services at large would be benefited to people belonging to urban and semi urban areas12. There would be improvement in the quality standards13. Acceptance of credit, debit and Sodexo cards also encourage the purchases in big shopping malls14. Permitting foreign investment in food-based retailing is likely to increase the capital flow into the country.15. Usage of latest technologies in the farming sector can improve farmers income (by reducing wastage of agricultural produce, enabling them to get better prices) & agricultural growth thereby lowering consumer prices inflation.16. By selling their goods directly to the foreign players would help the farmers in getting remunerative prices by their produce therefore reducing the long chain of intermediaries or middlemen.Disadvantages to FDI:1. Multi national companies require high investment, infrastructure facilities, packaging costs, advanced security system, high maintenance costs and very high variable cost of operation. And may be in the long run incurring huge losses.2. Many fear that a time would come when these MNCs making direct investments start dictating terms over the company into which the investment is made may influence the political system in the country. And many politicians felt allowing FDI in retail will push the country towards economic slavery3. Small vendors and hawkers feel that these big giants would badly affect the domestic industry, thereby affecting their livelihood.4. The items which these Multinational companies introduce in the market are beyond the competitive capacity of the small venders.5. Multi National Companies (MNC)s could generate meager employment opportunities that is to for selected professional people. Farmers would be affected due to monopolization of the MNCs, competition, loss of entrepreneurial opportunities and self employed indigenous retailers who provide employment to many will be forced to close down their shops as they unable to face the highly unhealthy competition from the MNCs6. Due to increase in multi brand products and increased purchasing power people are introduced to a new kind of lifestyle which they are not used to may force to change their lifestyle which may affect their future economically.7. Unlike in America where the shopping malls are in the outskirts of the city and the family shops for a month and it is considered as a family activity. Whereas in India food items are purchased in small quantities as many do not have adequate money to buy for a month nor do they have massive storage facilities at home. Unlike Americans, Indians do not drive miles and do bulk purchasing.In what way FDI is beneficial to farmers?The Indian Farmer and Industrial Alliance (IFIA), a joint venture of the Consortium of Indian Farmers Associations (CIFA), recognized the potential benefits of eliminating middlemen and has expressed its support for opening the retail sector to foreign investment.

Views against the FDI :1. Small traders feel they will not be able to withstand the competition. self employed indigenous retailers who provide employment to many will be forced to close down their shops, unable to face the highly unhealthy competition from the MNCs2. Some felt that the government should impose a blanket ban on foreign retailers from entering into retail trade

FDI in Retail Sector

What is Retail sector?In 2004, The High Court of Delhi defined the term retail as a sale for final consumption in contrast to a sale for further sale or processing (i.e. wholesale). The Retail Industry is the sector of economy which is consisted of individuals, stores, commercial complexes, agencies, companies, and organizations, etc., involved in the business of selling or merchandizing diverse finished products or goods to the end-user consumers directly and indirectly. A retailer is involved in the act of selling goods to the individual consumer at a margin of profit. Thus, retailing can be said to be the interface between the producer and the individual consumer buying for personal consumption.

According to the Investment Commission of India, the retail sector is expected to grow almost three times its current levels of $250 billion to $660 billion by 2015. The Indian Retail Industry is the 5th largest retail destination and the second most attractive market for investment in the globe after Vietnam as reported by AT Kearneys seventh annual Globe Retail Development Index (GRDI), in 2008 Retail sector contributes to maximum percentage of employment after agriculture. In spite of the recent developments retail sector is assumed to possess huge growth potential. The retail industry is mainly divided into:-

1) Organised and2) Unorganised Retailing

Organised retailing- refers to trading activities undertaken by licensed retailers, that is, those who are registered for sales tax, income tax, etc. These include the corporate-backed hypermarkets and retail chains, and also the privately owned large retail businesses. In India 97% of the business is done by organized sector.

Unorganised retailing - refers to the traditional formats of low-cost retailing, for example, the local kirana shops, owner manned general stores, paan/beedi shops, convenience stores, hand cart and pavement vendors, etc.

What is FDI in Multiple brand retail?Multiple brand retail means selling the same product under different brand names. FDI in multi-brand retailing should be carefully monitored as there are chances that if left alone it can directly impact a large percentage of population and would ultimately deepen the gap between the rich and the poor. So in order to ensure development, it can be stipulated that a percentage of FDI should be spent towards building up of back end infrastructure, logistics or agro processing units, and reconstituting the poverty stricken and stagnating rural structure with at least 50% of the jobs in the retail outlet should be reserved for rural youth.

What is FDI in Single brand retail?FDI in Single brand retail means that a retail store with foreign investment can only sell one brand. i.e. if a foreign brand want to sell its product in India then it has to sell its product with the same name rather using a new name. The main motive to introduce such a policy was to enable Indians to spend the money on the same goods in India which they spend on shopping abroad.Allowing 100%FDI in single brand retail would be of twin benefit to both the forging player and the Indian businessman as the foreign investor would develop knowledge and understanding of the Indian market. Whereas the Indian businessman would get to know about the global best management practices, designs and technological knowledge.

Advantages of Mom-and-Pop Retail outlets:1. Small kirana stores all available at almost every street in villages and cities and both seller and buyers share a special bondage because of proximity in living in same area which is absent in the big shopping malls.2. Kiranas are patronized by the local folks due to personalized human touch which is not available in the malls as they possess more of business oriented approach.3. Items can be purchased in small quantities4. Due to acquaintance with the people in locality the kirana shops allow credit for certain periods of time.5. These outlets are a place of discussions for many people6. Large Bargaining Power is available whereas in malls there is no scope for bargain.7. Not much of an investment is needed and can be established every where. Even in the front yard of the house a shop can be established whereas malls cannot be established every where as they need big space.8. Less manpower is required, less infrastructure and shops are generally established at a walk able distance.9. These are generally run by people of low income groups and it is a good source of self employment and an avenue for employment generation.10. There would be long operating hours, strong customer relations, convenience and hygiene.Disadvantages of Mom-and-Pop Retail outlets:1. Not much of range and variety of goods are available resulting in less choice2. Generally kirana stores are small and there is no scope for a good ambience

India and the Global Financial Crisis What Have We Learnt?

