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The Rupee’s Wake-Up Call

PRINCETON – The Indian rupee has weakened rapidly in recent months, with the exchange rate against the US dollar dropping by 11%, to around 60 rupees, since early May. As a symbol of India’s economic strength, the rupee’s fall has provoked more than the usual hand-wringing and angst at home and abroad.

There is indeed reason to be worried, but not because the rupee’s value has declined. In fact, the slide has been long in coming, and recent market uncertainty has merely been a wake-up call.

The real reason to worry is that India has lost international competitiveness and has been buying time by borrowing from fickle lenders. Growth momentum has fizzled and, with inflation persistently high, Indian producers are struggling to compete in world markets. The current-account deficit is increasing relentlessly, owing to a widening trade deficit (now at 13% of GDP), raising the danger of a balance-of-payments crisis.

Indian GDP grew at heady rates of 8-10% per year between 2004 and 2007, a period that seemed to herald a decisive break from the anemic “Hindu rate of growth.” Reforms had unleashed new entrepreneurial energies and the prospect of a brighter future lifted people’s aspirations.

With foreign manufacturers piling in to satisfy a new hunger for consumer durables, India turned its gaze outward. The global economy – in a phase of buoyant expansion – welcomed India’s information technology services. Bangalore (the information-technology hub), Bollywood, and yoga became symbols of India’s soft power. That was the moment to invest in the future.

But the opportunity was wasted. Infrastructure did not keep pace with the economy’s needs. And, more deplorably, educational standards lagged. For a country positioning itself as a leader in the global knowledge economy, neglecting investment in education was a grave error, with other countries now staking a claim to the role to which India aspired. And, even when times were good, India never gained a foothold in the global manufactured-goods trade. Today, domestic investment has plummeted, exports are languishing, and GDP growth is down to around 4.5% per year.

Moreover, India has developed a tendency for chronic inflation, owing to an unhappy combination of supply bottlenecks (caused by poor infrastructure) and excessive demand (thanks to persistent public deficits). Budget deficits offered what appeared to be a free lunch, as the resulting inflation eroded the real value of public debt, while the government had privileged access to private savings at near-zero real interest rates.

With so much largesse to spread around, the government became a source of contracts with annuity-like earnings, which offered robust returns for those with political access. That weakened the incentives for entrepreneurship. And, as India’s external position deteriorated, the rupee became significantly overvalued between early 2009 and late 2012, trading in a narrow range while domestic inflation galloped ahead in a global environment of relative price stability.

Amid weakening competitiveness, the rupee was propped up by increasingly unstable foreign sources of funds. Traditionally, nearly half of India’s trade deficit has been financed by remittances from Indian expatriates. Part of this flow is steady, because it supports families at home; but much of it is opportunistic investment seeking real returns. According to recent data, remittances have slowed or even fallen slightly.

Similarly, long-term foreign investors have had reason to pause. This is not surprising, given the slowdown in consumption growth (car sales, for example, are suffering a prolonged decline). India has been left to finance its external deficit increasingly through short-term borrowing, the most capricious form of international capital.

As Rudi Dornbusch, the late MIT economics professor, once warned, a crisis takes longer than expected to arrive but moves faster than anticipated when it does. India may be particularly vulnerable, because all players there have been complicit in a silent conspiracy of denial. An overvalued exchange rate strengthens repayment capacity, so international bankers cheer it on – until they cut and run. And the Indian government played a large part in fueling rupee appreciation by easing companies’ ability to borrow abroad.

Indeed, at a time when restricting access to short-term international funds has acquired intellectual respectability, the government’s reluctance to enforce curbs has been puzzling. The International Monetary Fund, which now supports selective imposition of capital controls, seems unconcerned: the rupee, its annual review concludes, is fairly valued. This benign assessment is consistent with the IMF’s record of overlooking gathering crises.

With an overvalued rupee, there are no good policy choices. To avert a disorderly fall, short-term macroeconomic management requires officially engineered depreciation through administrative methods and restraints on external borrowing. A depreciated rupee should help revive Indian exports and lift growth. But, in the absence of complementary action, depreciation – whether engineered or market-driven – will make matters worse.

To dampen the additional inflationary pressures implied by a weaker rupee, more aggressive fiscal retrenchment is needed. Even so, a depreciated rupee will increase the burden of repaying foreign debt, and deepen the woes of domestic companies and banks.

To reclaim its promise, India must foster a new generation of productivity growth. The time for action is now. Unfortunately, a serious crisis may be required to initiate that response.