How the Federal Reserve caused the Great Recession

This column is slightly different from the ones I usually write. On most days the idea is to write on something which is currently happening. This column doesn’t fit that formula.

In this column I wanted to write about how our world view plays a huge part in what we think and the decisions that we make, and how those decisions can turn out to be majorly wrong in the long-term, even though when we were making them they seemed to be the perfectly correct thing to do.

The dotcom bubble started to burst in early 2000. Soon after on September 11, 2011, several airliners were hijacked, of which two flew into the iconic World Trade Center in New York and one into Pentagon. The American economy which was going through tough times in the aftermath of the dotcom bubble collapsing, got into even more trouble after 9/11.

Alan Greenspan, who was the Chairman of the Federal Reserve of the United States, at that point of time, recalls in his book The Age of Turbulence that the American economy had been in a minor recession for a period of seven months before September 2001. And in the aftermath of the attacks, the reports and statistics streaming in painted a very worrying picture.

Americans had stopped spending on everything other than the items they would need in case there were more attacks. Sales of grocery items had gone up; so had sales of security devices, insurance, and bottled water. On the flip side, businesses like travel, entertainment, hotels, tourism, and even automobiles were majorly hit.

The American economy is very consumer driven and if consumers stop spending, then the economic growth immediately collapses. This was likely to happen in the months that followed September 2001.

With spending collapsing, there was a danger of the minor recession turning into a major one. To prevent this, Greenspan, as he had in the past, decided to cut interest rates. The federal funds rate, which was at 3.5 percent before the attack, was cut four times and brought down to 1.75 percent by the end of the year, starting with the first rate cut of 50 basis points, or half a percentage point, on September 17, 2001, six days days after the attack. (One basis point is one hundredth of a percentage). The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

Central banks cut interest rates in the hope that consumers would borrow money to spend and businesses would borrow money to expand, and so the economy would grow. As James Rickards writes in The Death of Money—The Coming Collapse of the International Monetary System: “We all asked ourselves how we could help [in the aftermath of the attack]. The only advice we got from Washington was ‘get down to Disney World … take your families and enjoy life’.”

People did borrow and spend, but they went overboard with it. America’s new bubble after dot-com was real estate and it was built on the belief that anyone could make money in real estate. As Stephen D. King puts it in When the Money Runs Out: “The white heat of the 1990s technological revolution was replaced by the stone cold of a housing boom.”

Between January 2001 and mid-2003, the federal funds rate was cut by 550 basis points to one percent. The interest rate stayed at one percent for little over a year.

The Federal Reserve did not want the United States to become another Japan. Japan had been in a low growth environment since the collapse of the stock market and the real estate bubbles, starting in late 1989. Prices had been regularly falling. In an environment of falling prices(or deflation) consumers keep postponing consumption in the hope of getting a better deal in the future. This leads to businesses suffering and the economic growth collapsing.

Ben Bernanke, who would takeover as the Chairman of the Federal Reserve from Alan Greenspan in 2006, joined the Federal Reserve in 2002 as a governor. Bernanke was a scholar on the Great Depression of 1929.

In one of the first speeches that Bernanke made after joining the Federal Reserve he said: “Whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation—a decline in consumer prices of about 1 percent per year—has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors … the consensus view is that deflation has been an important negative factor in the Japanese slump… I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small… So, having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether.”

This fear of not becoming another Japan and at the same time not engineering another Great Depression led to the Federal Reserve keeping interest rates low much longer than it should have. This led to the real estate bubble which would finally start bursting in 2007-2008.

As Barry Eichengreen writes in his brilliant new book Hall of Mirrors—The Great Depression, The Great Recession and The Uses—And Misuses—Of History: “With benefit of hindsight, we can say that the Fed overestimated the risk of deflation and responded too preemptively and aggressively. As a student of Japan and of the Great Depression, Bernanke may have been overly sensitive to the danger of deflation at this point of time. In other words, history may be useful for informing the views of policy makers of how to respond to certain risks, but it may also shape and inform outlooks in ways that heighten other risks”

Bernanke’s world view led to the Federal Reserve keeping interest rates low much longer than it should have. Over and above this, the inflation data that was coming out at that point of time may also have had a role to play. As Eichengreen writes: “Distorted data may have also contributed to the Fed’s exaggerated concern with deflation. Contemporaneous data showed the personal consumption expenditure deflator[the inflation index that the Federal Reserve follows], cleansed of volatile food and fuel prices, falling to less than 1% in 2003, dangerously close to negative territory. Subsequent revisions revealed that inflation in fact had already bottomed out at 1.5% and was now safely on the rise.”

