In a quarterly macroeconomic assessment last week, the Reserve Bank of India (RBI) said the “exchange rate is not a foolproof tool for addressing…structural inflation…(for which) fiscal policy needs to work.” The central bank was suggesting that the interest rate channel is its preferred monetary tool, countering the government’s expectations that currency appreciation could check imported inflation and allow lower rates.
This is somewhat of a departure from the monetary-fiscal policy mix followed by RBI and the government in 2010-11. Then, currency appreciation and low interest rates amid strong foreign capital inflows helped keep inflation lower than it otherwise might have been, while a halt to reserves’ accumulation saved quasi-fiscal sterilization costs and kept government borrowing costs, viz. long-bond yields, low. Overall, this assisted fiscal licentiousness, averting pressure to withdraw the post-crisis stimulus.
The macroeconomic outcomes of this strategy are by now well-known: Still high-inflation with accumulated price pressures; ever-rising subsidies with a marked deterioration in public balances; an extraordinary rise in imports, build-up of private, external debt with a steadily expanding current account deficit and weakened indicators of external vulnerability. To the point that these imbalances led to heightened risks of macroeconomic instability and a country reappraisal manifest in a hefty depreciation of the exchange rate. Nothing short of a crisis except for the comfort of large forex reserves, a flexible exchange rate and still-favourable growth differential.
Unfortunately, the exchange rate response isn’t proving so helpful in external adjustment, much unlike 2008-09 or even as far back as 1990-91. Elsewhere, RBI said that import-export elasticities are low so the positive impact of exchange rate depreciation on the trade balance is limited; this is explained by the high-import content of exports and slower supply responses to price changes, while the price inelasticity of imports (ex-oil) arises from gold and fertilizers, where pass-through is incomplete. RBI estimates that a 10% real depreciation is required to raise non-oil exports by about 4% the following year; conversely, net petroleum imports drop by just a percentage point.
Although the central bank was cautious about the robustness of these results, the tepid response of the trade gap even in the short period for which these results hold is disturbing: if an external price reduction does not stimulate an expenditure switch between tradable and non-tradable sectors, how to rebalance external payments is a concern for macroeconomic policy.
Not so long ago, RBI’s Annual Report (2009-10) had evidence that currency appreciation significantly worsened the trade balance; a 1% real appreciation widened the trade balance by almost 0.7% over 1996-2009. What has changed structurally in this short span to cause such a dramatic reversal in the effects of exchange rate movements?
Clearly, hard policy questions arise here. For instance, what has caused the increase in import propensity and diversification of exports into items where firms have greater market/pricing power? Was the strong absorption of foreign capital in post-crisis years productive? If so, how does this reconcile with simultaneous decline in the investment rate? Can a consumption-driven, import-fed model deliver high growth rates without the drivers of investment and exports? The list is quite long. But answers to these should set the course of medium-term policies for repairing imbalances.
Renu Kohli is a New Delhi-based macroeconomist; she is a former staff member of the International Monetary Fund and the Reserve Bank of India.