K.R. Narayanan Oration by Dr. Duvvuri Subbarao, Governor, Reserve Bank of India at the South Asia Research Centre of the Australian National University, Canberra on June 23, 2011

By all accounts the 2008/09 crisis has been the deepest financial crisis of our times. It has taken a devastating toll on global output and welfare. Arguably, the fundamental causes of all financial crises are the same - global imbalances, loose monetary policy and high levels of leverage driven by irrational exuberance. In that respect, this crisis has been no different.

5. Where this crisis has been different, however, is in its manifestation. Most recent crises had occurred in individual emerging economies or regions, and they were, at their core, traditional retail banking or currency crises. The countries in trouble could be rescued by multilateral interventions; besides, the advanced countries provided a buffer for trade and financial support. In contrast, this crisis originated in the most advanced economy, the United States, and hit at the very core of the global financial system. With virtually no buffers to fall back on, the crisis rapidly engulfed the whole world. Much to their dismay, emerging market economies too were soon pulled into the whirlpool.

How was India hit by the Crisis?India was no exception. We too were affected by the crisis. Output growth that averaged 9.5 per cent per annum during the three year period 2005/08 dropped to 6.8 per cent in the crisis year of 2008/09. Exports that grew at 25 per cent during 2005/08 decelerated to 12.2 per cent in the crisis year (2008/09) and declined by 2.2 per cent in 2009/10. In the pre-crisis years, we had capital flows far in excess of our current account deficit. In contrast, during the crisis year, net capital flows were significantly short of the current account deficit and this put downward pressure on the rupee. The exchange rate depreciated from ` 39.37 per dollar in January 2008 to ` 51.23 per dollar in March 2009.

Notwithstanding our sound banking system and relatively robust financial markets, India felt the tremors of the tectonic shocks in the global financial system. The first round effects came through the finance channel by way of sudden stop and then reversal of capital flows consequent upon the global deleveraging process. This jolted our foreign exchange markets as well as our equity markets. Almost simultaneously, our credit markets came under pressure as corporates, finding that their external sources of funding had dried up, turned to domestic bank and non-bank sources for credit.

By far the most contagious route for crisis transmission was the confidence channel. For weeks after the Lehman collapse in mid-September 2008, everyday there was news of yet another storied institution crashing. In this global scenario of uncertainty, the lack of confidence in advanced country markets transmitted as hiccups to our markets too. The net result was that all our financial markets - equity, debt, money and foreign exchange markets - came under varying degrees of pressure. Finally, the transmission of the crisis through the real channel was quite straightforward as the global recession that followed the financial crash resulted in a sharp decline in export demand for our goods and services.

Why was India hit by the Crisis?There was dismay in India that we too were affected by the crisis, and this dismay arose mainly on two counts. First, the exposure of our banks to toxic sub-prime assets was marginal and their off balance sheet activities were limited, and so, the argument went, we should not have been affected by a financial sector crisis that originated from these causes. Second, Indias growth is driven by domestic demand and a drop in external demand, it was contended, should have caused no more than a small dent in output growth. Yet the crisis hit us, and did so more ferociously than we thought possible. The reason for this is globalization: India is more integrated into the global system than we tend to acknowledge. Let me illustrate that point with some broadbrush numbers.

Indias two way trade (merchandize exports plus imports), as a proportion of GDP, more than doubled over the past decade: from 19.6 per cent in 1998/99, the year of the Asian crisis, to 40.7 per cent in 2008/09. Note that global trade declined by 11 per cent in 2009 as a result of the crisis in contrast to a robust average growth of 8.6 per cent during the previous few years 2004/07. Such a sharp collapse in world trade had an impact on our export demand demonstrating that our trade integration was quite deep.

If our trade integration was deep, our financial integration was even deeper. A measure of financial integration is the ratio of total external transactions (gross current account flows plus gross capital account flows) to GDP. This ratio had more than doubled from 44 per cent in 1998/99 to 112 per cent in 2008/09 evidencing the depth of Indias financial integration. In sum, the reason India was affected by the crisis, despite mitigating factors, is its deepened trade and financial integration with the world.

Managing GlobalizationWhat the experience of the crisis demonstrated clearly was the power of globalization. Globalization is a double edged sword; it opens up incredible opportunities but also poses immense challenges. India surely benefitted from opening up to the world but had also incurred costs on that count. The challenge for India, and indeed for all Emerging Market Economies (EMEs), is really to minimize the costs and maximize the benefits of globalization.

Lessons of CrisisA lot is being written about how this crisis has been too important to waste, how we should learn the lessons of the crisis and apply them in a Schumpeterian creative destruction mode. Some people have, however, questioned the wisdom of drawing lessons even before the crisis is fully behind us. When Zhou Enlai, former Chinese Prime Minister, was asked what he thought of the French Revolution, he said it was too early to say. Historians who take a long view may agree with Zhou Enlai but practical policy makers do not enjoy that luxury. So, let me use the opportunity of this platform to draw out eight big picture lessons of the crisis.