This led to Federal Reserve maintaining low interest rates, when it should have been raising them. In the process, the Fed ended up fuelling the real estate bubble, which finally led to the bankruptcy of Lehman Brothers in September 2008, and the start of the current financial crisis, which was followed by what is now known as the Great Recession.

The column originally appeared on The Daily Reckoning on May 29, 2015

How the Congress party got corporates addicted to govts buying land for them

One of the main questions that has been asked in the current controversy surrounding the issue of land acquisition is—why does the government need to buy land? Jairam Ramesh and Muhammad Ali Khan try and answer this question in their new book Legislating for Justice—The Making of the 2013 Land Acquisition Law. 

As they write: “Acquisition of property is founded upon the universally recognized principle of ‘Eminent Domain’.” And what is Eminent Domain? “[It] is the power of the Government…to take over resources for the greater national good. At its most basic Eminent Domain refers to the inherent authority of the Government to acquire private property on the payment of fair compensation for a use that benefits public at large,” explain the authors.

Further, a lot of public infrastructure gets built because of Eminent Domain. As Ramesh and Khan write: “Without the power of Eminent Domain, the Government could not establish the infrastructure that we rely on—roads, hospitals, airports, public schools, common facilities such as warehouses for farmers, playgrounds for children all are made possible through the use of Eminent Domain.”

So far so good. But why does the government have to acquire land for private companies? Before I get to answering this question, it is important to realize that the land acquisitions carried out by the government in India can essentially be divided into two eras—those carried out before 1991, the year of the economic reforms, and those carried out after.

As Michael Levien of the Johns Hopkins University writes in a recent research paper titled From Primitive Accumulation to Regimes of Dispossession: Six Theses on India’s Land Question: “Since 1991, India has passed from a regime that dispossessed land for state-led industrial and infrastructural expansion to one that dispossesses land for private—and increasingly financial—capital. Between 1947 and 1991, the Indian state largely dispossessed land for public-sector projects to expand the industrial and agricultural productivity of the country. The main forms of this dispossession were public sector dams, steel towns, industrial areas, and mining.”

But that changed after the economic reforms of 1991, when the private sector began to play a more active and larger role in the Indian economy. The economic reforms unleashed the Indian IT and BPO industry. These sectors had an unending appetite for land and the government helped them by acquiring land for them.

Gradually, public-private partnerships became the preferred method for building physical infrastructure. And this led to the government acquiring more land for private firms. In fact, as Levien points out: “Crucially, compensating private infrastructure investors with excess land and/or development rights became an increasingly popular method of cost recovery in these arrangements—whether for roads, airports, or affordable housing (Ahluwalia 1998; IDFC 2008, 2009). Infrastructure investment thus became a vehicle for private real estate accumulation, culminating with Special Economic Zones in the mid-2000s.”

Hence, land became a sort of a currency for the government. Also, given that the government could acquire land for private firms, it is obvious that a lot of politicians must have made a lot of money as well.

Nevertheless, the question is how did the government get around to acquiring land for the private sector? Before the 2013 land acquisition law was passed, land acquisition in India was governed by the Land Acquisition Act 1894—a law from the time when the British ruled India.

In fact, an amendment made in 1984 to the 1894 Act expanded the government’s ability to “acquire lands for a public purpose ‘or for a private company’”. This amendment allowed the government to acquire land for private companies. And it is worth reminding the readers, those were the days when the Congress party ruled the country.
It was this amendment which was abused by the various state governments around the country to acquire land for private companies. This amendment allowed the government to acquire land from farmers at cheap rates and then sell it on to private companies at a significantly higher price.

The ‘Yamuna Expressway’ is a very good example of this, where the land was acquired by the Uttar Pradesh from farmers and then sold on to private parties at multiple times the price the farmers had been paid for it.

As Ramesh and Khan point out: “In 2009, the Uttar Pradesh Government had indeed acquired land as part of a concession agreement and then resold it to Jaypee associates group as part of a bundling project for the construction of the Yamuna Expressway. There was no legal bar on doing so under the old law [i.e. the 1894 Act].” Further, the purpose for which the land was acquired could be changed as well.

