Through this paper, I aim to bring into perspective the role of markets and governments in initiating, promoting and sustaining growth in these emerging economies. The close coordination of the various forces which shape an emerging economy requires better understanding to appreciate the dynamicity and core growth equations behind the success story of emerging economies. Through this study, we may be able to better understand their deep interplay as well as the intrinsic challenges they face.

The final part in this 3 part series covers the counter balancing forces of government policy needed to stabilize and drive emerging economies into a progressive future.

Role of Government as a Regulatory and Growth promoting body

Monetary and Fiscal Policies

Modern economics is greatly influenced by Keynesian theories propounding the increased role of governments in regulating and stabilizing markets to ensure stable growth. Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle. In the Keynesian economic model, the government has the very important job of smoothening out the business cycle bumps. They stress on the importance of measures like government spending, tax breaks and hikes, etc. for the best functioning of the economy.

Monetary Policy works by lowering the interest rates, which attractive private companies to invest in real assets which increase the aggregate demand indirectly, by raising the private sector expenditure. The opposite is also done to reduce the money supply in the economy so that inflationary tendencies are minimized and economy over-heating is prevented.

Fiscal Policy is more direct, but acts more slowly. It works by increasing demand for goods. Government does the borrowings to build roads, buildings etc, does the tax cutting, and tries to put more spending power in the hands of households.

Traditionally, the working of monetary policies can be summed up as: Central Bank lowers the interest rates as a result injecting liquidity in the financial system. Commercial banks try to lend the additional money leading to the falling of interest rates further. This leads to the fact that risky business becomes profitable. Firms and houses, as a result, begin to buy more number of goods, thereby increasing employment.

The financial tools available in the hands of the Reserve Bank of India to control the monetary and fiscal policies are:

1. Bank Rate: It is the Discount Rate, rate which the central bank charges on loans and advances to commercial banks (Short term).
2. Repo Rate: It is the rate at which the RBI lends money to commercial banks, a short term for repurchase agreement. A reduction in the repo rate will help banks to get money at a cheaper rate. It is equivalent to the discount rate of US. (Long term).
3. Reverse Repo Rate: It is the rate at which Reserve Bank of India (RBI) borrows money from banks.
4. Cash Reserve Ratio (CRR): It indicates the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method to drain out the excessive money from the banks
5. Statutory Liquidity Ratio (SLR): It is the amount a commercial bank needs to maintain in the form of cash, or gold or govt. approved securities (Bonds) before providing credit to its customers. SLR rate is determined and maintained by the RBI in order to control the expansion of bank credit.

Thus, through the use of Monetary and Fiscal policies, the government can effectively control the money supply and hence the demand fluctuations of the market. This is essential as growth cannot be uncontrolled. An uncontrolled spiral of growth invariably is built on shaky foundations which are bound to cave in bringing everything crashing down. Until growth of the economy is backed by strong fundamentals, the speculative trading would remain strictly short term with the specter of a long term crash imminent. The sub-prime mortgage crisis caused by speculative trading in realty is an apt example of such a scenario. This long term thinking is what stabilizes growth and makes emerging economies an attractive destination since they have robust fundamentals.

Production in Core Sectors

The government steps in for production of goods or services in areas which either are economically unviable for private enterprise, natural monopolies requiring heavy capital investments or are restricted from private industry participation. Investment and growth of these sectors are in the best interests of the nation. However, some of these industries require very high capital investment and may achieve break-even after many years. This makes it an unviable project to be invested and pursued by private enterprise that is mostly answerable to shareholders for their business results. The role of governments here is to invest in the long term growth and development of the nation. Pandit Nehru, the first Prime Minister of India, called these as nation building activities which required state involvement for sharing the fruits of growth and prosperity with the entire society. The investment of government in such areas as infrastructure also provides a firm foundation for the future growth of the country. Infrastructure provides connectivity, new untapped markets and a chance to boost commerce in distant corners of the nation. Secondly, such capital investments provide employment opportunities as well as a boost to the country’s GDP. This GDP boost also in turn shows an effect on the valuation of the private firms trading through the stock markets (see Figure 1). Government can also use this as a chance to collaborate with indigenous industries and increase their growth prospects. Thus, similar to the magic multiplier effect in banks, the government capital infusion and government controlled industries produce multiple positive effects on the economy thus producing robust growth prospects.