Lesson 1: In a globalizing world, decoupling does not workThe crisis challenged many of our beliefs, and among the casualties is the decoupling hypothesis. The decoupling hypothesis, which was intellectually fashionable before the crisis, held that even if advanced economies went into a downturn, EMEs would not be affected because of their improved macroeconomic management, robust external reserves and healthy banking sectors. Yet the crisis affected all EMEs, admittedly to different extents, bringing into question the validity of the decoupling hypothesis.

15. Some analysts argue against such an outright dismissal of the decoupling hypothesis and suggest a more nuanced evaluation. Recent IMF research2 in fact illustrates that the transmission of distress from advanced economies to EMEs took place in three distinct phases. The first phase runs from the time early signs of the crisis appeared in mid-2007 till the Lehman collapse in September 2008. During this period, the growth performance of EMEs outshone that of advanced economies indicating decoupling. The second phase, starting with the Lehman collapse till the first quarter of 2009 was one of recoupling when advanced economies pulled EMEs too into the downturn. The third phase started in the second quarter of 2009 when EMEs started recovering from the crisis ahead of advanced economies suggesting a shift once again to decoupling.

So, have EMEs decoupled from the advanced economies? The answer has necessarily to be nuanced. A useful way to visualize decoupling in the wake of the crisis is to distinguish between trend and cycle decoupling. Trend decoupling is reflected by the widening gap between the trend rates of growth of EMEs and of advanced economies. This is evidently owing to the growing weight of domestic factors, mainly consumption, in the EMEs growth process. However, given that there is still significant integration between the two groups of countries, cycles are still coupled. From a lessons perspective, what this means is that EMEs should focus on strengthening domestic drivers of demand and instituting automatic stabilizers to buffer themselves against cyclical shocks from advanced economies.

Lesson 2: Global imbalances need to be redressed for the sake of global stabilityNo crisis as complex as this has a simple or a single cause. In popular perception, the collapse of Lehman Brothers in mid-September 2008 will remain marked as the trigger of the crisis. At one level that may well be true. Indeed, I can visualize future text books in finance dividing the world into before Lehman and after Lehman. But if we probe deeper, we will learn that at the heart of the crisis were two root causes - the build up of global imbalances and developments in the financial markets over the last two decades. And received wisdom today is that these two root causes are interconnected, and that financial market developments were in a sense driven by the global imbalances. Global macro imbalances got built up because of the large savings and current account surpluses in China and much of Asia in wake of the East Asian Crisis a decade ago. These were mirrored by large increases in leveraged consumption and current account deficits in the US. In short, Asia produced and America consumed. Between the US consumption boom and the Asian savings glut, there is a raging debate on what was the cause and what was the effect. Regardless, the bottom line is that one was simply the mirror of the other and the two share a symbiotic relationship.

And how did these imbalances build up? The answer lies in globalization - globalization of trade, of labour and of finance. The world witnessed a phenomenal expansion in global trade over the last three decades; global trade as a proportion of global GDP increased from 34 per cent in 1980 to 51 per cent in 2007, just before the crisis hit us.3 Globalization of finance was even more prolific, especially over the last decade. For the world taken together, the ratio of foreign assets and foreign liabilities to GDP rose from 133 per cent in 1994 to over 300 per cent in 2008.4 The impact of globalization of labour was by far more striking. Emerging Asia added nearly three billion to the worlds pool of labour as it integrated with the rest of the world over the last two decades thus hugely improving its comparative advantage. Together, the three dimensions of globalization - trade, finance and labour - helped emerging Asia multiply by a factor its exports to the advanced economies. The result was large and persistent current account surpluses in the Asian economies and corresponding current account deficits in the importing advanced economies.

The chain of causation from these imbalances to the financial crisis is interesting although not obvious. As Asia accumulated savings and simultaneously maintained competitive exchange rates, the savings turned into central bank reserves. Central banks, in turn, invested these savings not in any large, diversified portfolio but in government bonds of the advanced economies. This in turn drove down risk free real interest rates to historically low levels triggering phenomenal credit expansion and dropping of the guard on credit standards, erosion of credit quality and search for yield, all of which combined to brew the crisis to its explosive dimensions.

It is argued that if the US Fed had refused to supply the incipient demand for liquidity in the late 1990s and early 2000s, higher interest rates could have prevented the borrowing boom and the follow on widespread deterioration of financial standards and the subsequent melt down. But this also would have meant lower growth in the US and the rest of the world. The short point is that even as macroeconomic imbalances should not be allowed to proliferate, it is necessary to balance the need for global economic growth against the disruptions which follow the unwinding of such imbalances.

So, where do we go from here? The G-20 is now actively engaged in the challenging task of redressing structural imbalances in the global economy. At their Pittsburgh Summit in September 2009, the G-20 leaders agreed on a Framework for Strong, Sustainable and Balanced Growth and committed to a Mutual Assessment Process (MAP) which is a peer review of each countrys progress towards meeting the shared objectives underlying the framework. Recognizing that global imbalances which had narrowed during the crisis started widening again in the exit phase, driven mainly by the uneven recovery around the world, the G-20 resolved that promoting external sustainability should be the focus of the next stage of the MAP and entrusted this task to a Framework Working Group (FWG). India is privileged in co-chairing, together with Canada, the FWG for managing the task of developing the indicative guidelines for assessing and addressing persistent global imbalances. The FWG has adopted a two-stage approach: a limited number of indicators will guide the initial assessment process, while a broader set - including qualitative ones - will be used in the second stage to inform an in-depth external sustainability assessment. The success of this initiative is critical for redressing the problem of global imbalances.

