The Indian economy has been battered by turbulence. Unless proactive action is taken, it risks flying into a perfect storm for three reasons. First, more external shocks lie ahead. All the economic data point to the United States Federal Reserve reversing its current monetary policy quicker and faster than previously expected. Further rupee pressures lurk around the corner. Second, looming elections will amplify uncertainty. Third, and perhaps most important, as we argued in our previous column, the current macroeconomic policy mix does not adequately address the situation - decelerating growth, soaring inflation and fiscal deficit, a high current account deficit, and tattered market confidence - that India faces. So what constitutes right action? In the medium to long run, India has to make deep institutional changes (which we will elaborate in a future column) to boost manufacturing and exports as the underlying drivers of growth and to underpin an effective redistribution strategy. Here we want to focus on the short-run remedies that will minimise the risks of a crisis before the elections and serve as a bridge to their aftermath. The government has three short-run objectives: reversing the cyclical component of the growth slowdown; making some dent in the current account deficit; and preventing inflation, which is already high, from getting out of control. (Addressing these objectives will help restore a modicum of policy credibility.) And it has three policy "levers": the exchange rate, monetary policy and fiscal policy. Our suggested policy mix is for rupee depreciation to address the first two objectives, a tariff-based fiscal policy to dampen demand, which would help with the second and third objectives; and a moderate tightening of monetary policy to address the inflation objective. Consider why and how. Some simple analytics first. Macroeconomics 101 suggests that reducing the current account deficit requires two actions: switching demand away from, and encouraging production of, domestically produced goods; and reducing aggregate demand to essentially compress imports. A key distinction: demand switching will help reduce the current account deficit and increase short-run growth; in contrast, demand reduction will improve the current account deficit but at the cost of reducing growth. For this analytical reason - and given the severe political pressures working against curtailing growth and demand (especially via higher interest rates) ahead of the elections - the primary instrument for the first two objectives must be exchange rate depreciation, the classic demand-switching policy. The rupee's decline is desirable - because it has given India the best adjustment mechanism possible to reduce the current account deficit while helping growth - and it is unavoidable because the policies to defend the rupee are politically unsustainable. A rate of Rs 70 to the dollar seems calamitous compared to the rate of Rs 48.5 at the end of 2008. But adjusted for the 50 per cent inflation during this period, the two rates are roughly equivalent in terms of the economy's competitiveness. Of course, the recent rupee depreciation will have costs that will need to be addressed. Two costs need highlighting: additional inflation and the adverse effect on companies that have borrowed in foreign currency, and hence on the banking system. According to one estimate, depreciation by 10 per cent will add 0.8 percentage points to inflation. If the rupee settles at 70 to the dollar, the economy is looking at about two or three per cent higher inflation - which means a consumer price index-based inflation of 12 or 13 per cent. This is serious, especially if expectations get entrenched, saddling India with indefinitely high inflation.
An under-appreciated cost of high inflation is the reduction in savings and surging gold imports that have widened the current account deficit. The best way to address inflation is monetary tightening. However, the new governor of the Reserve Bank of India will have to contend with not just the political pressures against tightening, but also the additional problem of signalling that the tightening is not to defend the rupee but to mitigate the inflationary consequences of the currency's decline. Consequently, it is critical for fiscal policy to play a key complementary role in shouldering the burden of meeting the objectives of bringing down inflation and reducing the current account deficit (a lower deficit will also be necessary to absorb the substantial additional burden on the government from the likely need to recapitalise state-run banks). One of the key problems in the current policy mix is the lack of measures to reduce aggregate demand, which would help meet both these objectives. To be fair, there has been some tightening of liquidity, which will help reduce demand - but few believe in the political sustainability of tightening measures. Ideally, there should be fiscal tightening, and ideally, this should take the form of reducing public consumption expenditures and simultaneously raising domestic taxes. Truth be told, both - especially the first - seem pie in the sky under current political circumstances. Is there an alternative? There is a third-best measure that would both reduce and switch demand. The government could announce the imposition of, say, a five to eight per cent across-the-board (excluding oil and coal imports) temporary import surcharge. The rate can be calibrated to the desired magnitude of reduction in the current account deficit, but it should probably be below double digits. This surcharge would raise revenues; a rough estimate is that an eight per cent surcharge could generate 0.6 to one per cent of GDP in additional revenues. This could, thus, constitute a serious fiscal deficit reduction action, thereby helping reduce the current account deficit. By raising the price of imports, it would switch demand towards domestic import-competing substitutes and simulate a partial rupee depreciation. Thus, its key political attraction would be its growth-neutral or growth-enhancing way of reducing the deficit in the short run (the efficiency costs of import barriers kick in the medium run). To be sure, imposing the surcharge will entail costs. Therefore, it should be accompanied by key safeguards to minimise costs. Safeguards should include a clear timetable for phasing it out within a year to provide reassurance of India's non-protectionist intentions. The surcharge should be notified to the World Trade Organisation to reassure India's trading partners and to signal willingness to keep it under multilateral scrutiny. Moreover, the across-the-board nature of the surcharge will minimise distortions and avoid the selective and arbitrary raising of barriers, which are more likely to evoke pre-1991 India. Costly as the surcharge may be, it would be the lesser evil compared to a macroeconomic situation spiralling out of control. Given the government's eagerness to go ahead with the food security Bill (and resulting increases in subsidy), it is important that the proposed import surcharge be coupled to at least one important policy change signalling resolve to reduce the deficit - be it fuel or fertiliser subsidies, whichever is politically least unpalatable. Simultaneously, the government must add ballast by expending its scarce political capital in pushing through the Constitutional Amendment Bill on the goods and services tax in the next session of Parliament. Things have come to a pretty pass, where protectionist action - even of the circumscribed variety we are proposing - seems necessary proactive policy. But the first casualty of deep and self-inflicted troubles is the luxury of good options. (The final instalment of the three-part series will appear next week)
Devesh Kapur is director, Centre for the Advanced Study of India at the University of Pennsylvania, and Arvind Subramanian is senior fellow at the Peterson Institute for International Economics and Centre for Global Development