Sectoral spending patterns of governments reveal that the emphasis is towards promoting areas having lower growth as well as empowering disadvantaged sections of the nation to ensure the trickling down of prosperity in an equitable manner. Additionally, government spending even in developed countries is seen in such areas such as education, law and judiciary, healthcare, pension schemes and defense. This shows the central role of government in nation building for the future as well as in providing services for the betterment of the citizens.

Regulatory Responsibilities

The governments in emerging economies also shoulder regulatory responsibilities which enable it to control various macro-economic aspects of the economy. Through regulation, government can iron out the inconsistencies and inefficiencies of the market as well as shape the economic environment as per the shifting global and local trends. Regulations are essential in certain areas to ensure fair practices, preservation of rights and the empowerment of the citizens. Government also holds in its grips the tariff regulations which enable it to preserve the indigenous small scale industries from global competition as well as prevent dumping of inferior goods on local markets. The presence of multinational companies and low cost markets abroad having incentive to dump such rejected goods in the market can skew the prices and hence create inefficiencies in the free market price discovery process as well. This kind of actions can severely affect indigenous industries and can result in monopolies emerging. The regulation of trade is another key focus area of policy since unrestricted trade can lead to local markets facing inflation. The working of the CCI (Competition Commission of India), SEBI (Security Exchange Board of India), IRDA (Insurance Regulatory and Development Authority and other such regulatory bodies working in tandem with central and state government in India ensure that legal and ethical practices are followed and the general public is given a fair deal.

Overall, we can see the central role taken up by government in controlling and shaping the growth in emerging economies. While their involvement definitely has its benefits, there needs to be a balance since open market policies work best when they have minimal intrusions from external entities so that pure market forces determine the valuations and expectations of the consumers. Stringent government regulation and high tariff walls lead to protectionist tendencies which can choke private industries and mar the conducive environment for foreign investment.

Conclusion

Overall, through the various aspects considered above, we can see that emerging economies possess great dynamism which is fostered through the market economy as well as regulated through the presence of government intervention. The initiatives taken through promotion of free markets, investment in developmental projects, the focus on improvement of social development indexes, the maturing of governmental policies all point towards a focused effort at breaking into the league of world super-powers. Through their growing political, economic and trade clout, these maturing economies have started shifting the balance of power slowly and surely towards themselves. Through the exploration of various aspects of the role of markets and government in fuelling their growth, it has been clearly seen that such markets are increasing in the complexity of their operations and the span of their influence. The interconnectedness of development in laws, policies, frameworks, growth sectors, social indices, new markets, indigenous small scale industries etc. shows a uniformity of purpose as well as a clear roadmap charted out by these emerging economies in being the engines of growth for the world of tomorrow.

Figure 1 - This figure shows the relation between GDP growth on the stock market through a study using index data of a wide range of funds over a period of time in the BSE Indian Stock Exchange.

Data captured from http://www.sscommonsense.org/page04.html

Nabarun Sengupta

Masters of Business Administration (2010-2012)

IIT Kanpur

Through this paper, I aim to bring into perspective the role of markets and governments in initiating, promoting and sustaining growth in these emerging economies. The close coordination of the various forces which shape an emerging economy requires better understanding to appreciate the dynamicity and core growth equations behind the success story of emerging economies. Through this study, we may be able to better understand their deep interplay as well as the intrinsic challenges they face.

The 2nd part in this 3 part series covers the role of Markets as growth drivers in Emerging economies while the final part of the series next issue will deal with the counter-balancing forces.

