Correcting imbalances is a long and laborious process. The huge expansion of the trade deficit to $18 billion in September, a tad short of last October’s peak of $19.6 billion and after some months of relief-giving compression, is a reminder of this. Project the trade balance a bit to fathom where the current account deficit is headed—4.9% of gross domestic product (GDP) in July-September by most estimates. Factor in the dangerous dependence on short-term portfolio flows for financing it and you know the currency remains susceptible to sudden stops.
Policymakers should be alert to this reality. Instead of pinning hopes upon a hollow-legged appreciation, they should be quick to back the short-run stabilization with substantive measures to correct the drift in fundamental variables.
What matters now is the trend. It was the steady increase in fiscal and current account deficits in the past couple of years that led to participants’ reappraisal of India in the first place, including the massive exchange rate depreciation. So the course of inflation, fiscal and current account deficits needs alteration to bring about macroeconomic adjustment that can be observed ahead by economic agents. This alone will now sustain the positive turn in sentiments.
The goal of course correction has to be productivity improvement in the medium term. Over 2009-11, excessive fiscal expansion and a hands-off exchange rate policy have combined to erode the economy’s competitiveness: The ensuing relative price shift diverted resources into non-tradables; the adjustment costs of this policy mix were inflation, an extraordinary rise in wages, imports substituting for domestic production and a rapid increase in external debt. That macroeconomic policy framework has to be reworked. Fiscal contraction with changes in the spending mix is necessary to realign investment incentives towards the tradable sector and raise savings, while exchange rate overvaluation needs to be avoided to address the trade balance.
Where can competitiveness gains come from? Successful reforms to attract overseas investments in aviation, power exchanges, insurance and pension businesses will attract lasting capital resources to match long-term funding requirements in spheres like infrastructure, but will generate little in hard currency earnings, while the absence of corresponding changes in land and labour markets will limit multiplier effects. The latter is relevant for manufacturing, too, which is adversely impacted by macro imbalances: High inflation and savings deficit push up funding costs, an uncompetitive exchange rate undermines competitiveness and land-labour-infrastructure issues further add to production costs. In this light, agriculture, whose productivity lags behind that of advanced and emerging, comparator countries, offers scope for quick response in view of its low-productivity base and expected future prices. A significant stimulus could be derived from deregulating agriculture markets: within the country and through external trade, so a long-term exim policy, as recently indicated by the agriculture minister, would be good step in this direction.
Arresting the rupee’s slide was necessary to limit the inflationary impact of depreciation alongside weak exports and inelastic imports. But this must now be supplemented with policy changes to return the key macro variables on a sustainable path.
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.