The corporates preferred the government acquiring land for them and then selling it to them at a higher price because of several reasons. Land records in India are poorly maintained and purchase of land can easily be challenged in court at a later date.

As Nitin Desai writes in a recent column in Business Standard: “Many companies want the government to acquire land for them…as to have the assurance that their right of ownership cannot be challenged by some new claimant.”

Further, as Ramesh and Khan point out: “After the initial round of consultations in July-August 2011, it was also acknowledged that land values are, on an average, a sixth of their represented or book value as drawn out in the circle rate. As one moved away from urban centres the disparity became more striking with land records not having been updated for decades in some parts of the country.”

As per the 1894 Land Acquisition Act the government had to compensate the owner of the land at market value. But given that the government land records were infrequently updated, the government on many occasions got away with paying a pittance in comparison to the ‘real’ market value.

Even if the government were to then sell on the land to a corporate firm at a higher price, the firm would still get a good deal because of the huge differential between the price as per the government land record and the real market price.

Another reason corporates liked to outsource the land acquisition process to the government lay in the fact that the 1894 Act had an ‘urgency’ clause. As Ramesh and Khan write: “Section 17 of the Land Acquisition Act, 1894 was used to forcibly disposes people of their land in a frequent and brutal fashion by suspending the requirement for due process…Section 5A…allowed for a hearing of objections to be made but put no responsibility on the Collector to take those claims into consideration.”

So people could complain, but it was up to the Collector whether he wanted to listen to them or not. Further, the definition of urgency was also left “to the authority carrying out the acquisition.”  This clause allowed the collector to “take possession of the land within fifteen days of giving notice”. He could take possession of a building within 48 hours of giving notice. No private company could hope to acquire land at such a quick pace.

The irony is that the 1894 Land Acquisition Act was allowed to run for almost 66 years after independence. The Congress party ruled the country in each of the decade after independence and chose to do nothing about it. Under the 1894 Act the government could acquire land in a jiffy, without adequately compensating the land-holder. When the Act was finally replaced, what came in its place has made it next to impossible to acquire land.

In fact, Ramesh and Khan,rather ironically admit to that in their book, when they write: “The law was drafted with the intention to discourage land acquisition. It was drafted so that land acquisition would become a route of last resort.”

To conclude, as far as the land acquisition process is concerned, it is safe to say that we have jumped from the frying pan into fire.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on May 28,2015 

Arvind Subramanian: when economists start talking like politicians, we have a problem

During the course of the last financial year, the finance minister Arun Jaitley, repeatedly kept asking the Reserve Bank of India (RBI) to start cutting the repo rate. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

The RBI finally cut the repo rate twice between January and March 2015. But this hasn’t been enough to get bank lending to start growing at a much faster pace. As of the end of October 2014, lending by banks over a one year period had grown by 11.2%. As of March 20, 2015, lending by banks over a one year period had grown by 8.6%. This, despite the fact that the RBI cut the repo rate twice between January and March by a total of 50 basis points (one basis point is one hundredth of a percentage) to 7.5%.

As I have often explained in the past, a fall in interest rate does not always spur consumption or lead to increased borrowing by corporate firms. As John Kenneth Galbraith points out in The Economics of Innocent Fraud: “If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will thus produce goods and services, buy the plant and machinery they can afford now and from which they can make money, and consumption paid for by cheaper loans will expand.”

But things play out a little differently in the real world. “The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical experience. Business firms borrow when they can make money and not because interest rates are low, Galbraith points out.

Also, by taking about the RBI needing to cut the repo rate, over and over again, the impression that the finance ministry tries to send out is that the RBI is holding back economic growth. And that is really not true. If India has to grow at a much faster rate, then interest rates are just a very small part of the overall puzzle.
There is a lot that needs to be set right at the level of the government—from reforming labours laws to improving the ease of doing business to ensuring that the subsidies offered by the government reach the right people and are not stolen as they go down the system.

Over and above this, there are many projects stalled due to land acquisition issues, lack of environmental clearance or simply the fact that the firm carrying out the project is highly indebted. There is nothing that the RBI can do about these things. It can just hope to set interest rates.

Subramanian also went on to say that: “China is now cutting the interest rate quite aggressively in response to its growth slowing down…We need to respond accordingly.” This is a convenient use of facts as they are.

