Monday, November 24, 2014

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.

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    1. CommentedProcyon Mukherjee

      No new crisis would be needed to generate the response, the crisis is already passed its infancy; with dangerous and ominous symptom of growth rates that reminds one of the Hindu rates of growth, from Indian Inc to Am Admi reels under the same pressures.

      The fundamental is supply, which has been choked and Say's Law rules absolute, missing supply further chokes demand. Why is the supply been choked systemically, so that political rent and bureaucratic rent could be collected bit by bit.

      To give a simple example, the State with the most Mines, Odisha has only 130 Mines operational out of the 600 Mines in its kitty. No one is bothered to make them operational. How many jobs would this have created and how many insurgent attacks could this have stopped?

      The polity is rather complacent that their advance in the next election does not depend on the growth of the economy, but on the growth of the 'choked' channels of investments, which serves as a means to an end.

      So be it.

    2. CommentedArvind Gupta

      The implication of this article seems to be that growth rate could slip further and that India could face a BOP/Fiscal crisis. And only then would minds in India get focused!

      Aggressive fiscal retrenchment is being recommended. How much, possible specific actions and in what time frame? What would be their impact on competitiveness at a macro level?

      There is also a suggestion to undertake complementary actions that have a beneficial effect on competition, investments and productivity. What exactly are the specifics and how quickly would they ripple through the economy?

      The government has recently announced a number of policy changes and new initiatives. Are these adequate? What more can be done?

    3. CommentedWalter Gingery

      One important factor that Mody doesn't touch on is the undemocratic nature of Indian political parties. In the Congress, for example, power and advancement depend more on loyalty to the Gandhi family than on satisfying the needs of the voters, thus the widespread corruption and 'slippage' between the will of the electorate and the acts of the government.

    4. Commentedsrinivasan gopalan

      Prof.Mody's refrain on the illus plaguing the Indian economy has now become passe that the ruling dispensation hardly gets exercised over the brewing crisis. In fact, when fiscal austerity is the flavour of the season elsewhere across the world, India believes in spending its way to grow. How else one can explain the expeditious despatch of food security ordinance okayed by the Indian cabinet recently to offer freebies to millions without doing due diligence on the practicality of such a profligacy. Leave aside focussing on basic education, primary health and building physical infrastructure, the so-called economist Prime Minister Dr Manmohan Singh believes that the road to electoral victory for his Congress party is paved with keeping the electorate in good humour in the penultimate year to the General Election-- all else such as weakening rupee, whopping current accoutn deficit and raging consumer price inflation are nothing to worry for the nonce. Homilies from academia and media do not even mildly shake the authorities in India as they have their tasks cut out to please all even as they store up trouble for the succeeding government. G.Srinivasan, Journalist, New Delhi

        Commentedcaptainjohann Samuhanand

        What Indian Media advises is more FII infusion and not belt tightening. The Indian media only sees the freebies for poor which comes its way during elections but not the Non Performing assets of corrupt Indian business who in turn corrupt the politicians.