Lesson 3: Global problems require global coordinationThe crisis demonstrated the interconnectedness of the world through trade, finance and confidence channels. What originated as a bubble in the US housing sector soon snowballed into a crisis and radiated in two different ways - first, in a geographical sense, from the US to other advanced economies and then to the rest of the world; and second, in a sectoral sense, from housing to all productive sectors. Even as each country started dousing the fires on its own, it was soon realized that the effort was in vain and that global coordination is a necessary condition for managing a global crisis.

From that perspective, the London G-20 Summit in April 2009 will go down in history as a clear turning point when the leaders of the world showed extraordinary determination and unity. Sure, there were differences, but they were debated and discussed and compromises were made without eroding the end goal - that is to end the crisis. This resulted in an agreed package of measures having both domestic and international components but all of them to be implemented in coordination, and indeed in synchronization where necessary. The entire range of crisis response measures - accommodative monetary stance, fiscal stimulus, debt and deposit guarantees, capital injection, asset purchases, currency swaps - all derived in varying degrees from the G-20 package.

Now, as we exit from the crisis, there are concerns and apprehensions that the vaunted unity that the G-20 had shown during the crisis is dissipating. But might it also be a tad unrealistic to expect the degree of unity shown in managing the crisis to also be shown in addressing peace time issues? The focus of G-20 now is to flesh out the agenda for economic and financial restructuring at national and international levels so that the world can prevent, or at any rate minimize the probability of, another crisis of the type we have gone through. Differences of opinion, when the agenda is so broad, are not only to be expected, but may in fact have a positive influence in determining what is collectively optimal.

The common thread running through the entire G-20 agenda is the need for global cooperation in solving our most pressing problems of today. The crisis has taught us that no country can be an island and that economic and financial disruptions anywhere can cause ripples, if not waves, everywhere. The crisis also taught us that given the deepening integration of countries into the global economic and financial system, uncoordinated responses would lead to worse outcomes for everyone.

The global problems we are facing today are complex and not amenable to easy solutions. Many of them require significant and often painful adjustments at the national level. Because short-term national interests conflict with globally optimal solutions, it is quite understandable that there are differences of views within the G-20. We must remember though that in a world divided by nation-states, there is no natural constituency for the global economy. At the same time, the global crisis has shown that the global economy as an entity is more important than ever and that global coordination to solve global problems is critical.

Lesson 4: Price stability and macroeconomic stability do not guarantee financial stabilityThe years before the crisis were characterized by steady growth and low and stable inflation in advanced economies and rapid growth and development in EMEs. The so called Great Moderation prompted a growing consensus around the view that the best practice in monetary policy framework is the pursuit of a single target (price stability) by means of a single instrument (short term policy interest rate). The success of the Great Moderation fortified the argument that price stability is a necessary and (a nearly) sufficient condition for economic growth and for financial stability. Central bankers believed they had discovered the holy grail.

That sense of triumph was deflated by the unravelling of the crisis. As the global financial sector came to the brink of a collapse even in the midst of a period of extraordinary price stability, it became clear that price stability does not necessarily guarantee financial stability.

Indeed the experience of the crisis has prompted an even stronger assertion - that there is a trade off between price stability and financial stability, and that the more successful a central bank is with price stability, the more likely it is to imperil financial stability. The argument goes as follows. The extended period of steady growth and low and stable inflation during the Great Moderation lulled central banks into complacency. Only with the benefit of hindsight is it now clear that the prolonged period of price stability blindsided policy makers to the cancer of financial instability growing in the underbelly.

A dominant issue in the wake of the crisis has been the role of central banks in preventing asset price bubbles. The monetary stance of studied indifference to asset price inflation stemmed from the famous Greenspan orthodoxy which can be summarized as follows. First, asset price bubbles are hard to identify on a real time basis, and the fundamental factors that drive asset prices are not directly observable. A central bank should not therefore second guess the market. Second, monetary policy is too blunt an instrument to counteract asset price booms. And third, central banks can clean up the mess after the bubble bursts. The surmise therefore was that the cost-benefit calculus of a more activist monetary stance of leaning against the wind was clearly negative.

The crisis has dented the credibility of the Greenspan orthodoxy. The emerging view post-crisis is that preventing an asset price build up should be within the remit of a central bank. Opinion is divided, however, on whether central banks should prevent asset bubbles through monetary policy action or through regulatory action. On one side, there is a purist view questioning the efficacy of resorting to monetary tightening to check speculative bubbles. Opposed to this is the argument that a necessary condition for speculative excesses is abundant liquidity, and that controlling liquidity which is within the remit of monetary policy should be the first line of defence against irrational exuberance. No matter how this debate settles, a clear, if also disquieting lesson of the crisis is that price stability and macroeconomic stability do not guarantee financial stability.

Lesson 5:Micro prudential regulation and supervision need to be supplemented by macro prudential oversight The crisis has clearly demonstrated that a collection of healthy financial institutions does not necessarily make a healthy financial sector. This is because there are complex interconnections in the financial sector across banks, other financial institutions, markets, and geographies and a problem in any part of the system can rapidly transmit through the system, cascade across layers and develop into a crisis. Systemic safety can also be jeopardized by procyclicality. As the crisis demonstrated, there is a strong collective tendency among financial entities to overexpose themselves to the same type of risk during an upturn and become overly risk averse during a downturn. Importantly, individual institutions, and indeed microprudential oversight too, fail to take into account the spillover impact of the actions of the rest of the financial system on them. This raises the paradox of the fallacy of composition. What is good from an individual institutions point of view can become disruptive, and even destructive, if all institutions act in a similar way.

That a bubble that started in the US housing sector snowballed into a major crisis is a vivid illustration of the risks arising from the interconnectedness of the global financial system and the risks of procyclicality. The lesson clearly is that as much as microprudential supervision is necessary, it needs to be supplemented by macroprudential oversight to prevent systemic risk building up.

