This isn't 1991

Indian Express, 30th April 2012

What the country should do to prevent a balance of payments crisis

India has been downgraded, the GDP growth has fallen sharply, the fiscal deficit and current account deficit have become bigger and inflation has risen. Despite all these difficulties, the country can prevent a balance of payment crisis if it maintains a favourable environment for foreign private capital flows and allows rupee flexibility. In the short term, exchange rate stabilisation will depend on the capital that can come into India. In the medium term, stabilisation of the economy critically relies on exchange rate depreciation.

The GDP growth has fallen sharply from 9.83 per cent in Q2 2009 to 4.25 per cent in Q4 2011 (quarter-on-quarter, seasonally adjusted). This is as bad as what happened during the crisis - when growth crashed from 11.73 per cent in Q4 2007 to 4.89 per cent in Q1 2008. But that was externally driven, while the growth crash after early 2009 is more rooted in Indian economic policy.

The question on everyone's mind today is: are we headed for another 1991-style BOP crisis and an IMF programme? In the pre-1991 days, India had an administered rate. In addition, there was no access to private capital flows. That resulted in a crisis with no dollars left to import essentials like oil. The only way out was to go to the IMF and ask for money.

Both elements - the exchange rate and access to private capital flows - are now on a different footing. India now has a good deal of experience with exchange rate flexibility. The rupee has been allowed to move both ways in the post-1991 years and by now it is apparent that rupee flexibility has not resulted in any big disaster. After the global financial crisis, despite the large reserves, India has allowed rupee depreciation, and not intervened much to hang on to unviable levels of the exchange rate. Moreover, Indian exports have performed well after the rupee weakened, despite the slowdown in world trade.

The second big difference with 1991 lies in India's integration with global financial markets. In 1991, we lived in a FERA world, where cross-border transactions were criminalised. Today, India has made progress in building a deep engagement with global capital markets. In the areas of equity investment, private equity investment and borrowing by large corporations, global financial firms participate in the Indian financial system. Private capital flows into India, bringing in money required to finance the current account deficit. On this front, government policy, budget announcements, tax policies, tax treaties and capital controls have to be mindful that with the sudden, sharp increase in the current account deficit, India needs foreign private capital inflows. If the inflows are small, the rupee will depreciate.

In the past five months the RBI has been intervening in the foreign exchange market and selling dollars to prevent a sharp depreciation of the rupee. If the pressure on the rupee to depreciate was only transitory, the RBI would not have needed to intervene month after month. However, if the pressure is caused by fundamental weaknesses in the economy, a higher inflation rate, a large current account deficit, loss of confidence in the growth story and slowing down of capital inflows, then the RBI intervention can only put off the depreciation and not prevent it altogether. Cutting of interest rates will only weaken the rupee further and propping it up by intervention or by imposing capital controls can only buy some time.

But is preventing depreciation an appropriate policy in a slowing economy? Currency depreciation is an automatic stabiliser, were it allowed to happen. The impact of a depreciation is to raise the price of imports, thus pushing more import substitution, and to lower the price of exports, thus pushing exports. Both elements raise domestic production. While policymakers worry about lower growth and try to push growth through cutting interest rates, if, at the same time, the RBI blocks the automatic stabliser role that the currency plays, it hurts growth.

Even though the RBI has defended the rupee in recent months, if the crisis deepens, it should be obvious that there is no point in selling reserves in an attempt to defend the rupee. While macroeconomic policy-making at the RBI has many problems, it will hopefully know when it cannot stand in the way of a significant move of the rupee. It is unlikely that the RBI will exhaust its reserves trying to defend the exchange rate. Indeed, even in the global crisis most countries held on to their reserves and allowed their currencies to depreciate.

Given how Indian economic policymaking is now under way, it is likely that we will encounter difficulties in coming months. We need to have clarity about our sources of stabilisation and to keep working on strengthening them. First, we need to continue the process of capital account decontrol so as to have strong channels for foreign capital to flow in. Second, we need to move away from the exchange rate policy of recent months, where the RBI has been getting into dangerous ground by selling reserves and defending the exchange rate. The very loss of reserves and the inadequate rupee depreciation that is out of line with the deterioration of fundamentals are triggering off nervousness.

In conclusion, economic conditions in India are dire, but we are not going to have a BOP crisis, particularly if two important changes in policy are made (stop defending the rupee and continue to liberalise the capital account). We cannot hope that an IMF programme will reboot Indian economic policy. We will remain stuck in dreary conditions until we find the internal energy to reverse the policy mistakes that have given us a crash in growth from Q2 2009 onwards.

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