The People’s Bank of China has cut interest rates thrice since November 2014. In November last year, the Chinese central bank cut the one year benchmark deposit and lending rates by 25 basis points and 40 basis points to 2.75% and 5.6% respectively. There was another small change it carried out, which Subramanian did not talk about in the general statement that he made.

As Wei Yao of Societe Generale points out in a research note she wrote in November: “Along with the rate cut, the People’s Bank of China also lifted the upper limit that commercial banks can offer above the benchmark deposit rates to 1.2 times from 1.1 times. That is, the maximum permitted rate for 1-year deposits was 3.3% (3%*1.1) and is still 3.3% (2.75%*1.2). Given that commercial banks have been losing deposits recently, they will probably choose to stick to the upper bound.”

And what about lending rates? “As for lending rates, the lower bound to the benchmark lending rates was removed more than a year ago. In theory, there is no hard restriction stopping commercial banks from lowering loan rates anytime or by any amount. Therefore, the benchmark lending rate cut is also nothing more than a suggestion,” wrote Wao.

In end February 2015, the People’s Bank cut interest rates again. This time the one year benchmark deposit rate was cut to 2.5% from the earlier 2.75%. Further, the Chinese central bank increased the upper band of bank deposit rates from 1.2 to 1.3 times of the benchmark rates. What did this mean? “As a result, the maximum one year deposit rate that commercial banks can offer is now 3.25% (2.5%*1.3), only 5 basis points lower than the previous level of 3.3% (2.75%*1.2),” wrote Wao.

Earlier this month (May 2015), the People’s Bank cut the one year benchmark deposit rate again by 25 basis points to 2.25%. Nevertheless as Wao writes: “After the cut, the benchmark one-year deposit rate is now at 2.25%, but the ceiling is lifted to 1.5 times of the benchmark, up from 1.3 times previously. Hence, the maximum rate that banks can offer has actually increased from 3.25% (=2.5%*1.3) to 3.375% (=2.25%*1.5), which is even higher than the level (3.3%) at the beginning of this easing cycle.”

Hence, even though the People’s Bank of China has cut the one year benchmark deposit rate by 75 basis points since November 2014, the maximum rate that a bank can pay on its deposits has actually marginally gone up to 3.375% from 3.3% in November. In that sense, there has been no real cut in interest rates.

Now contrast this with India, where the RBI has cut the repo rate by 50 basis points since January to 7.5%. A 50 basis point cut is not very different from a 75 basis point cut. Further, deposit rates in India unlike China are not controlled by the central bank and many banks in India have reduced fixed deposit rates.

Though the cut in deposit rates has not been followed by a cut in interest rate on loans. In late April, the minister of state for finance, Jayant Sinha, had pointed out that, only 21 out of the 91 scheduled commercial banks in the country had cut their lending rates, after the RBI cut its repo rate twice.

To conclude, what this tells us is that Subramanian’s statement was too general to have been made of an economist of his stature. I wouldn’t have been surprised if Jaitley or Sinha would have made such a statement. But coming from an economist of Subramanian’s calibre, this is unacceptable. Also, the ministry of finance needs to realize that people who run the RBI know their job well and it is best if they are left to themselves to do it properly.

