As countries struggle to keep their economies afloat in the midst of a global recession, what role does the International Monetary Fund play? Kalpana Kochhar, deputy director of the IMF’s Asia-Pacific department and its country head for India, brings two decades of experience to her coverage of countries from India all the way to Australia and New Zealand. Her research focuses on the region’s economic growth, fiscal policies and financial sector. In an interview with India Knowledge at Wharton at the 2010 Wharton India Economic Forum, Kochhar explained why India’s reforms need to move faster, why robust debt markets are so important for continued progress — and how the IMF itself is engaging in reforms in response to criticism of its loan policies.
An edited transcript of the conversation follows.
India Knowledge at Wharton: Tell us about India’s role in the global economic recovery.
Kalpana Kochhar: As you know, India was quite badly hit in the immediate aftermath of the crisis [starting around] October 2009. This might surprise people, because they think of India as being a fairly closed economy. But actually, India is very tightly integrated with the global economy, particularly through financial channels. A lot of India’s investment depends on foreign finance. When the crisis hit, initially that dried up. But a couple of things happened.
First, policy makers were very nimble in providing stimulus to the economy. Interest rates were cut. A lot of facilities were put in place by the Reserve Bank of India to keep credit flowing through the economy. Some measures were also put in place by the Ministry of Finance, through public finances. Keep in mind that India had just come off an election cycle, so there had already been some fiscal stimulus in the pipeline, which turned out to be very timely. Therefore, India’s downturn was very short-lived, and [the country] has since been contributing very strongly to the global recovery, along with China, which is another [fast] growing economy. As a region, [Asia is] leading the global recovery.
India Knowledge at Wharton: Do you think that India was affected less, or recovered quickly from the crisis, in part due to the financial-sector market controls that were in place?
Kochhar: To some extent, yes. India is integrated with the global economy, but still maintains quite a lot of controls. In particular, the banking system in India did not become involved in any of the activities that, in the end, brought down the banking systems in the U.S. and in Western Europe. So it was completely insulated from the toxic assets that were being held by banks in these other countries. While there was a general pullback of capital as banks were consolidating through the crisis, once that period was finished, funds started to flow back to India. You saw stock markets getting back funds. You saw the SENSEX and other indices in India going back up. So, yes, the controls — and the fact that the Indian economy, especially the financial sector, is still relatively insulated — helped. And then, as I said, the policies that were put in place also helped.
India Knowledge at Wharton: In spite of that, though, does there still need to be [more] financial-sector reform? If so, what kind?
Kochhar: To put things in perspective, India’s come a long way. In the early 1990s, there were a slew of financial sector reforms: interest rate deregulation, opening up the capital markets. The Indian authorities have a very clear hierarchy in the kind of capital that they want [coming] into the country: equity, foreign direct investment (where somebody actually builds a plant or invests in a plant in India), and then debt. So debt is the least desirable, and that’s the hierarchy that they follow. They opened up the capital markets to equity, and you had one of the most successful stock markets in India, both from the point of view of returns on assets, but also in market infrastructure.
That said, there is now a need for major financial sector reforms. Why? India has large needs in infrastructure. These investments require large amounts of money. These are not small projects; typically, they cannot be financed through the banking system. Most people have their money in the banking system, the so-called “liability side.” The deposits are three months, one year, maybe five years, whereas infrastructure projects typically take five, 10, 15 years to build, and [only] then return assets. [In our jargon, that’s called] an asset-liability mismatch. You have an asset of a much longer duration and a liability of much shorter duration. Banks really can’t have that on their books, so you need financial markets. You need a corporate bond market. You need debt markets.
[While the government has followed] the hierarchy, the time has now come to build debt markets. Debt markets can be generated through [existing Indian] pension funds and insurance funds, but you need foreign funds as well. I think that has to be the next frontier for financial sector reforms in India. This, by the way, is well recognized by the authorities and steps are being taken to do it. But in my opinion, much more rapid progress has to be made.
India Knowledge at Wharton: In order to meet India’s planning targets for infrastructure, what should the time frame be?
Kochhar: Typically, these markets take a lot longer to develop than one imagines. I turn to the example of Malaysia, which was affected by the Asian crisis in the late 1990s. It was a very bank-centered economy. One of the lessons they learned from the crisis was that they needed to diversify their sources of funding away from banks and into different kinds of debt markets. They made a concerted effort to develop their corporate bond market. It took about three or four years before they could get it going, and there had to be a fair amount of government intervention. The government had to put in enabling regulations to get rid of some of the impediments. These kinds of markets do take a while. That’s why [in India] we need to have the reforms very soon, knowing that the gestation period is long and the funds are needed now. The ambition was [to have] $500 billion of infrastructure investment over the current five-year plan, which actually ends in a year…. So they need these reforms for the next phase of infrastructure investment.
