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Washington consensus -- II: Fallout of interest rate, trade policies

Looking into the fourth, fifth and sixth goals of the Washington Consensus, P. R. Brahmananda points out that the interest rate and trade policies implied in the Consensus are contrary to the tenets of the IMF, which is working towards lower rates of inf lation among the developing countries and more realistic interest rates.

The programme will not only hurt industrial activity but also make governments borrow more and, thus, go against fiscal discipline.

THE fourth `objective' specified in the Washington Consensus concerns interest rates. The Consensus favours interest rates that are market-determined, and real rates which are positive but moderate. Market determination is in terms of nominal rates of in terest -- short-term, medium-term and long-term. Depending on the expected rate of inflation, which itself is largely determined by past and on-going inflation rates, the real rate will be the nominal rate of interest minus the expected rate of inflation .

As the Washington Consensus does not directly specify any level of the inflation rate to be pursued by the Authorities, for any given market-determined nominal rate, the higher the expected rate of inflation the lower will be the residual real rate. The Consensus does not go into the question of what determines the optimum real rate in a developing economy. In fact, it is probably incorrect to state that the real rate should be positive but moderate without going into the question of what determines the optimum real rate.

There is a consensus among economists that the optimum real rate would be close to the expected long-term growth rate of the economy. Obviously for an economy growing at 6-8 per cent per annum, the optimum real rate would be higher than that for an econo my growing at 2-3 per cent. The latter is the case with most developed countries, and the former holds good in many developing countries, such as India, China, and some South-Asian and Latin American countries.

If the monetary authorities in a developing economy are not able to contain the inflation rate to below 5-6 per cent per annum, the real rate will then have to be close to 11-14 per cent. In India, the long-term inflation rate is close to 8 per cent. It will take some years before the expected rate can come down to 5-6 per cent. Hence, the optimum nominal rate will be above 11 per cent. To have nominal rates below this will be to depress the real rate from its optimum value. This is an invitation to dep ress the propensity to save and to invest in capital-intensive projects.

It will also lead to less inflow of foreign capital than otherwise and may deter potential exchange earnings from flowing back to the economy. I wonder whether the framers of the Washington Consensus realise the implications of its emphasis on moderate r eal rates. In fact, the policy implied in the Consensus goes contrary to the tenets of the IMF, which has been working towards lower rates of inflation among the developing countries and more realistic interest rates.

The Washington Consensus programme will imply heavy monetary and financial repression. It will discourage financial deepening, apart from encouraging too much capital deepening. It will also make the governments borrow more and, thus, go against fiscal d iscipline. The worst effects are that the developing countries will depress the savings ratios within, without being able to invite more foreign capital from abroad. I wonder which monetary or development economist will endorse the Consensus' policy.

The reference to market determination of interest rates is understandable in the context of countries with broad, deep and resilient financial and security markets. Many developing countries are yet to attain that status. In fact, money and financial mar kets are narrow, shallow and structurally almost inelastic. In this context, monetary authorities will have to think in terms of hypothetical rates as would be desirable given the country's economic conditions.

Government borrowing from the markets is large, and governments' interest rates being low, this results in low short-term rates maintained by huge central bank direct and indirect support, with large-scale inflationary inductions of money and credit. Con sequently, inflation rates keep rising, and to prevent this partially, governments have to indulge in large-scale imports, which destroy domestic industry and deplete the reserves. Soon, the economies get into balance of payments crises.

The fifth `objective' is specified as `competitive exchange rates'. The Washington Consensus does not specify market-determined exchange rates. It is aware that individual developing countries are unable to protect their exchange rates against direct and indirect speculative onslaughts. Hence, the Consensus probably wants the countries to pursue partly-administered exchange rate mechanisms, which take into account the movements of exchange rates in other countries. One method would be to tie the country 's exchange rate to a highly market-competitive currency, such as the US dollar or the yen.

Another method would be to make the domestic exchange rates move in harmony with a basket of other currencies, or with a strong international currency. Basically, it is a question of keeping the real exchange rate with the US dollar largely constant. Thi s means the nominal exchange rates will have to follow the course of the US dollar. It is not clear whether this policy is the best from the angle of particular developing countries.

If the country concerned is subject to inflation rates higher than that in the countries with which it has trade relations, it may have to go on depreciating its currency. As the Washington Consensus does not specify that monetary discipline would result in a substantially low rate of inflation in a developing economy, the advice implicit in the Consensus may lead to persistently downward movements in nominal exchange rates. Expectations of this would imply a speculative outburst against which the count ry may be helpless.

The sixth `objective' refers to trade liberalisation, and this is interpreted as `replacement of quantitative restrictions with low and uniform tariffs'. Especially in the Indian economy, this component of reforms has met with stiff opposition. The frame rs of the Washington Consensus must be aware that the quantitative restrictions are particularly concerned with the import of products manufactured in the domestic economies of the particular countries, or which would be in the nature of luxury items who se imports could lead to huge consumption disparities in the economies, given the pattern of income distribution.

High tariffs by themselves cannot prevent imports of the latter type of commodities. There could be two arguments against quantitative restrictions. The first argument would be that by replacing such restrictions with high import duties, considerable rev enues could be earned by the domestic economies. Since the Washington Consensus desires low tariffs, this reason may not find favour with the framers of the Consensus.

The second argument is that quantitative restrictions would lead to smuggling of banned commodities into the country. It could be argued that the way out should be to strengthen Customs checks. The Consensus desires low tariffs on all imported commoditie s. This would mean domestic production would now meet with stiff competition. Moreover, the governments would also lose heavy revenues.

Both these effects have been noticed in the Indian economy. A large number of domestic industries have been closed down. Since there are insufficient mechanisms and authorities to reduce dumping, and the leading dumping country -- China -- is not yet par t of the WTO, India is helpless, as large-scale imports of a wide variety of consumer goods are now pouring into India at prices that which are probably below normal costs. These goods are produced in China with the latest American technology and capital , aided probably by ultra cheap labour. These products are marketed even at the street level, and often on a door-to-door basis.

The pruning of the negative list of imports in the commerce policies by the previous and the current Commerce Ministers was strongly criticised by this columnist. He had warned of the depressive effects of these policies on a whole range of domestic indu stries. But political personalities, even in the opposition did not voice their criticisms at the time the policies were introduced.

We now find that if these policies continue, the Indian economy's industrial structure, including small industries, would be virtually wiped out in the next few years. The swadeshi concept received its biggest blow from these policies. But the government of the day has not been responsive at all to the woes of industry. The Washington Consensus, so blindly followed by the two Ministers, is seriously hurting industrial activity, especially in Karnataka, Tamil Nadu, Maharashtra and Gujarat.

The case for uniform tariffs is not acceptable in the latest economic theory concerning indirect taxes. The elasticities of demand and supply for different goods are not the same. Hence, it would be wrong to pursue a policy of uniform tariffs. There is r eally no rationale for this at all.