Would crisis have been mitigated if Yuan was free float?

Dr. Rakesh Mohan, Deputy Governor of RBI in his recent speech says (a nice ppt as well):

It would be interesting to explore the outcome had the exchange rate policies in China and other EMEs been more flexible. The availability of low priced consumer goods and services from EMEswas worldwide.  Yet, it can be observed that the Euro area as a whole did not exhibit large current account deficits throughout the current decade.  In fact, it exhibited a surplus except for a minor deficit in 2008.  Thus it is difficult to argue that the US large current account deficit was caused by China’s exchange rate policy.  The existence of excess demand for an extended period in the U.S. was more influenced by its own macroeconomic and monetary policies, and may have continued even with more flexible exchange rate policies in China. 

In the event of a more flexible exchange rate policy in China, the sources of imports for the US would have been some countries other than China. Thus, it is most likely that the US current account deficit would have been as large as it was – only the surplus counterpart countries might have been somewhat different. The perceived lack of exchange rate flexibility in the Asian EMEs cannot, therefore, fully explain the large and growing current account deficits in the US.  The fact that many continental European countries continue to exhibit surpluses or modest deficits reinforces this point.

He says main problem was low interest rates for an extended time leading to a search for yield and huge capital flows in emerging economies. These have reversed right now posing problems for EME. Further US demand cotinued to outstrip supply leading to US huge US borrowing and debt levels. And then came the crash….

He says the impact on India has been minimal as:

The initial impact of the sub-prime crisis on the Indian economy was rather muted. Indeed, following the cuts in the US Fed Funds rate in August 2007, there was a massive jump in net capital inflows into the country. The Reserve Bank had to sterilise the liquidity impact of large foreign exchange purchases through a series of increases in the cash reserve ratio and issuances under the Market Stabilisation Scheme (MSS).

The direct effect of the sub-prime crisis on Indian banks/financial sector was almost negligible because of limited exposure to complex derivatives and other prudential policies put in place by the Reserve Bank. The relatively lower presence of foreign banks in the Indian banking sector also minimized the direct impact on the domestic economy (Table 3). The larger presence of foreign banks can increase the vulnerability of the domestic economy to foreign shocks, as happened in Eastern European and Baltic countries.

There was also no direct impact of the Lehman failure on the domestic financial sector in view of the limited exposure of the Indian banks. However, following the Lehman failure, there was a sudden change in the external environment. As in the case of other major EMEs, there was a sell-off in domestic equity markets by portfolio investors reflecting deleveraging. Consequently, there were large capital outflows by portfolio investors during September-October 2008, with concomitant pressures in the foreign exchange market.  While foreign direct investment flows exhibited resilience, access to external commercial borrowings and trade credits was rendered somewhat difficult.

He also adds India’ calibrated approach is the best way for liberalisation:

The Indian approach to financial globalization has been reflected in a full, but gradual opening up of the current account but a more calibrated approach towards the opening up of the capital account and the financial sector.  As far as the capital account is concerned, whereas foreign investment flows, especially direct investment inflows are encouraged, debt flows in the form of external commercial borrowings are generally subject to ceilings and some end-use restrictions.  Macro ceilings have also been stipulated for portfolio investment in government securities and corporate bonds.  Capital outflows have also been progressively liberalized. Along with the calibrated approach to opening of the capital account, we have also practised prudential regulation, particularly of banks to manage financial instability.

Dr Mohan also points to empirical research justifying RBI’s stance. Though, am sure various economists would not like RBI’s stance. Well, if they do not like it they need to come up with better arguments and better research to support their views.  As I said earlier, RBI’s approach is always appreciated in these times of crisis. I still do not understand why despite numerous research pointing that effect of financial liberalisation and capital account liberlaisation are negligible on growth, are the two pushed so extensively on EMEs?

An excellent speech from Dr Mohan summarising the key issues in the crisis from an EME and Indian perspective.