The column originally appeared on The Daily Reckoning on May 28, 2015  

How India’s informal black economy severely hurts the government

rupeeThe annual report of the ministry of finance points out that the total number of income tax assessees as on October 30, 2014, had stood at 4.79 crore.
The number had stood at 4.7 crore as on March 31, 2014. As on March 31, 2011, the number had stood at 4.08 crore. This means that between March 2011 and March 2014, the number of assessees filing their income tax returns went up by a minuscule 4.8 per year.
In fact, the method of measuring the total number of income tax assessees was revised in March 2014 and this revision has pushed up the number of assessees considerably. As per the earlier method, the total number of assessees as on March 31, 2011, had stood at 3.55 crore. The new method pushed up the total number of assessees by more than 50 lakh, as of end March 2011. This is not a reason to worry given that the new methodology is more reliable and accurate.
Nevertheless, despite this revision, on the whole, the total number of income tax assessees in India remains very small. In comparison, nearly 45% of American population files income tax return. What this means in an Indian context is that India has a huge informal economy which as Taimur Baig of Deutsche Bank Research puts in a recent research note, operates “outside the lens of formal observation, oversight, or analysis.”
“India’s statistics commission suggests that half the gross national product is accounted for by the informal economy…Numerous businesses are unincorporated, transactions involving huge quantities proceed daily on a cash basis, most people and businesses do not file for taxes, making a sizeable chunk of the economy unregulated and unsupervised…The government finds it hard to widen the tax net, ending up overburdening the formal sector,” writes Baig.
The government’s inability to widen the tax net as Baig writes and as data in the annual report of the ministry of finance suggests, has led to a situation where the government has to regularly slash expenditure towards the last few months of the financial year. Take the case of the last financial year 2014-2015, the total expenditure of the government when the budget was presented in July 2014 had stood at Rs 17,94,892 crore. By the time the next budget was presented in February 2015, the total expenditure had been slashed by 6.3% to Rs 16,81,158 crore. This is a trend that has played out in each of the last three financial years.
Typically when the government has to cut down on its expenditure, it is the plan expenditure which faces the severest cut. Take the case in 2014-2015, the plan expenditure at the beginning of the year had been set at Rs 4,53,503 crore. It finally came in at 19.1% lower or Rs 3,66,884 crore As I have often pointed out in the past, plan expenditure is essentially money that goes towards creation of productive assets through schemes and programmes sponsored by the central government.
Non-plan expenditure on the other hand is an outcome of plan expenditure. For example, the government constructs a highway using money categorised as a plan expenditure. But the money that goes towards the maintenance of that highway is non-plan expenditure. Interest payments on debt, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure. Given the regularity of the non-plan expenditure the asset creating plan-expenditure gets slashed. And that is clearly not a good thing.
This largely happens due the inability of the government to grow its tax base. Another disturbing trend that has emerged over the last few years is the growing dependence of the government on revenues from indirect taxes like customs duty, excise duty and service tax.
Data from the Reserve Bank of India shows that in 1990-1991, direct taxes (income tax, corporation tax and wealth tax, which has been done away with from this financial year) formed 16.06% of the total taxes collected by the government. Indirect taxes formed 83.94%.
In 1991-1992, the year economic reforms were first initiated, direct taxes jumped to 20.2% whereas indirect taxes fell to 79.8%. Since then, direct taxes maintained their upward move and by 2009-2010 formed 59.5% of the total taxes. The share of indirect taxes had fallen to 40.5%.
The trend has been reversed since then and in 2013-2014, the share of direct taxes had fallen to 53.9%, whereas indirect taxes had jumped to 46.1%.
This is a clearly worrying trend simply because indirect taxes are regressive. A regressive tax is essentially a tax which is applied uniformly on everyone and given that it means that individuals with lower-incomes are hit harder.
That isn’t the case with direct taxes like income tax where the marginal rate of taxation goes up as the taxable income goes up. Given this, it is important that the government focuses on increasing the total number of people paying direct taxes.
As Baig of Deutsche Bank Research points out: “Tax authorities in recent decades have handed out simplified procedures to file for taxes and register businesses, although the results have not been encouraging. Previously untaxed parts of the economy, especially in the services sector, have been brought into the tax net, but the fact that tax yield has not improved suggests room for improvement.”
Also, the government seems to be focussed on recovering the black money that has already been accumulated. Some focus on widening the tax base and ensuring that the black money that will be generated in the future comes down will not do it any harm.

The column appeared originally on The Daily Reckoning, on May 27, 2015

Why does Arvind Subramanian want India to outsource its monetary policy to the United States?