Macroprudential oversight requires both analytical sophistication and good judgement. Regulators need to be able to analyze the nature and extent of risk and be able to make informed judgement on when and what type of countercyclical buffers they must impose. Both type I and type II errors - imposing buffers too early out of excessive caution or delaying imposition of buffers till it is too late to avert an implosion - can be costly in macroeconomic terms.

Lesson 6:Capital controls are not only unavoidable, but advisable in certain circumstancesAs EMEs started recovering from the crisis earlier than advanced economies, they also began exiting from the crisis driven accommodative monetary stance ahead of the advanced economies. This multi-speed recovery and the consequent differential exit have triggered speculative capital flows into EMEs resulting in currency appreciation unrelated to economic fundamentals. This poses complex policy management challenges. Currency appreciation erodes export competitiveness. Intervention in the forex market to prevent appreciation entails costs. If the resultant liquidity is left unsterilized, it could potentially fuel inflationary pressures. If the resultant liquidity is sterilized, it puts upward pressure on interest rates which not only hurts competitiveness, but also, in a curious variation of the Dutch disease, encourages further flows.

Capital inflows far in excess of a countrys absorptive capacity could pose problems other than currency appreciation. Speculative flows on the look out for quick returns can potentially lead to asset price build up. Also, in the current juncture, one of the driving forces behind hardening commodity prices in recent months is the excess liquidity in the global system which has possibly triggered financialization of commodities.

Quite unsurprisingly, the old debate about whether capital controls are a legitimate policy option has resurfaced again. This debate has traditionally frowned on moderation. Critics maintain that capital controls are distortionary, largely ineffective, difficult to implement, easy to evade and that they entail negative externalities. On the other hand, supporters of capital controls argue that controls preserve monetary policy autonomy, save sterilization costs and tilt the composition of foreign liabilities toward long-term maturities and ensure macroeconomic and financial stability.The debate on capital controls resurfaced after the Asian crisis of the mid-1990s, especially as one of the root causes of the crisis was the open capital accounts of the East Asian economies. However, as the Asian economies recovered in quick order, regained their export competitiveness and started building up external reserves for self-insurance, the debate was not pursued to its logical conclusion, and the orthodoxy that capital controls are undesirable persisted.

The recent crisis has, however, been a clear turning point in the worldview on capital controls. Notably, the IMF put out a policy note in February 2010 that reversed its long held orthodoxy that capital controls are inadvisable always and everywhere. The note has referred to certain circumstances in which capital controls can be a legitimate component of the policy response to surges in capital flows. The World Bank and the Asian Development Bank Outlook - 2010 too echoed these views.

A useful way of assessing the capital account management of an EME is to draw a distinction between strategic and tactical controls. Strategic controls would involve defining a long term policy indicating the inter se preference, or the hierarchy of preferences as it were, across different types of capital flows and the controls that will be deployed to operationalize that policy. Strategic controls give stakeholders a clear and predictable framework of rules to make informed choices and to manage risks, and they give policy makers sufficient levers to calibrate the flows; in essence they define the boundaries of the playing field. Tactical controls, on the other hand, introduce barriers into the playing field itself. They are deployed opportunistically to stem a surge in inflows or outflows. By their very nature, tactical controls introduce a new element of uncertainty into the calculations of both domestic and foreign stakeholders. Indias approach to capital account management is typically strategic. For example, we have an explicitly expressed preference for long term over short term flows and equity over debt flows, and we have used both price based and quantity based controls to operationalize this policy. We have, of course, periodically recalibrated elements of the strategy in pursuit of capital account liberalization. An important lesson from Indias experience is that even with relatively large swings in capital flows during the crisis, the pressure to use tactical controls did not build up because the strategic controls provided automatic buffers.

Even as we debate what EMEs should or should not do to manage excess capital flows, we should remember that to the extent that lumpy and volatile flows are a spillover from policy choices of advanced economies, managing capital flows should not be treated as an exclusive problem of emerging market economies. How this burden is to be shared raises both intellectual and practical challenges. The intellectual challenge is to build a better understanding of the forces driving capital flows, what type of policy instruments, including capital controls, work and in what situations. The practical challenge is the need to reach a shared understanding on a framework for cross border spillovers of domestic policies in capital-originating countries, and the gamut of policy responses by capital receiving countries.

Lesson 7: Economics is not physicsA few months into the crisis, the Queen happened to be at the London School of Economics and asked a perfectly sensible question: how come none of the economists saw the crisis coming. The Queens question resonated with people around the world who felt that they had been let down by economics and economists. As economists saw their profession discredited and their reputations dented, the economic crisis soon turned into a crisis in economics.What went wrong with economics? It now seems that by far the most egregious fault of economics, one that led it astray, has been to project it like an exact science. The charge is that economists suffered from physics envy which led them to formulate elegant theories and models - using sophisticated mathematics with impressive quantitative finesse - deluding themselves and the world at large that their models have more exactitude than they actually did. Admittedly, in a limited sense there may be some parallels between economics and physics. But similarity in a few laws does not mean similarity in the basic nature of the academic discipline. The fundamental difference between physics and economics is that physics deals with the physical universe which is governed by immutable laws, beyond the pale of human behaviour. Economics, in contrast, is a social science whose laws are influenced by human behaviour. Simply put, I cannot change the mass of an electron no matter how I behave but I can change the price of a derivative by my behaviour.

