It is ironic that India – which, just a handful of years back, had almost everything going for it and also handled the Global Financial Crisis (GFC) with aplomb – has become the sickest Asian economy. Indeed, no other Asian country comes close in having misdiagnosed its economic problems and undertaken egregious policy mistakes. These mistakes made the already challenging situation worse, increased complications and delayed corrective actions.
Equally, no other Asian economy’s macro adjustment is as misunderstood as India’s. Economic problems have been made worse by denial and myopic politics, the use of a Band-Aid approach and treating symptoms rather than curing the causes.
India is still adjusting to the current, less favourable global liquidity environment. Global risk-on/off swings will still create near-term waves of optimism and pessimism that could coincide with domestic favourable and unfavourable news. Basically, India has been turned into a global risk-on/off fireball because of its high dependence on volatile risk-driven capital inflows to finance an unsustainably large current account deficit, and a policy approach in which, in the absence of reforms in recent years, the real sector is unable to digest the consequences of greater financial sector openness.
The most under-appreciated aspect of the current macro adjustment is the impact of global liquidity. The surge in global liquidity between 2003 and 2007 contributed to a propitious combination of domestic and external factors that facilitated unprecedented economic growth and equity market gain. These outcomes were despite a fourfold rise in crude oil prices. Further, the greatest pressure on the rupee to appreciate was during these years, despite the negative terms-of-trade shock of higher crude oil prices that caused a worsening of the current account deficit.
A coordinated policy response cushioned the hit from the GFC. But fiscal irresponsibility thereafter made the economic cycle abnormal, which, along with other policy boo-boos, led to a sick economy with uncomfortably high inflation expectations despite a dramatic deceleration in growth. Thereafter, crisis-like pressures on the balance of payments (BoP) precipitated unprecedented depreciation of the rupee.
India’s BoP dynamics in the coming years will need to undergo three key adjustments that cannot rely only on global factors. First, the current account deficit has to shrink to a more sustainable 2-2.5 per cent of GDP from 4.2 per cent in 2011-12. Second, a much greater share of the financing of the current account deficit has to be long-term in nature and less reliant on risk-driven global capital inflows. And third, the Reserve Bank of India (RBI) has to increase its stock of foreign reserves. The combined outcome of these adjustments, which will need to go beyond curbing gold imports and the uncertain blessing of lower crude oil prices, has important implications for the pace of sustainable growth and the RBI’s approach towards the exchange rate.
There has been a dramatic change in the pace of accumulation of foreign reserves, mainly an outcome of the shift in the RBI’s approach towards rupee management. Consequently, there has been a continuing decline in the import cover provided by foreign reserves. While still sufficient – even after taking into account the recent jump in intervention in the forward currency market in May – the import cover will continue to decline in the absence of a lasting increase in reserves. Such a declining trend in the import cover is unsustainable.
It is a foregone conclusion that the RBI will need to increase its foreign reserves or India’s external liquidity ratios will worsen further. Such an outcome will raise more worries among sovereign credit rating agencies. However, the increase in foreign reserves will occur only when India begins posting overall BoP surpluses and the RBI intervenes to prevent rupee appreciation. India is not there as yet but the current adjustment to narrow the current account deficit via below-trend growth is a step in that direction.
We cannot just rely on curbing gold imports, whose surge is also indicative of a vote of no-confidence in the inflation fight. Also, because of its asset characteristics, gold import is like a capital outflow. Thus, lower gold imports will improve the current account deficit, but the related impact on the capital account should not be ignored. But unless high inflation is fixed, households will find other avenues to escape the high inflation-driven erosion of their savings.
Eventually, most pressure points lead to the rupee. In recent years, the RBI has tried both extremes on rupee management. Up to 2008, it was interventionist as the volume of capital inflows was destabilising and a high multiple of the current account deficit. However, after the GFC, it adopted a hands-off approach. In the pre-GFC years, the currency intervention contributed to inflation via greater monetisation of the sharply higher overall BoP surpluses. In the post-GFC period, a wider current account deficit removed the need for aggressive currency intervention as capital inflows largely matched the wider current account deficit. But the RBI’s hands-off approach inadvertently allowed the rupee to become overvalued in real effective exchange rate (REER) terms because of India’s higher inflation relative to that of its trading partners and inadequate depreciation to compensate for the inflation differential. Indeed, between early 2010 and early 2011, the REER appreciated despite the depreciation of the nominal effective exchange rate. The significant depreciation against the dollar since end-July 2011 has been largely to correct the REER appreciation.
Thus, currency weakness is part of the solution, not part of the problem. This is especially true as the inflation fight is less potent than it should be, despite higher policy rates. The RBI is monetising the fiscal deficit, keeping government bond yields artificially lower than what they otherwise would be and is increasing the supply of dollars, which in turn fuels demand. Perversely, the RBI is helping the government, which is the most price-insensitive borrower and whose bloated market borrowing is contributing to macro imbalances, including high inflation. Ultimately, sustained low inflation and higher domestic savings rates are the key prerequisites for a lasting acceleration in non-inflationary growth.
Exchange rate movements impact inflation but it is not fully appreciated that high relative inflation also affects the exchange rate. Attracting more capital inflows does not eliminate the need to adjust the rupee for India’s higher inflation differential. Given that the global liquidity cycle will be less favourable in the coming years (although there will be swings due to shifting global risk appetite and responses of policy makers in some industrialised economies), Indian policy makers have a choice: they can either bring inflation down decisively or, as is more likely, continue the weak and uncoordinated attack on inflation.
The latter approach could cause the rupee to return to the almost forgotten days of annual depreciation. Such a view will be jarring to many investors and analysts but should be given serious thought. It is the one basic lesson that Indian policy makers should have learnt from their exchange rate management in recent years.
The author is senior economist at CLSA, Singapore.
These views are personal