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Rajeev Malik: Picking up the pieces

A misguided approach to salvage near-term growth has not only hurt growth but also compromised macro stability

Rajeev Malik
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Let us not kid ourselves: India has become a laughing stock within the international investment community. The actions and communication of politicians and policy makers have left and businesses, both domestic and international, scratching their heads. They are all trying to figure out why Indians have repeatedly used their own proverbial axe on their feet. It's high time policy makers and politicians took a step back to regroup and pick up the scattered pieces. Indeed, it is imperative that basic economic sensibilities guide efforts to restore the shine to India's structural economic story.

India's economic mess did not degenerate into its current putrefying state overnight. The irony with India's situation is that the problems were known and the solutions were clear. But timely political will to adequately fix things was absent; instead, there was a penchant for short-term fixes and band-aids, treating symptoms rather than the disease. Policy makers seemingly deliberately chose to make the economy more vulnerable by increasing its dependence on short-term, risk-driven volatile capital inflows while ignoring the worsening current account deficit. Emerging economies provide a host of similar case studies. It appears that India has not learnt anything.

There are five key areas on which to focus. First, politicians and policy makers need to better appreciate the art of communication with financial markets. Sitting in the trenches, we are often confused by the noise generated by hyperactive talking heads. Financial markets have tunnel vision, and their reactions at times can be irrational and exaggerated. But there's no denying that Indian policy makers have walked into a trap of their own making; they are now hostage of, and reactive to, market pressures.

Chanting "all is well", giving lessons in the English language, and preaching that the whole financial world has misinterpreted the guidance of the chairman of the United States Federal Reserve, or that investors in India should not look at US data only give the impression that policy makers are not with it. A more effective way is to address the specific issues that are bothering investors. Remember, less is more - it is not necessary to comment on everything.

Second, it is ironic that efforts in the last couple of years to avoid hurting growth have resulted in not only weaker growth but also compromised macro stability. This fallout happened because high has been ignored, interest rates have been eased, and there was a delay in returning to more sustainable balance-of-payments dynamic. India's fiscal-monetary fix is out of whack. The fiscal lever needs to be quickly pulled back significantly. Perhaps a way to start is, say, an increase of Rs 5-6 a litre in diesel prices, complemented with Rs 1 adjustment every month. Immediate reduction in other subsidies is also warranted.

Policy makers need to decide what they want to save in the context of a less favourable global backdrop for capital flows: near-term economic growth, the or fiscal sanity. A sovereign credit downgrade has the potential to mess up the government's political calculations. It is best to prevent it even if near-term growth suffers - especially if those actions result in more sustainable macro dynamics and a better-quality economic turnaround.

Third, the chronic neglect of uncomfortably high retail inflation is unforgivable. The rupee's problems did not emerge three months ago. And despite the recent palpitations about financing the balance of payments, it is grossly irresponsible to keep ignoring high retail inflation, which affects household inflation expectations. High consumer inflation - whatever its drivers - has also contributed to the rupee's demise as it erodes purchasing power.

High retail inflation is not just the result of high food prices. While interest rates cannot directly fix the structural supply-side impediments, monetary policy cannot ignore the fallout of persistently high inflation. In an aggregate demand-supply imbalance, one can either enhance supply to meet higher demand or curtail demand to meet supply. The absence of any supply-side response by the government forced the second option on India. There is little merit in blaming the Reserve Bank of India (RBI) for this.

Fourth, the exchange rate policy is out of sync with the real economy. In the last seven to eight years, the rupee has experienced significant appreciation and depreciation pressures. India has tried both excessive currency intervention and a hands-off approach. Flip-flops in global capital inflows have been an important player behind the swings - but so has the delay in taking timely and adequate action to correct the fault lines in the sustainability of our balance of payments.

The RBI's hands-off approach - not using its foreign reserves to defend unrealistic levels for the rupee - has prevented a quicker and bigger crisis. But inaction on structural changes in the real economy remains a key missing ingredient. Hopefully, there will now be greater focus on lasting solutions to the underlying imbalances rather than reliance on the quick fix of opening up new taps of foreign capital.

Finally, it is disheartening that some in the current government - whose prime minister is a former central bank governor - have tried to make the RBI a scapegoat for the growth debacle. No institution is perfect, but Indian and foreign investors and generally have more faith in the RBI than in our governments. It is not a mere coincidence that countries in which governments undermine their central banks by forcing them to toe their line typically don't have sustained stability in their currencies.

Governor-designate Raghuram Rajan comes in with a rock-star academic image but limited real- time policy-making experience. Ironically, the former could be a bigger hindrance than the latter. This is because it has generated unrealistic hope that he has some magical prescription to fix our problems. There is no such solution, in my view. He would do well to start off by offering a clinically objective and realistic assessment of our troubles and some indicative adjustment paths. He will quickly realise that his words now carry more weight and credibility; this is just the individual legacy of North Block and Mint Street.

I wish Dr Rajan the very best. The success or failure of RBI governors is dictated by how they navigate what I call India's self-manufactured unholy trinity of government interference, RBI credibility, and economic and market pressures. I have little doubt that he'll do what is right for the good of the country even if it involves some near-term pain. That is more desirable than buckling under political pressure to do what is narrowly beneficial for the government of the day.




The writer is senior economist at CLSA, Singapore.
These views are his own

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