The laws of physics are universal in space and time. The laws of economics are very much a function of the context. Going back to the earlier example, the mass of an electron does not change whether we are in the world of Newton or of Einstein. But in the world of economics, how firms, households and governments behave is altered by the reigning economic ideology of the time. To give another example, there is nothing absolute, for example, about savings being equal to investment or supply equalling demand as maintained by classical economics but there is something absolute about energy lost being equal to energy gained as enunciated by classical physics.

In natural sciences, progress is a two way street. It can run from empirical findings to theory or the other way round. The famous Michelson-Morley experiment that found that the velocity of light is constant led to the theory of relativity - an example of progression from practice to theory. In the reverse direction, the ferocious search now under way for the Higgs Boson - the God particle - which has been predicted by quantum theory is an example of traversing from theory to practice. In economics, on the other hand, where the human dimension is paramount, the progression has necessarily to be one way, from empirical finding to theory. There is a joke that if something works in practice, economists run to see if it works in theory. Actually, I dont see the joke; that is indeed the way it should be.

Karl Popper, by far the most influential philosopher of science of the twentieth century, propounded that a good theory is one that gives rise to falsifiable hypotheses. By this measure, Einsteins General Theory was a good theory as it led to the hypothesis about the curvature of space under the force of gravity which indeed was verified by scientists from observations made during a solar eclipse from the West African islands of Sao Tome and Principe. Economics on the other hand cannot stand the scrutiny of the falsifiable hypothesis test since empirical results in economics are a function of the context.

The short point is that economics cannot lay claim to the immutability, universality, precision and exactitude of physics. Take the recent financial crisis. It is not as if no one saw the pressures building up. There were a respectable number of economists who warned of the perilous consequences of the build-up of global imbalances, said that this was simply unsustainable and predicted a currency collapse. In the event, we did have the system imploding but not as a currency collapse but as a melt down of the financial system.

We will be better able to safeguard financial stability both at global and national levels if we remember that economics is a social science and real world outcomes are influenced at a fundamental level by human behaviour.

Lesson 8:Having a sense of economic history is important to prevent and resolve financial crises Let me finish with the last lesson that is on a larger canvas - that having a sense of economic history is important to prevent and to resolve financial crises. In their painstakingly researched book, This Time is Different: Eight Centuries of Financial Folly, Kenneth Rogoff and Carmen Reinhart argue that every time a crisis occurs and experts are confronted with the question of why they could not, based on past experience, see it coming, they would argue that past experience was no guide as circumstances had changed. Yet this this time is different argument does not hold. Reinhart and Rogoff put forward impressive evidence showing that over eight hundred years, all financial crises can be traced to the same fundamental causes as if we learnt nothing from one crisis to another. If only teaching in economics had included a study of economic history, perhaps we can avoid repeating history, never mind as a farce or a tragedy.

Changing Inflation Dynamics in India

Speech by Deepak Mohanty, Executive Director, Reserve Bank of India, delivered at the Motilal Nehru National Institute of Technology (MNNIT), Allahabad on 13th August 2011

The headline wholesale price index (WPI) inflation averaged 9.6 per cent in 2010-11 as compared with 5.3 per cent per annum in the previous decade. Similarly, the average consumer price inflation, measured by the consumer price index for industrial workers (CPI-IW), was even higher at 10.5 per cent in 2010-11 as compared with 5.9 per cent per annum in the previous decade. Moreover, this elevated level of inflation also persisted through the first quarter of 2011-12. In response to inflationary pressures, the Reserve Bank has raised the policy repo rate 11 times bringing it up from a low of 4.75 per cent in March 2010 to 8.00 per cent by July 2011. It is expected that inflation should come down towards the later part of this year.Why has inflation been so high and persisted for so long? This is the theme of my talk today. In my presentation, I propose to address the following questions: Is India an outlier among major countries in terms of recent inflation performance? Has the inflation process changed? What are the causal factors global and domestic as well as supply and demand? I will conclude with some thoughts on managing the inflation dynamics on the way forward.

Is India an outlier in the inflation performance among major countries?It is important to appreciate the global backdrop in which we are experiencing a resurgence of inflation now. In the last decade, inflation was low, both in advanced countries as well as in emerging and developing economies till the global financial crisis unfolded. Consequently, global economy got into a recession and global output declined by 0.5 per cent in 2009. However, global output growth rebounded to 5.0 per cent in 2010.

As the global economy recovered from the worst effect of the global financial crisis, inflation picked up in emerging and developing economies. This was because the global recovery was largely driven by emerging market economies (EMEs) what was termed as a two-speed recovery a faster growth in EMEs accompanied by a slower growth in advanced economies. As output gaps closed, there was increasing inflationary pressure in EMEs, particularly in Asia. According to the International Monetary Fund (IMF), consumer price inflation in developing Asia almost doubled from 3.1 per cent in 2009 to 6.0 per cent in 2010 and is projected to be around the same level in 2011. Latest data suggest that inflation in rapidly growing BRICS remains elevated.

Global factorsWith recovery, global commodity prices rebounded given the higher level of commodity intensity of growth in EMEs.There was also an element of financialisation of commodities given the global excess liquidity. Crop loss due to adverse weather conditions in many parts in the world coupled with increased diversion of foodgrains towards biofuel exerted added pressure on global food prices. Thus, global commodity prices including food prices rose sharply. For example, the IMF Commodities Index rose by 24 per cent in 2010 on top of an increase of 43 per cent in 2009. It further rose by 20 per cent in December 2010April 2011, before moderating by about 2 per cent during JuneJuly 2011. Notwithstanding some softening in the last few months, it is important to recognize that the current level of commodity prices is almost double of that two and half years ago.

