Aspects of the Indian crisis have no parallels in recent history, and the crisis has consequently been misdiagnosed
India's current predicament is clearly not unique because other emerging markets such as Brazil, Indonesia and South Africa are also encountering turbulence. Nonetheless, aspects of the Indian crisis are unique when compared to previous historical experiences. This uniqueness has been missed by analysts and the crisis has consequently been misdiagnosed. Is it any surprise that remedies administered have been less than appropriate?
What is the crisis? That is best answered by dismissing what this crisis is not. Consider four misdiagnoses.
n This is not India 1991 or Latin America circa 1982. That is, India today does not face an old-fashioned balance of payments crisis. Such crises originate in fiscal binges, often in fixed exchange rate regimes, financed by external debt. Typically, the country overheats, leading to an overvalued exchange rate and an unsustainable external situation with low levels of foreign reserves. A crisis ensues because foreign obligations cannot be met.
India has run large fiscal deficits and the government has been allowing external debt to build up. Nevertheless its external indebtedness ratios are low (substantially lower compared to 1991) and foreign reserves are reasonable enough to cover short-term obligations. Critically, the rupee has been floating and has avoided over-valuation. And while the fiscal deficit has been high, the deterioration in the current account has coincided with the period of slowing growth, not the period of the fiscal binge.
n This is not East Asia circa 1997 or Eastern Europe 2007: that is, India does not quite face a "sudden-stop crisis". In such cases, as in East Asia and Eastern Europe, which also had fixed exchange rates, large private capital flows finance not government spending binges but private sector activity. The capital flows nevertheless drive up currencies, worsen current account balances, and, most distinctly, lead to "mismatches" in private sector balance sheets, which is another way of saying firms' obligations are in dollars while their revenues are in local currencies. When these flows start to reverse (hence "sudden stops"), the ensuing sharp declines in the currency adjustment wreak havoc on private firms because their debt servicing costs rise and profitability deteriorates. In turn, the domestic banking system, which has lent heavily to these firms, is adversely affected.
Clearly, India is experiencing a withdrawal of private capital. But India today has not pegged its currency, avoiding the over-valuation problem. And while debt especially in the private sector was accumulated, research by Joe Gagnon of the Peterson Institute suggests that the magnitudes and mismatches have been smaller in India than in East Asia. For example, private sector debt as a ratio of exports was about 50 per cent greater in Korea in 1997 than it is in India today. India today is also different in that its fiscal deficit is much greater than that of East Asian governments in the 1990s.
n This is not United States 2008: that is, India is not experiencing a conventional cyclical slowdown. To be sure, some part of the deceleration in economic growth from the heady nine per cent to 5.5 per cent is cyclical. But a substantial part is structural, relating to the fundamental doubts about the Indian model of growth based on high-skilled labour, and about the unstable regulatory regime, corruption and weak infrastructure that have depressed private investment. More, the slowdown is accompanied by elevated inflation and high and worsening current account deficits.
n This is not Greece 2010: that is, India's government finances are not unsustainable. Bad as India's fiscal deficit is (nine per cent of GDP), the Indian debt picture is nowhere close to being unsustainable. The reason, of course, is that India has had rapid growth in GDP (2003-2010) or high inflation (2009-2013) or both, which has meant that India's debt-to-GDP ratio has been declining even as deficits have remained high. According to International Monetary Fund figures, this ratio declined from about 75 per cent in 2009 to 66 per cent today. In other words, India has a fiscal deficit, not a public debt, problem. Consider next the policy errors from these misdiagnoses.
The first error flows from overlooking the fact that, unlike the old-fashioned balance of payments crises, India has had a flexible exchange regime. The financial community in India has played a key role in undermining the role of exchange rate depreciation as the natural adjustment for a current account problem. Current account deficits can be reduced by demand reduction or demand switching (from foreign to domestic goods). With political pressures limiting further fiscal correction as a demand reduction policy, demand switching through depreciation is the only choice. And attempts at defending the rupee have had the unfortunate effect of blocking that only route.
Faulty assumptions also play a role here. Indian macroeconomic policy seems to be afflicted with exchange rate pessimism, the notion that depreciation cannot boost exports and reduce imports. High levels of intermediate inputs and foreign indebtedness may dampen and delay the positive impact of exchange rates. But all the experience around the world suggests that there will be positive effects. If it does not, that would amount to saying that prices change behaviour with the notable exception of the most important price, the exchange rate.
The second error relates to the comparison with the East Asian crisis. The financial community in India has publicly worried about "inadequate financing" of the current account deficit. The government has attempted to roll out a series of measures in response - an obsession leading to some good reforms (liberalising foreign direct investment), some bad reforms (seeking to attract more debt flows), and some terrible reforms (imposing controls on capital outflows).
Another measure to finance the current account promoted by the financial community has been to defend the currency via tighter policy. The government and the Reserve Bank of India have - fitfully and half-heartedly, to be sure - accepted this advice. Not only does this action further stress private sector balance sheets, it also overlooks the fact that the currency depreciation will be less damaging than in the Asian crisis because of lower levels of external indebtedness.
A third policy error might flow from treating the current Indian situation like any other cyclical recession. Some, including Professor Kaushik Basu of the World Bank, have called for India to either loosen fiscal policy to revive growth or at least not further tighten on similar grounds. But this slowdown has characteristics of overheating (because of high inflation and worsening current account). Keynesian reflationary policies or even maintaining large fiscal deficits will, therefore, be counterproductive.
Which leads to the last - and least likely - policy error. India cannot afford conventional Keynesian remedies, but nor does it need to be subject to stern austerity because India does not have a fiscally unsustainable situation like Greece. And excessive austerity will have deleterious effects on growth and fragile private sector balance sheets.
In sum, India's economic situation is unique in its combination of slowing growth, high deficits, high inflation, a weak external situation and a plunging currency. It needs to carefully craft its own unique policy mix. What that should be is the focus of the next column.