Role of Markets as a Growth Engine

Price Discovery – Economists have traditionally believed that there exists an invisible hand in a free market based economy, which bring a state of equilibrium in market and this in-turn result in price discovery. Advocates of the free market form of economy argue that price discovery is a natural process that ensures fair, accurate, and responsive pricing. The essential philosophy of price discovery is that firms maximize their profit and consumers maximize their benefits. The preconditions for price discovery to happen are the presence of a large number of buyers and sellers, absence of any buyer/seller having absolute power to influence the market and absence of any form of information asymmetry among the parties involved. This concept of price discovery is the most intrinsic feature of a free market based economy. The mechanism of price discovery ensures that there is an unbiased way to determine the intrinsic value of any good in the market. Through the presence of a large number of buyers and sellers, the continuous exchange of goods enables all parties involved to obtain the best value with minimal inaccuracies. This technically ensures that skewed pricing schemes or incorrect valuation is not followed and every product has a constantly varying price affected by its quality and the nature of its demand. This dynamicity brings out the competitive forces in the market and ensures that innovation is always at the forefront of any industry policy.

Foreign Investment Opportunities – A major attraction of following free market policies is its ability to attract foreign investors into funding growth and development projects in the country. Foreign investors and angel investors generally look for high growth opportunities to invest their money in as seen by the increasing FII and FDI inflows into India (see Chart 1). With the maturity of developed markets and flat growth seen in such economies, these developed countries divert large sums of money into such emerging investment locations offering higher growth rates. The only caveat is the added risk introduced into their investment profile. For this reason, such investment vehicles generally prefer politically stable and economically progressive countries which have transparent policies and lower regulations on investments. Such foreign investments are crucial for augmenting the government spending on key sectors like education, healthcare, infrastructure, natural resources. India recently made news when FII inflows crossed the magical figure of Rs. 1 Lakh Crore which reinforced the confidence of foreign funds on the robustness of the Indian markets and its capability to sustain high growth with balanced policy (see Chart 2).

Chart 1

Chart 1

Data Source: Department of Industrial Policy & Promotion, Govt. of India
* Data for FY10 is for the first 11 months – Apr. 2009-Feb. 2010

Chart 2

Chart 2

Data shows the Total FII Inflows of 2010 which went beyond Rs. 1 Lakh Crore

However, a word of caution must be added to this rosy picture. The basic premise of foreign investment into emerging economies is to capitalize on the high growth rates offered. Hence, this funding is primarily profit seeking in its nature. An over dependence on these inflows would leave a country in a sensitive position where a slight destability may lead to huge outflows of investment. The onus is firmly on these emerging countries to establish and maintain a stable environment conducive for investment and presenting a balanced picture of sustainable growth. There are many instances of economies encountering pricing bubbles and speculative trading on the back of erratic foreign investments. So not only is it essential that investment is attracted, but regulations must also be made to limit these inflows to ensure sustainable growth. The inflationary tendencies of the economy as well as the speculative valuation of stocks on the back of FII and FDI inflows are well documented and hence need extra caution to be exercised.

Growth in GDP – Gross Domestic Product or GDP is a primary measure of the vitality of an economy as it conveys the dollar value of all the goods and services produced by that country over a specified period of time. As can be clearly seen, a robust and dynamic market can spur growth in the investment in private industries which in turn helps fund their growth plans. The highly capital intensive nature of heavy industries and core sectors requires heavy investments and this is where markets come into the picture. Through the stock markets as well as foreign investment vehicles, industries gain the capital required to pursue high growth strategies and scale up their businesses. This in turn results in increased production of goods and services and hence a robust GDP growth. As seen in Chart 3, the promising growth of emerging economies such as India and China is set to outstrip Western countries and sustain at much higher rates as per independent estimates.

Chart 3

Chart 3

Data shows the projections of the Real GDP growth of the major economies of today based on growth rates and figures taken historically.

Rise of the Consumer – The market structure promotes transparency of pricing, infusion of cash for growth initiatives and provides competitively priced technologically superior products in the hands of the consumers. In addition to this, the growth impetus provided by market economies results in huge employment opportunities resulting in increased per capita income. This increased income thus boosts consumer spending and helps in developing high growth markets internally. The presence of large number of competitive firms in every sphere helps shift the power into the hands of the consumer and empowers him to make informed decisions. Consumer spending accounts for nearly 60% of the total GDP of United States of America and international trends show the importance of a strong local consumer demand to ensure robust growth patterns.

