Role of Markets and Governments in managing the growth in Emerging/Developing Economies

Thu, Sep 1, 2011

Biz Arena

Abstract

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

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One Response to “Role of Markets and Governments in managing the growth in Emerging/Developing Economies”

  1. Rashmi Shukla Says:

    Superb Nabarun..this was very informative…:)


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