India Knowledge at Wharton: As you look around the Asia-Pacific region, are there other lessons India can learn, for example, from China?
Kochhar: Well, obviously China has had a lot of success, right? I think the Minister of Civil Aviation who spoke this afternoon, said, in India, people wait until there’s strong demand pressure and then take action — whereas, [in] China, they just build stuff, even before they need it. Now, obviously there are risks to both strategies. The Chinese strategy could be risky because you could be building something that in the end doesn’t prove to be very useful. But … we’ve come to the point where India needs to generate large amounts of employment. For employment, you need industry. The service sector, which has grown in India, tends not to be as employment-intensive. For industry to really thrive – and also, for industry to thrive in a way that can absorb the huge [numbers] of workers that are going to come into the labor force – you need infrastructure. So there has to be a proactive and concerted strategy.
I suppose the lesson one can learn is: What are the main impediments that India faces? And how did China overcome them? You’ll often hear people saying, “Well, India’s a democracy. China’s not.” Nevertheless, there are some lessons that one can learn. Korea’s another [success] — they went through the demographic transition that India’s going through [now] in the 1960s and 1970s, and really capitalized on it. They went from being a country that had a lower per capita income than India in the early 1960s, to where they are now, which is an OECD [theOrganisation for Economic Co-operation and Development, an international economic organization] country.
India Knowledge at Wharton: Indians tend to be very excited and optimistic about their country’s prospects. Do you see any risk factors that could undermine this success story?
Kochhar: In general, I share that optimism. We’re going to have the youngest labor force in the world for the next 50 years. Typically, countries [with] that kind of demographic transition have succeeded. You have an extremely vibrant private sector — a private sector that seems to have excelled despite the government in India. So, it is difficult to be anything but optimistic. But there are some constraints, and there are some risks. Number one is inclusion. This government has … won two successive elections based on the platform of inclusiveness. We are going to get to the point where the income gaps are so large that we risk some kind of serious social consequence. So this government is completely right in saying [that] we need to pay attention not only to growing the pie, but also to making sure that the pie is distributed more evenly. But the pie has to grow first. There have to be policies put in place to grow the pie.
The other risk I see is in India’s large fiscal deficits. We have deficits close to 10% of GDP now, and we have a debt of 80% of GDP. We spend significant amounts of the revenue that we collect just servicing the debt. When you have 350 million people living below the poverty line … again, I come back to this issue of inclusiveness. If you’re not able to provide for your people, and every year you run a deficit of 10% of GDP, which means you’re spending 10% of GDP more than you’re taking in, sooner or later, people are going to say, “What’s the effect of these deficits that you’ve been running?” So I see a stability risk from these deficits. Not in the same way as some other countries, [like] Greece or Turkey, because India doesn’t borrow in foreign currency; this has saved it from a violent crisis. But there is a downside: You’re basically eating into your own growth potential.
India Knowledge at Wharton: The IMF has been criticized at times for the conditionality of loans. We’re seeing some pretty interesting things happening in Greece, Spain, etc. What changes need to be made to avoid this? Do we need a global consortium, a la the Bretton Woods agreement that the leaders of 44 nations signed in 1944 to establish a global system of monetary management?
Kochhar: Probably not. Remember that the Bretton Woods meetings gave birth to the IMF and the World Bank. So the institutions exist. What is unique about [organizations like] the IMF and World Bank is that we have near universal membership. There’s no other international organization outside the United Nations system with that kind of legitimacy. Conditionality is very much a part of the design of the IMF’s lending program. The IMF basically gets its funding from quota subscriptions; it’s like a membership fee [for countries]. And it’s the only money we have, from which we run not only our operational budgets, but also [the loans]. It is a fund that has to be paid back in order for us to make loans to other countries when they need them. Conditionality is designed to insure that we’re repaid.
Over the years, the design of conditionality has changed. At times, it’s been much more intrusive than it is now. There is now a concerted effort to make sure that the conditionality imposed is really relevant for the problem that we’re trying to fix. The quota subscriptions are determined on the basis of your economic strength. It’s a formula that depends on a whole bunch of things. The world has changed a lot, and you could say, shifted eastward. The quota subscriptions have to be shifted now to reflect that change in strength. The trouble is that when you’re trying to shift quota shares around, somebody wins and somebody loses. And that makes it very difficult to implement. The losers would be the smaller western European countries. The winners [would be] emerging markets, particularly in Asia, with China being one of them. [At the fund we call such governance “voice.”] Quota and voice have to change. Our managing director has pledged that there will be a reform of these by early 2011. And preparations are being made to that effect.