Business Standard

Chidu-nomics - the threat within

Preventing managed rupee depreciation is a key internal inconsistency in the finance minister's economic prescription

Rajeev Malik 

At the end of February, Finance Minister P Chidambaram, one of the few promising politicians in India, will unveil what will probably be the last effective Union of the second term of the United Progressive Alliance (UPA). Typically, for a normally functioning government, the last of its term is an exercise in enjoying the gains of previous years, with a greater focus on feel-good measures. Some sensible – even tough – decisions would have already been taken in previous years to create a macroeconomic backdrop that facilitates some flexibility in offering a pre-election

Alas, the UPA has hardly been a normally functioning government. It preferred the reverse order, with self-inflicted and misguided macro irresponsibility in the earlier years forcing it to finally wake up in last September and undertake long-overdue corrective measures.

Mr Chidambaram returns to announcing the Union Budget after February 2008, which was also the fifth straight Budget he announced as finance minister of UPA-I. Frankly, the period between 2004 and 2007 would be the wish and delight of any finance minister. He became finance minister in 2004, the early phase of what was a spectacular run-up in India’s economic growth and the Sensex, aided by the strongest global liquidity surge we have ever experienced. This unprecedented global credit cycle eventually resulted in the global financial crisis in 2008, but most people in the government and the private sector were misled into thinking of it as being largely driven by India-specific factors.

Indeed, so loud was the government’s chest-thumping that Mr Chidambaram said in his 2008-09 Budget speech, “I am of the firm belief that we owe our sustained progress to the policy of economic reforms first ushered in by a Congress government and now carried forward by the UPA government.” The global backdrop apparently did not seem to matter. He further added that he was “…confident that high growth was sustainable”. I wonder if the finance minister in his forthcoming Budget speech will acknowledge the macro damage done by UPA-II’s policy incoherence and misguided populism in the name of inclusive growth.

There are no real reformers in India. Most politicians – including the technocrats-turned-politicians and accidental reformers, such as Prime Minister Manmohan Singh – have been unable to make a convincing case to voters about the merits of reforms. There are several technocrats who emphasise reforms, but most have little political clout. At best, they are occasionally successful in pushing through some measures — as has been the case in the last six months, when the economy was precariously positioned.

Mr Chidambaram perhaps comes closest to being a politician with some reformist credentials. He certainly deserves credit for the measures since September that have prevented further economic deterioration. But the real credit should go to Sonia Gandhi for giving her political blessing for these measures, whatever the underlying motivation, or political desperation.

Two stains on his UPA-I years were liberal use of off-Budget special subsidy bonds to make the official fiscal deficit look better than it was and the infamous farm loan waiver. Also, Mr Chidambaram initially resisted the sage advice of the Reserve Bank of India (RBI) to restrict foreign borrowing by Indian companies. In the end, however, the then RBI Governor Y V Reddy got his way and saved India from a financial earthquake that could have dwarfed the 1991 crisis.

Mr Chidambaram’s term as finance minister with UPA-II was born in difficult circumstances, thanks to money-does-grow-on-trees approach of the Congress party. More than an ideological reformer, he comes across as a pro-equity market finance minister. More worryingly, economic vulnerabilities have increased, but the fault lines are masked by the easy global liquidity.

Mr Chidambaram has a challenging task ahead of him. Fiscal contraction in the run-up to a general election is hardly a recipe for electoral success. What makes the challenge more daunting is that part of reducing government expenditure requires unpleasant political decisions about cutting non-food subsidies. Fuel subsidies also need to be cut to make some room for the potential hit from the food security Bill, often characterised as UPA-II’s political trump card ahead of the next general election.

The UPA-II is now trying to fix a system it broke with a risky approach and it could still backfire. Mr Chidambaram is attempting to doctor an economy that has become a low growth-high inflation economy, thanks to his government. The twin deficits are unsustainably large, investment is frozen, consumer spending cannot be unaffected by the cuts in subsidies, and the economy is exposed to volatile risk-driven capital flows like never before in India’s history. The rupee has had one bout of the currency flu, but is showing the symptoms of more serious suffering for which policy makers are ill-prepared.

Policies have ironically made the supply-constrained Indian economy less competitive. The cost of capital in India was never low and it has become more expensive in recent years because of much-needed monetary tightening. Land has essentially been all about rent-seeking behaviour, which was not addressed in a timely manner and subsequently contributed to crippling investment. India’s labour market has been off-limits, and the employment guarantee legislation, directly and indirectly, raised wages. But, and this is an important point the government is uncomfortable to confess, without any gain in productivity.

The way to address this erosion of competitiveness is a combination of domestic cost deflation and currency depreciation. The land acquisition Bill will further worsen the cost structure of the economy. That leaves rupee depreciation. But Chidu-nomics favours rupee appreciation even if the underlying economic situation doesn’t support it. Therein is the biggest internal inconsistency in Chidu-nomics, not to mention the increased vulnerability to an unexpected reversal in global capital flows.

The mood was worse than the reality on the ground before last September. The reverse is true now, thanks to the re-rating of the equity market. Given the idiosyncratic factors responsible for crippling investment, fiscal correction in India’s case is a necessary but not a sufficient condition for investment revival.

The only reason Chidu-nomics has not already resulted in a more serious crisis is the exceptional easy global liquidity. All of us want India to do better. The question to be asked about Chidu-nomics is not what if it works, but what if it doesn’t work, as we are not prepared for the consequences of that. As global events of recent years have shown, economic fault lines eventually assert themselves, even if delayed. Policy makers are risk managers, not risk takers. Worryingly, that distinction has lost its relevance in India.

The writer is senior economist at CLSA, Singapore.

These views are personal

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First Published: Tue, February 12 2013. 21:40 IST