Prime minister Manmohan Singh well recognizes the archetype of a traditional emerging-market crisis, where a lethal pattern of exchange rate depreciation combines with high levels of foreign-currency debt to trigger negative assessments and amplify the crisis dynamics. And so he flagged currency stabilization and strengthening balance-of-payments as his topmost tasks on taking over as finance minister.
Subsequent external sector statistics released for January-March 2012 buttress this view: The current account deficit worsened to 4.5% of GDP; the overall balance was in shortfall for the second consecutive quarter; the entire year’s deficit, at 4.2% of GDP, overshot all expectations; and reserves’ coverage shrank further, with 50% earmarked for short-term debt upto a year’s maturity.
Addressing the falling currency trend is the correct first step. So clarifications about retrospective and other proposed taxation changes are important signals to revive investor confidence. This fresh initiative, however, must be complemented by quick action to stem the evaporating belief of many investors in the India growth story. Basic things that are politically not so difficult and require no legislation can generate the energy required to stimulate investments, which is the PM’s objective.
In the near term, this implies sorting out the niggling impediments in infrastructure projects to accelerate execution and implementation; resolving problems in the power segment is equally essential as these threaten to engulf the banking sector, besides hurting productivity. Over a longer period, the expenditure-switching impact of rupee depreciation must be exploited; so segments of industry gaining in competitiveness (e.g. textiles) need backing to galvanize manufacturing and exports.
The timing couldn’t be more opportune as a bunch of positive factors are converging to tilt the tide in India’s favor at this point. Crude oil prices, the key rupee variable, have fallen 25% since March, with both cyclical and structural factors likely to keep them soft. Commodity prices have fallen across the board, with a glut in global supplies. With gold imports curbed by duties and rupee depreciation, the huge savings in the import bill implies that the current account deficit can only narrow from here onwards. Lower crude oil prices take the stress off other areas too: The most significant impact is the enormous savings in budgetary subsidies and lesser fuel price adjustments the government has to do.
The impact upon inflation is benign as well as the rupee-adjusted price fall exceeds currency depreciation, lowering production costs in future. Along with slower demand and assuming the monsoon holds, this may create the space for RBI to lower interest rates ahead.
That macro variables have troughed is reflected in market valuations that are now very reasonable, if not the lowest, relative to history. The changing sentiments have also led several large foreign as well as domestic investors to upgrade weights on India.
The government must ride this tide. Taking advantage of the easing pressures, it should consolidate macroeconomic policies, i.e. switch expenditures from consumption to investment and create space for monetary easing, and build the momentum for an economic uptick ahead. There is a vast pool of long-term capital abroad waiting to invest.
Renu Kohli is a New Delhi-based macroeconomist; she is a former staff member of the International Monetary Fund and Reserve Bank of India.