The increase in commodity prices has affected different countries differently depending on whether they are net importers or exporters of commodities. India being a net importer of commodities, the adverse impact on domestic inflation has been stronger. Inflation increased in developing and emerging economies with a combination of closing of output gaps and sharp increase in commodity prices. In this regard, India is not an exception. But the level of inflation in India has been high compared to those in many EMEs. This suggests that apart from global factors, domestic factors have had a significant influence on the inflation trajectory in India.

Has the inflation process changed?In India, we have multiple price indices 6 consumer price indices and a wholesale price index (WPI). While the Reserve Bank examines all the price indices both at aggregate and disaggregated levels, changes in the WPI is taken as the headline inflation for policy articulation. Within the WPI, non-food manufactured products inflation is considered the core inflation3.

Going by any measure of inflation, India comes out as a moderate inflation country, though occasionally inflation crossed the double digit mark. The historical average long-term inflation rate was around 7.5 per cent. But significantly, there was substantial moderation in inflation in the 2000s. The annual average inflation rate was around 5.5 per cent irrespective of the inflation indices taken, whether WPI or CPI. This raises the question: did the inflation dynamics change in the 2000s? Monthly WPI inflation data suggest that there was a structural break around the mid-2000s with the inflation rate during the latter half being higher.

Average WPI inflation increased from 5.2 per cent in the first half of 2000s to 5.5 per cent in the second half. This was largely contributed by primary food inflation. In fact, the core non-food manufactured products inflation moderated from 4.2 per cent to 3.9 per cent. What did cause the structural break in the mid-2000s? A disaggregated assessment suggests that protein items largely contributed to this change in trend.

Not only did the average food prices rise during the second half of 2000s but they were more volatile.

Structural food inflationFood prices being subject to supply shocks tend to be volatile. For example, the performance of monsoon has a significant bearing on the trend of domestic foodgrain prices. Spikes in food prices normally subside as they are transitory. However, empirical analysis suggests that inflation in protein items has become persistent. This suggests that protein inflation has assumed a structural character and is partly driven by demand factors. Within the protein group, persistence was lower for pulses as well as egg, meat and fish, but it was markedly higher for milk. Thus, the persistence of protein inflation has changed the inflation dynamics in the latter half of the 2000s. Increase in demand for protein appears to be an inevitable consequence of rising affluence (Gokarn, 2010). This process was further accentuated by renewed global food price shock during 2010-11. Among the processed food items, the persistence of inflation for edible oils was high.

International price pass-throughWhile the persistence of inflation on protein items has increased, it still has a relatively smaller share in overall WPI inflation. What matters more for the overall inflation trajectory is the non-food manufactured products inflation which has a higher weight of 55.0 per cent in the WPI. It averaged 4.0 per cent in the 2000s with a moderation in the second half. Subsequently, there has been a sharp increase in 2010-11 and 2011-12 so far. The non-food manufactured products inflation shows a major structural break towards the middle of 2009-10 around the time the global commodity prices rebounded. This has also raised the question: is the non-food manufactured products inflation an imported inflation?

Further, analysis suggests that industrial raw material prices also showed a structural break in early 2009 and the average price increase has been high and volatile. Moreover, the pass-through from non-food international commodity prices to domestic raw material prices has increased particularly in the recent years reflecting growing interconnectedness of domestic and global commodity markets.

This trend is also corroborated by corporate finance data which show that the share of raw material costs as a percentage of both expenditure and sales has been rising.

Demand factorsPrice pressures can emanate from the supply side but it will be difficult to sustain it without rising demand. In this context, important information on recent trend in expenditure pattern and wages is available from the 66th round of NSSO consumption survey and Labour Bureau. The average annual monthly per capita expenditure has increased at a faster pace in the second half of 2000s as compared with the first half, both in nominal and real terms.

While the share of per-capita expenditure in food has gone down, as could be expected from rise in income levels, both in rural and urban centers, the dietary pattern has shifted in favour of protein items whose share has gone up markedly in the second half of 2000s.The sharp increase in rural consumption of protein seems to have been sustained by increase in wage rates of the unskilled rural labourers both in nominal and real terms.In the formal sector, company finance data suggest that the wage bill has risen at a faster rate since the middle of 2009-10 .As per the NSSO surveys (61st round and 66th round), nominal wage rates of skilled workers in both rural and urban areas increased much faster in the second half of the 2000s than in the first half. While the real wage rates declined in the first half, it increased significantly in the second half of 2000s.There has also been added stimulus from the crisis driven fiscal expansion as the fiscal consolidation process was reversed in 2008-09 and continued through 2009-10.These evidences taken together suggest that sustained rise in real wages both in the formal and informal sectors in the recent years contributed to increase in demand.

ConclusionsThe recent surge in inflation has become more generalised. Food inflation, prone to supply shocks, is also assuming a structural character given the change in the dietary habits and high demand, in absence of adequate supply response. Sharp increase in non-food manufactured product inflation suggests that producers are able to pass on the cost increases, given higher demand. While the persistence in non-food manufactured products inflation is high, the persistence of food inflation has increased making the overall inflation rate sticky. The current inflation process, therefore, is an amalgam of both supply constraints and demand pressures.

Prolonged high inflation even if originating from supply side would give rise to increased inflation expectations and cause general prices to rise. Poorly anchored inflation expectations make long-term financial planning more complex with potential adverse effects on investment and growth. Moreover, high inflation is the most regressive form of taxation, particularly on the poor. It is, therefore, important to contain inflation and keep inflation expectations anchored so that consumers do not mark up their long-run inflation expectations by reacting to a short period of higher-than-expected inflation.