Arvind_SubrahmaniyamArvind Subramanian, the chief economic adviser to the ministry of finance, has latched on to the finance minister Arun Jaitley’s formula. During the course of the last financial year, given half an opportunity, Jaitley asked the Reserve Bank of India (RBI) to cut interest rates.
Subramanian did the same yesterday when he said: “
They (other countries) are aggressively easing monetary policy,” implying that the RBI should also cut the repo rate soon. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.
Subramanian also went on to suggest that it was time that India started to imitate China on the currency front. As he said: “If you were to ask me how did China accumulate $4 trillion of reserves, it’s essentially buying it to keep the currency very, very competitive. So, it is a lesson for all of us. It is not what everything China does we should we imitate… but that is the lesson we should learn from.”
The above statement is nowhere as straightforward as it looks. Subramanian talks about China having accumulated $4 trillion of reserves in an effort to keep its currency, the yuan, competitive. What does he mean by this? Chinese exporters get paid in dollars (largely). When they get these dollars back to China, they need to convert them into yuan, given that their expenses are in yuan, they need to pay taxes in yuan and so on.
Hence, the exporters need to sell dollars and buy yuan. This would push up the demand for the yuan and lead to an appreciation of the yuan against the dollar. An appreciating yuan would not be good for exporters given that they would be paid fewer yuan when they convert their dollars into yuan.
Let’s consider the case of an exporter who makes a $1 million. If one dollar is worth 6.2 yuan (as it is now) the exporter would make 6.2 million yuan. But if one dollar has appreciated and is worth 6 yuan, then the exporter would make only 6 million yuan, which is lower. Hence, an appreciating yuan hurts.
Given that China is an export powerhouse, in the normal scheme of things, the yuan should have been appreciating against the dollar, over the years. And that would have hurt Chinese exports making them uncompetitive.
But that hasn’t happened. From October 2011 onwards the value of the dollar has ranged between 6.34 to 6.20 yuan Hence, when a Chinese exporter exports he has a fairly good idea of what kind of money he is going to make in terms of yuan. Between July 2008 and May 2010, the dollar was worth between 6.8 to 6.82 yuan.
The question is how does this happen? The People’s Bank of China, the Chinese central bank, keeps intervening in the foreign exchange market. It buys dollars and sells yuan. In the process it ensures that there are enough yuan going around in the financial system, and the value stays stable against the dollar.
Nevertheless, the intervention by the People’s Bank is not free of cost. As Raghuram Rajan writes in
Fault Lines—How Hidden Fractures Still Threaten the Global Economy: “If it[i.e. the People’s Bank] intervenes a lot, the abundance of renminbi[another name for the Chinese yuan] in circulation will push up inflation.”
How does that happen? When the People’s Bank buys dollars, it has to sell yuan. Where does it get these yuan from? It prints them (or these days creates them digitally on a computer). The money supply in the financial system goes up. As a greater amount of money chases the same amount of goods and services, prices go up.
The People’s Bank has to avoid this. So what does it do? It carries out what is known as an sterilized intervention. The central bank also sells government bonds that it holds in its kitty. When it sells government bonds it gets paid in yuan. In the process, the People’s Bank manages to ensure that the total amount of yuan in the financial system does not go up dramatically, after it has carried out the intervention to hold the value of the yuan.
Then there is another problem. The dollars that the People’s Bank ends up holding in its kitty are primarily invested in bonds issued in dollars, which includes bonds issued by the United States government and its institutions.
The People’s Bank also needs to pay an interest on the government bonds it sells to suck out yuan from the financial system. The interest on these bonds needs to match the interest that the People’s bank earns by investing in the United States.
If the interest to be paid on the bonds being sold by the People’s Bank is higher than the interest that the People’s Bank is earning by investing in dollar assets, then there is a problem. As Rajan writes: “If the interest paid on dollar assets is low, while renminbi[another name for the Chinese yuan] interest rates are high, the central bank will effectively be holding a low-yield asset while issuing a high-yield liability—which means it will incur a loss. If this negative spread were multiplied by $2 trillion worth of foreign reserves(not all dollars, of course) that China has, it would blow a gigantic hole into the Chinese budget.” [The foreign exchange reserves are now $4 trillion, hence the hole would be bigger. Rajan’s book was published in 2010.]
This is something that cannot be allowed to happen. Hence what does China do? As Rajan writes: “A direct effect of such a policy is that China mirrors the United States’ monetary policy. If interest rates in the United States are very low. China also has to keep interest rates low. Doing so risks creating credit, housing and stock market bubbles in China, as much in the United States. With little freedom to use interest rates to counteract such trends, the Chinese authorities have to use blunt tools: for example, when credit starts growing strongly, the word goes out from the Chinese bank regulator that the banks should cut back on issuing credit.”
Getting back to the chief economic adviser Arvind Subramanian—what he is essentially suggesting is that like the People’s Bank of China, the RBI should also more actively manage the value of the rupee against the dollar, in order to benefit the exporters.
But as Rajan so beautifully explains in his book, what China has done comes with costs attached to it. The Chinese government has been able to manage the negatives because it can do things which other governments which are democratically elected cannot do.
Further, the Indian government (or the RBI) does not have the same control over banks as the Chinese government does. During the last financial year, many statements were made to get banks to cut interest rates and increase lending. But that never happened. Also, India has a thriving private banking sector, over which the government has next to no control.
To conclude, why does Subramanian want India to outsource its monetary policy to the United States? This is something only he can tell us.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on May 27, 2015