Can India learn from China's Exchange Rate Management?

Jahangir Aziz (heads the China division at the IMF), and Kalpana Kochhar (heads the IMF’s India team) responds;

We would argue that China has not found a magical solution to keeping inflation down, limiting interest rate increases, holding off faster currency appreciation and accumulating reserves, all at the same time. Its economy is paying a price in the form of widening economic imbalances, which increase the odds of an eventual painful adjustment. The lesson for India is that allowing the rupee to appreciate helps to cool an overextended economy without driving interest rates so high as to kill off much-needed investment. Resisting nominal exchange rate appreciation because of concerns over export competitiveness is counterproductive—the resulting higher liquidity and inflation will inevitably erode competitiveness by making domestic goods more expensive. A much more sustainable strategy would be to achieve cost efficiencies through urgent infrastructure upgrades and education and labour market reforms.

In the last five years, China’s economy has grown by an average of 10 per cent and India’s by around 8 per cent. Non-food, non-energy inflation in China is around 1 per cent, while India’s inflation has jumped to well above 6 per cent. At the same time, the People’s Bank of China (PBC) has limited renminbi appreciation to less than 7 per cent against the dollar since July 2005 and has raised interest rates by less than 100 basis points. On the other hand, the rupee has appreciated by around 14 per cent over the same period and interest rates have risen by over 200 basis points.

Why the difference? The short answer is that India’s economy is supply constrained—rapid growth in consumption (and more recently investment) demand is pushing up prices because the economy is hitting capacity constraints caused by insufficient past investment. Meanwhile, China’s economy is demand constrained: a torrid pace of investment in the past has created excess capacity that domestic consumption cannot absorb. The PBC needs to tighten monetary policy to curb investment growth to prevent
this excess capacity from causing future price declines and eventual loan defaults. The RBI needs to tighten monetary policy to keep current inflation from getting out of hand, while ensuring that the investment that is badly needed to ease capacity constraints can be sustained...

To summarise then, the lesson for China is that relative prices—including the exchange rate—need to reflect underlying economic forces so that households and firms can make the right decisions. Distortions only serve to encourage decisions that sooner or later have to be readjusted, and often that readjustment is painful. And the lesson for India is that exchange rate flexibility combined with efforts to improve efficiency through urgent infrastructure upgrades, and education and labour market reforms will yield the most enduring gains in competitiveness.