As we have seen above, there are numerous benefits of an open economy which triggers and sustains high  growth in an economy. However, an area of concern is the formation of asset and valuation bubbles due to large inflows of investments. Since emerging economies are currently riding high on consumer sentiments, FIIs and FDIs are reaching unprecedented levels. This is primarily backed by strong short term profit making interests. An uncontrolled free market structure can result in valuation bubbles which are basically high valuations built on weak fundamentals. Preventive measures for such scenarios require a strong presence of regulatory authorities and balancing policy shifts to ensure that growth is balanced and sustainable.

Part 3 concludes next issue with the counter balancing forces of government policy needed to stabilize and drive emerging economies into a progressive future.

Nabarun Sengupta

Master in Business Administration(2010-2012)

IIT Kanpur

When America sneezes – the rest of the world catches a cold

It may be true with rest of the world but India had some higher immunity to resist the global meltdown which started in USA in 2007. This financial crisis impacted various economies across the world; including USA, UK, Japan, China, France and India. During this turmoil the countries had varying impacts; countries like China and India had a lesser share of the worldwide despair. There are many reasons which it has led the world to believe that India survived the global problem.

Financial policies implemented in India after liberalization in 1991 played an important role in this perspective. In India we have strictly regulated market by active participation of financial regulators like Reserve Bank of India, Securities and Exchange Board of India, Ministry of Finance, Ministry of Corporate Affairs. These regulators ensure that although Indian Markets have exposure to foreign players but at the same time have lesser vulnerability to global risks. Participatory Notes (P Notes) is one of the measures taken by Government of India (GOI) to control the Foreign Institutional Investment (FII). During recession stock markets gets plummeted if foreign players pull out their investments, P Notes is the key to check that. There are many such policies which had enabled GOI to run Indian Market as a tight ship. Some of the major Indian Banks were nationalized in 1969; it facilitated GOI in forcing certain policies like high Cash to Reserve Ratio (CRR), stringent credit policy and regulation of lending rate. This control over banks has proven to be a boon to India as recession started in U.S. due to the burst of Sub Prime Bubble; during this phase, to increase their profits, financial institutions started lending to the borrowers having lesser credibility at higher rates. In India above policies prevented Indian Banks from falling into this pitfall.

Apart from these, as compared to countries like USA and UK, people in India are traditionally less spend thrifty. In India people use their savings in accumulating wealth and making provisions for rainy day. As per the study published in Global Journal of Finance and Management, it has been found that Indians have higher risk aversion as compared to their European and American counterparts. Above study reflects the behavior of Indians in stock market, that they are less prone to speculative and risky investments. In India people also tend to put their savings in form of gold which further reduces the risk of losing investment. Gold is considered to be the best investment during recession times. US economy is having high level of consumerism which led to the avalanche effect of meltdown. India is still far behind USA in this aspect. Indian economy is still focusing more on its local markets, which makes it lesser susceptible to the risk posed by global markets.

India is one of the largest economies in Purchasing Power Parity Terms. It has made India a preferred location for Foreign Direct Investment (FDI). Large amount of FDIs make the economy of India robust and hence more resistant to the global fluctuations. Indian markets are still untapped at large and hence provide a much greater opportunity. Bigger local markets of India insulate her from global turmoil up to an extent. In India we still don’t have full Capital Account Convertibility (CAC). CAC is a nation’s feature to conduct various local financial transactions at market driven exchange rate. It has again protected India from various market forces and hence made India immune towards the global turmoil. Indian has broad government policies targeting the long term growth by facilitating growth in sectors like energy, infrastructure and manufacturing.

Another aspect of why India survived recession is the poverty prevailing in India. As per the World Bank Report, 80% of Indian’s population survives on less than 2$ a day. These people mostly earn their livelihood on daily wages. They are least impacted by any crises, as poor people will eat pulses and chapatti but if finds pulses are expensive he will switch to other cheaper alternatives like potato or sometime will have chapatti with just salt. In this way a large portion of Indian Population is completely immune to any financial turmoil.

India has not only shown greater resistance during financial crises but it was one of the countries showing the fastest recovery too. This financial crisis displayed the robustness of Indian economy. It has also helped in further fine tuning our economic policies and changing the vision of various corporate.

Vijay Kibe

Master in Business Administration(2010-2012)

IIT Kanpur