Green roots of recovery

Indian Express, 15 October 2009

Recent data on industrial production looks good and has encouraged suggestions that monetary policy can now be reversed. The data on exports, on the other hand, looks bad, and has led to media reports on how rupee appreciation needs to be prevented. Both data releases, which compare today to the pre-global financial crisis months, give wrong signals. Policy changes arising from ignoring the intevening months would be a mistake. More importantly, looking ahead, in the changed environment after the financial crisis, India needs to rethink its growth strategy. In the light of expected demand conditions in world markets, Indian policy makers need to focus on nurturing domestic markets. India needs a reversal of policy away from subsiding exports towards reforms that support faster growth of domestic markets.

The year on year growth in industrial production seen in the month of August fails to capture recent trends in the behaviour of production. To look at recent trends, and thus focus more on what happened in the last 12 months, rather than compare today to the month of August last year, we look at month on month growth rates. This data is seasonally adjusted to clean it of seasonal effects. The data shows that while June saw a sharp recovery in industrial production, there has been only a gentle increase since, at an average rate of below 5 percent. The critical message that comes from looking at the period after the Lehman crisis is that there is no reason to be eurphoric. We do see a pick up in growth, but not enough to begin a reversal of policy.

Indeed, what it suggests is that instead of a debate about a reversal of monetary policy, there needs to be one on how the nascent recovery in industrial production should be nurtured. The period from 2004 to 2007 witnessed very high growth rates of industrial production at a time when exports grew rapidly and domestic investment demand was high. Since circumstances are different, we need to discuss how to achieve high growth under the present conditions.

This is brings us to the clamour on exports. While year on year data still shows negative growth rates, i.e, it shows that exports today are lower than what they were in the pre-financial crisis period, data for seasonally adjusted month on month export growth shows a very strong pickup with average growth rates of more than 50 percent in the most recent quarter. This is not surprising as both world demand conditions, as well as trade credit availability, have improved compared to the period immediately after the crisis. However, with the year on year negative numbers, suggestions that RBI should prevent rupee appreciation to help exporters are back in newspaper editorials. Some of these do acknowledge that it may be a difficult policy, given the problems RBI could have with managing the impact of its intervention on monetary policy. While that is an important point, the bigger question policy makers need to turn to, is whether India should be attempting a policy of undervaluing its exchange rate. The RBI merely carries out the mandate of preventing appreciation if export promotion is an element in India's growth strategy. There is no reason it would put it itself in this quagmire, were the growth strategy different.

We now turn to the role exports played in high growth in India. In the last business cycle upswing exports boomed on the back of rapidly expanding world demand. Part of the policy package for achieving rapid growth was to keep exports competitive by preventing rupee appreciation. India needs to revisit the policy of aiming for an undervalued rupee in today's changed environment. This policy, supported by economists like Dani Rodrik and Arvind Subramanian, on the grounds that it results in high growth, has been popular with Asian economies with China leading the way. India has, without much debate, accepted its merits, and monetary policy has been overwhelmed by trying to prevent rupee appreciation. It is important now to ask ourselves afresh whether, looking forward, this is the best way to achieve high growth in India.

The effectiveness of an export promotion policy option can be expected to be limited, most likely in the long run, but at least in the coming quarters. The US economy is currently on a path of correction, with a weakening dollar and slower import growth. With US unemployment in the next quarter being forecast at 10 percent, and with households and banks both reluctant to increase consumer debt, a strategy based on rising demand from US households is unlikely to see success. Indian growth strategy needs to focus on domestic demand. This would require a reversal of the rupee policy. The rupee policy should not be guided merely by the difficulties that would arise in monetary policy if the RBI intervened in foreign exchange markets to prevent appreciation. A stronger rupee would make raw materials and capital goods cheaper for the bulk of domestic industry.

Apart from the immediate policy of not raising interest rate or curtailing liquidity to encourage domestic investment and production, the other important implication of this policy is to improve domestic market conditions in a number of ways. The laundry list of the reforms required is well known. It includes free movement of goods across the states and making India a single market through changing taxes, developing the domestic financial sector to make credit available to households and businesses, reform in agriculture such as in infrastructure, marketing and removing the cereal bias and constructing roads.

In summary, while there is improvement in the data, policy makers should not assume that things will go back to being as they were before the crisis, and the recipes and policy prescriptions that worked before the crisis will work again. Before policy reversals are done, India needs to rethink its long term growth strategy and reduce its focus on exports. Development of the domestic market and economic reforms must take priority.

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