The Reserve Bank of India (RBI) surprised markets by holding its policy interest rate steady. And the RBI governor, Raghuram Rajan, came forward to explain the decision. Both were welcome steps. When growth is low and inflation is high - when in the midst of "stagflation" - the task of monetary policy is hard, the governor noted. The RBI, he said, could not single-mindedly pursue lower inflation; it also needed to care about growth. He could have added that higher rates would make little dent in inflation in the current situation. Private consumption and investment are still weak - auto sales continue to fall. Persistently large government deficits remain the main source of inflationary demand pressures and the government does not really care about interest rates in determining its expenditures. Moreover, if a rise in interest rates hurts growth, supply bottlenecks risk being aggravated, thereby stoking inflation.
But is the RBI doing enough to stimulate growth? Consider its exchange rate policy. In the summer, when the governor of the United States Federal Reserve, Ben Bernanke, spoke about the possibility of reducing the monetary stimulus in the US, the mere expectation of a rise in US interest rates caused money to pull out of emerging markets with large current account deficits. The rupee was about 20 per cent overvalued then - the outcome of persistently higher inflation in India than in the world economy. The rupee had been held up by a form of "carry trade": low US interest rates prompted a search for higher yields in emerging economies, which strengthened their exchange rates, thereby attracting more money. But such carry trades are delicately poised and can unravel quickly. The rupee predictably took a knock.
But, curiously, rather than letting the rupee depreciate to a more appropriate value, the authorities pursued a "strong rupee" policy. They first sought to use their foreign exchange reserves to prop up the rupee. But since that is always a losing proposition, they imposed "temporary" controls on Indian investments abroad. The rupee continued to depreciate before recovering. It stands today at approximately Rs 61 to the dollar, about 12 per cent lower than it was in early May 2013. Exporters have benefited and exports have finally shown some life.
But, although the depreciation of the rupee helped, the strong rupee policy continues in effect - the temporary controls remain largely in place. It is possible that the exchange rate market, having taken a deep breath, would not have pushed the rupee further down. In that case, persevering with the controls signals a continued policy aversion to the weakening of the rupee.
Such a stance is seriously misguided. In the short run, it encourages corporate borrowing in cheaper US dollars, secure in the expectation that the RBI will not let the rupee depreciate. When the market eventually does not co-operate, the incentive will be to protect the companies exposed to exchange rate risk by holding up the rupee. This strategy may benefit some companies for some time, but financial vulnerabilities will build up. At some point, the defence could fail, and the damage to the corporate sector and the knock-on effect on the external balance of payments and growth will then be huge.
Moreover, a strong rupee policy is a refusal to learn from the successful experience of East Asian nations, who actively maintained weak exchange rates to promote exports and growth. China, in particular, captured large shares of the global market by holding down the value of the Chinese yuan. Under eventual pressure from the world community, China did let the yuan appreciate. By then, China's manufacturing prowess could counter the appreciation by producing higher-quality products. Barry Eichengreen of the University of California, Berkeley, finds that although exchange rate deprecation by itself does not raise long-term growth, countries can use depreciation to "jump-start" growth. India could be helped by such a jump start today, especially in the context of still subpar world trade growth.
In sum, the underlying cause of the rupee's overvaluation remains firmly in place. The International Monetary Fund projects that the consolidated general government fiscal deficit will remain above eight per cent of gross domestic product for the next five years; with that, India's inflation - although declining gradually - will remain stubbornly higher than global inflation. By not allowing the rupee to depreciate, the RBI is inviting financial instability and hurting growth.
A worry with currency depreciation is that it raises the costs of imports, which would add fuel to an already high inflation rate. Just as lower interest rates help growth and potentially raise inflation, so too does exchange rate depreciation. This is a special worry for the government: the size of the subsidies it doles out will increase as the import costs of subsidised products go up.
The solution to this conundrum is straightforward. The government's budget deficit, which is the source of the inflationary pressure in the first place, must be reduced in tandem with the depreciating exchange rate. In particular, the pace of reducing subsidies must be stepped up.
Some would, however, argue that sensible economic policy is political nonsense. The interest groups that have a claim on the government's budget exercise greater influence than those that benefit from a weaker exchange rate. The interested parties with clout extend to those who benefit from lower-cost borrowing in the US dollar and other foreign currencies. This may well be so. But make no mistake; if the politics is intractable, we remain susceptible to financial instability and compromised growth.
The governor's own scholarly work shows that when domestic interest groups work against the general good, then external forces can - and should - be harnessed to restore the balance. In this case, the exchange rate policy can be used as an instrument for change.
The RBI now has the opportunity to effect such a change by removing its "temporary" controls on capital outflows - not least for their symbolism - and, dare I say, by lowering interest rates. That should reduce short-term money flows into India and help weaken the rupee. The RBI could, thus, present the new government with a challenge, and an opportunity. Faced with pressure of a weaker exchange rate on the budget, the government would need to act by pursuing more rapid fiscal consolidation. In a reversal of traditional roles, the RBI would push for growth and the government would work on lowering inflation. Together, they will serve the country well.