Keeping in view the costs of inflation and the fact that high inflation is inimical to sustained growth, the medium-term objective of the Reserve Bank is to bring down inflation to 3.0 per cent consistent with Indias broader integration with the global economy. In this direction, monetary policy aims to contain perceptions of inflation in the range of 4.0 4.5 per cent with a particular focus on the behaviour of the non-food manufacturing component, which is considered as core inflation given its high degree of persistence. Going forward, both global and domestic factors will shape the inflation outlook. With increasing global integration, global commodity prices are having an increasingly significant influence on domestic prices. It is expected that global commodity prices will peak in 2011 which should provide some relief to domestic inflation scenario.

The Reserve Bank signaled the reversal from its crisis driven expansionary monetary policy stance in October 2009. Since then, the cash reserve ratio (CRR) has been raised by 100 basis points. The policy repo rate has been raised by a cumulative 325 basis points. As the liquidity in the system transited from surplus to deficit, the effective tightening has been of the order of 475 basis points. Thus, the cumulative monetary policy action would have the desired impact on inflation.

While inflation is expected to moderate towards the later part of the year reflecting monetary tightening and likely softening of global commodity prices, fiscal policy needs to be supportive in containing aggregate demand. In addition, there is an urgent need to address the issue of structural supply constraints, particularly in agriculture, so that these do not become binding constraints in the long-run hampering the task of inflation management.

Transnational Gas Pipelines

1. Natural Gas the Clean Fuel of 21st Century:Natural gas is a clean fuel and would be increasingly used in the 21st century. Gas is a mainly used in the power sector but is also used in refining, industry and domestic consumption.

2. Natural Gas Key to India|s Economic Growth:India does not have the gas reserves to match its growing needs. India imports 67 million cubic metres of gas per day as part of its requirement of 150 million cubic metres (mcm) of gas per day. By 2020 India|s demand for gas could go up to 400 mcm per day. Thus, an assured supply of gas will be the key India|s economic growth of 8-9 per cent.

3. Transnational Gas Pipelines:The Soviet Union constructed the first transnational gas pipelines in the 1970s to supply natural gas to West Germany and other parts of Western Europe. Currently Russia meets 30 per cent of Europe|s gas requirements. Currently over 100 gas pipeline projects valued at $100 billion are being implemented across the globe.

4. Main Sources of Natural Gas are in Asia:Analysts point out that the main sources of natural gas are in Asia. Russia|s Asian area has 27 per cent of the world|s proven reserves, with Iran (15 per cent) and Qatar (14 per cent) following. Over 70 per cent of the world|s reserves of natural gas are found in northern Central Asia and the Gulf.

5. Transnational Gas Pipelines to Increase in Asia with Increase in Demand for Gas:The transnational gas pipelines across Asia are set to multiply with an increase in gas demand over the next few years. Thus, as the energy requirements of Asia increase, the transnational gas pipelines will play an increasingly important role in meeting these demands.

6. Advantages of Gas Pipelines:

A.Gas Pipeline the Cheapest Mode of Transportation:There are three ways of transporting gas - by ships as Liquefied Natural Gas (LNG); through deep-sea pipeline; or by gas pipelines on land. Analysts point out that world over, gas pipeline transportation is the preferred mode for gas conveyance as it is the cheapest and does not entail any loss of energy in conversion.

B.India Should Make Gas a Strategic Determinant:Analysts point out that of the total global energy consumption in world, gas accounts for 30%. Gas will be a key commodity in the overall context of India|s national security calculus. Gas is an eco-friendly energy product and will play a key role in contributing to India|s energy needs from automobiles to industrial use. India should make gas a strategic determinant.

C.Gas Pipelines will Offset the High Cost of Crude Oil:Experts point out that in view of India|s growing energy needs, gas pipelines are seen as the best option for India given the high cost of crude oil and petroleum products.

D.Security Risk can be Offset by Economic Gains:Analysts point out that the security risks to gas pipelines can be overcome by an international consortium with penalties for non-supply. The gas pipelines can bind countries through close economic ties, improving relations and avoiding hostilities. Thus the security risks can be minimised by the gains of economic prosperity.

E.Widen and Deepen Economic Relations in South Asia:Analysts point out that the gas pipeline projects may in fact widen and deepen economic relations in South Asia. They could lead to the establishment of the much needed trust and confidence among India and its neighbours.

F.Big Confidence Building Measure with Pakistan:Sections of Indian industry welcomed the proposed gas pipeline projects by emphasising that the projects can act as a potential conduit for peace and a big Confidence Building Measure (CBM) between India and Pakistan. The gas pipelines could lead to diplomatic and commercial dividends.

G.Increase Stability in the Region:Analysts point out that the gas pipelines will bring direct and indirect benefits to the transit countries. Thus, Pakistan and Afghanistan, which have internal insurgency problems, will benefit from the transit of gas pipelines as it will guarantee a source of income and generate employment. This could help increasing stability in the region.

7. Risks Involved:

A. Security Risks:Analysts point out that gas pipelines face the security risks and require credible national guarantees. Onshore pipelines are insecure and can be blown up by militants. Assam and Balochistan are the prime examples. It is also pointed out that the gas supplying nations, Iran, Turkmenistan, Myanmar and Bangladesh are not stable democracies. The transit country Pakistan has problems with India and is very unstable. Analysts feel that given the history of Indo-Pak relations and the growing extremism in Bangladesh, the vision of friendship through economic integration is gamble.

B. Transnational Pipelines can be Used as Political Tools:Analysts point out that energy-rich countries are using the transnational pipelines as political leverage. These countries use the pipelines to forge political alliances, punish enemies and extract concessions from consumer nations.

C. High Economic Cost:The energy-rich countries demand a higher cost for the supply of gas. Thus, the Iran-Pakistan-India project is unable to progress further due to Iran|s demand for a higher price.