SYNOPSIS: Looks carefully at Krugman's call for Capital Controls and at Asian problems

From Business Standard Magazine

At a time when the Asian crisis is being dissected for possible lessons, Paul Krugman, MIT's celebrated Ford International Professor of Economics, has surprised policy-makers and economists alike by recommending imposition of capital controls as a last resort. The suggestion can be said to have a special relevance to the Indian economy, which is as yet only partially open.

In Calcutta to attend the three-day convention organised by the All-India Management Association (AIMA), Krugman underscored the need for prudent capital controls for emerging economies as a measure of abundant caution. He outlined lessons for India: Adequately capitalising banks, closing down weak ones and leaving the convertibility programme where it is. Krugman believes that by not being flavour of the month, India has avoided the worst. An interview with Saurav Majumdar.

Business Standard:
Assuming you were at the helm of India's finances at this point, what would you be doing to steer the economy?

Paul Krugman:
Well, I'd probably be advocating pressing ahead with reform... imports need to be liberalised. India should stop talking of disinvestment and start talking privatisation. They should deregulate as many remaining areas as possible. You see, India has had incomplete reform so far.

It's much more than what was there earlier, by far, but that's still only half way there. I would go for a strengthening of the banking system. Close the weak banks and impose serious capital requirements on the strong ones. Leave currency convertibility where it is. It's an extremely dangerous world out there. The risks of getting caught in the pinball game are too high. But what I'm not clear on is the Budget and the macro position. I don't know enough about these to make any specific comment.

You made the point about closing down weak banks. But in India, the social costs of this move could be disastrous...
You see, it may sound hard-hearted, but you cannot keep unsound financial institutions operating simply because they provide jobs. There can be a huge amount of damage a bad bank can create. There is a cruelty to our market system, but that cruelty cannot be eliminated. The alternative is fraught with danger, that of carrying on with the weak banks.

How do you think India has fared against the background of the Asian turmoil. Why, if at all, is the situation here not that bad?

India has avoided the worst. The answer is partly in the fact that the restrictions discouraged both inflows and outflows of short-term capital. The answer can also be attributed to the fact that India did not become flavour of the month too soon, or too long ahead of the crisis and was a relatively late entrant. For instance, among the troubled Asian economies, the ones which have been saved are the late entrants like the Phillippines.

No developing country with large-scale mobility in short-term capital is immune to these crises. India, fortunately, did not make the same mistakes. Had the crisis come, there would have been economic devastation, and the crisis would have fed on itself.
Look at Brazil. Just a few months ago, there was talk of the significant progress there. And now, there's a crisis. But you see, there is another aspect. I've travelled to a number of countries recently, and I have told a number of them that the crisis won't hit them, only to find later that it had. So, when I say that the crisis won't happen in India, I might just be wrong.

What is the one issue which is the basic cause of crises like these?
There's no one issue, really. Take a look at the affected countries --- you have the whole arc of east Asia, then you have Brazil and Mexico. The diversities of their policies and economies is enormous. But after going through all these things, with great hesitation I have arrived at this conclusion that there is no other plausible answer other than temporary capital controls. Otherwise, staying the course looks impossible.

Debt moratoria, which is one of the suggestions which have come, looks to be too strong and at the same time too inadequate. It is not really that external debt is a crushing burden --- it's not that big an issue. But the flight of capital has been major. If some variant of the current policies could work...structural reforms or the like, that's a judgement call. But it seems to be that there's little alternative.

When do you think is the time to impose such controls? I mean, when exactly should these be brought on?
I would say these should be brought about with an announcement of an intention to remove them after a point of time --- say, three years or so. Of course, if it is found that after the three years, the situation is still dangerous, then there could be a political price to pay for continuing with the controls. The controls can be lifted when it's safe again --- when emerging markets become popular again.

But I would much want to maintain, for the long term, prudential inward capital controls. Outward controls are all right, but inward controls are useful for the long term.

There's also the point about crony capitalism...
No, crony capitalism is not the only problem. It's not as if all the economies suffered simply because there were corrupt politicians who helped out their cronies and created rent. There's more to it. Look at Hong Kong. It's suffering because its exports are now hurt. But there's nothing wrong with the financial structure. The downturn in the stock prices has put Hong Kong's banks in some threat of being underwater. The natural policy answer for Hong Kong, the financial capital of the region, is to have its currency devalued, but they don't dare let it go for fear of a speculative reaction.

How do you read India's currency management?

I'm a little unwilling to stick my neck out on India, since I don't know too much about it. Maybe, if I do some in-depth research on India over two weeks, we can talk more fruitfully. But yes, the rupee is heavily managed. Smaller economies cannot have a benign neglect of the foreign exchange rate.
Unlike the United States, which ignores the exchange rate. We let it fall where it goes. To me, India looks a bit like Brazil. There's a large fiscal deficit, sluggish growth, unemployment. But on the other hand, it doesn't appear that the Indian government will raise interest rates to 50 per cent. And the government finances are also not such that it would get reflected on interest rates paid on government debt.

For those economies which are already in a crisis, there is a need for that extra degree of freedom. There is a need for outward capital controls. It's a bad policy, but better than the alternative --- that of economic devastation.

How do you look at the Malaysian controls?
The Malaysian economy is shrinking. I feel Mahathir Mohammad's policy is excessive and badly implemented. It's almost as if these controls are a permanent solution. But there's room to have some small growth. I feel Malaysia will see some growth next year. The crisis situation seems to me a bit like the 1930s. The countries that broke the rules did better.

There's a perverse, but relevant, point here. Properly instituted controls may actually end up being welcomed by investors. See, what are investors really afraid of? All they are afraid of is each other. It's like I'll keep in if you keep in. They don't want to stay on unless they are assured that the other investors, both domestic and foreign, will stay on. But when I talk of the 1930s, the comparison is only qualitative and not quantitative. This crisis has affected a very small percentage of global GDP.

When will we see the end of the crisis?
I think there will be a recovery relatively quickly. Argentina had problems. But it came out of those problems quickly because the changes were major. Following the 1930s crisis, there was a good recovery. In fact, very soon, there was a situation near to full employment.

I think there's going to be a pretty good recovery...I hope so. Not too far away. I think it'll happen pretty soon.