A.V. Rajwade, Independent risk management consultant and columnist

If answers to the questions are yes, as any Indian would like them to be, a lot will depend on studying what has happened in the global economy in the past three decades, and following macroeconomic, particularly exchange rate, policies to achieve the objectives.

Before discussing these, however, it would be useful to touch upon the ongoing sovereign debt crisis in some European nations. To me, their basic weakness was that, in the international currency (euro) regime, domestic inflation was higher than in a more disciplined Germany.

The result was that even as Germany was earning large surpluses on the current account, their economies were incurring increasingly large deficits on the current account. The inevitable corollary: persistent and growing dependence on capital inflows to balance the books. The crisis resulted when the costs of getting that capital, as reflected in bond yields, became unacceptably high.

Savings-investment imbalance

For economic analysis, I prefer to look at remittances as capital inflows, albeit of an irreversible nature; they, obviously, are not earnings of the domestic economy.

Chart 1 summarizes the changes in the external deficit and the net external liabilities since 2004-05. In the last six years, the trade and current account deficits have gone up year after year; the mirror image of this is the rapid rise in India’s net external liabilities, which have gone up to almost $220 billion by the end of the last fiscal, a significant amount in relation to our gross domestic product (GDP).

Our policymakers seem to believe that the rise in the current account deficit is the result of the higher investment needs of the economy, compared with its savings, which they see as a positive sign for future growth. The corollary is that we need not worry about the deficits on the current account, particularly as these are easily financeable. The refrain is: where can capital go in the current state of the global economy?

Is such complacency in our long-term interest? To my mind, there are other implications of the deficits and their impact on growth. The external value of the Indian rupee directly impacts the trade and current accounts through the competitiveness of the tradables sector.

Indirectly, it also affects domestic output and savings. Net exports are a part of the standard calculation of economic output of a country. To the extent the number is negative, the aggregate output is correspondingly lower. This means:

1. A reduction of government revenue through both direct and indirect taxes and, therefore, higher government dissavings;

2. Lower household savings as employment in the tradables sector falls, and also through higher consumption of cheap imports; and

3. Lower corporate savings as margins in the tradables sector are squeezed.

In short, the exchange rate is perhaps the single most important influence on the current account deficit whether one looks at it as the gap between external earnings and expenditure, or between savings and investments.

Exchange rate policy

Over the initial decade-and-a-half of economic reforms, Indian policymakers did not adopt extreme policies. The the capital account was gradually liberalized; but, broadly speaking, the exchange rate was so managed as to keep the rupee reasonably stable in real effective terms.


Despite the weaknesses of the trade-weighted index as a measure of competitiveness, the policy worked reasonably well. The current account deficit, as conventionally calculated, was less than $10 billion up to 2006-07, even as India built up reserves of the order of $200 billion and the central bank continued to absorb surplus capital inflows.

There seem to have been major changes since then. In the first few months of 2007-08, the exchange rate was allowed to appreciate sharply, but then held steady for the rest of the year through intervention (reserves $300 billion by March 2008).

Since the financial crisis (and the birth of G-20 at the heads of government level), there has been hardly any net intervention, thus completing the dramatic change from a reasonably managed exchange rate to a fully market-determined one.

One wonders whether, on this issue, we are more anxious to be on the so-called right side of the US in the G-20 debate on global imbalances, without giving adequate weight to what should be the prime objectives of our macroeconomic policies: growth, jobs and reduced inequalities.

Can these be achieved by following Anglo-American policies giving primacy to the financial economy over the real economy? Or do we really believe in their wisdom?

In the last 30 years, the fashion propagated by the Anglo-American ideology and the International Monetary Fund has been to liberalize the capital account (economist Jagdish Bhagwati once described this as a conspiracy of Wall Street and the US treasury) and, as a corollary, give up managed exchange rates.

It is strange that we still have faith in Anglo-American wisdom in understanding financial markets: the recent mortgage crisis itself was the result of policymakers’ faith in the wisdom of market participants in managing risk, in pricing assets, in efficient markets generally. The end result, lest we should forget, was that the world suffered the deepest recession since the 1930s. Only a return to Keynesian measures avoided a worse fate.

Before we get too enamoured of getting the US to praise us for our market-determined exchange rate policy, it is as well to remember post-Gorbachev Russia. His successor, Boris Yeltsin, dismantled the whole structure, bred a corrupt system in which a dozen oligarchs stole the state’s extremely valuable assets at throwaway prices; and life of the average Russian was far worse than under the Soviet system.

The country defaulted even on its domestic debt in the Yeltsin era. Yeltsin, incidentally, was a great favourite of the US and the UK.

In this connection, it is interesting to look at the exchange rate policies of large countries and the manufacturing sector’s contribution to GDP (see chart 2).

In our case, the share has remained stagnant in sharp contrast to other large Asian economies; even as the US and the UK, the strongest advocates of market-determined exchange rates, have deindustrialized themselves. Is that our objective even before becoming an industrial country?

No wonder economist Haseeb Drabu argued in a paper (29 May 2011) that “the unambiguous signals emanating from the Indian economy are that raw material production is more valuable than finished goods".

Rupee’s future

The future of the rupee depends on the two questions raised at the beginning of the article. If the answer to both is positive, we need a managed exchanged rate, aimed at keeping the current account deficit, net of remittances, within +/- 1% of GDP (it is currently 6%!); in other words, an exchange rate policy aimed at a competitive tradables sector, not the convenience of the financial economy or the Anglo-American ideology.

This can be done through intervention and sterilization as we did for a decade-and-a-half (but with a reformed index). One argument against this is that sterilization incurs costs to the extent domestic interest rates are higher than those on reserve currencies. This is true. But the costs of output loss arising from external deficits—the result of an over valued currency—are far higher; so are the translation losses on reserves.

In fact, many emerging market economies are resorting to intervention in the market, directly or indirectly, to stem the appreciation of their currencies: so, indeed, has Japan and, less successfully, even Switzerland, recently. China, of course, does so far more aggressively. And, we should not forget that our northern neighbour is the world’s most successful economy of the last three decades.

While on the subject of managing exchange rates, one also needs to take account of the so-called impossible trinity— that free or liberal capital flows, an independent monetary policy, and a managed exchange rate cannot coexist, at least in extreme situations.

In the 1920s, the accepted wisdom in the then leading economies (the US, the UK, Germany and France) was to give up an independent monetary policy. The period ended in global depression.

In the initial 30 years of the post-war era, most countries gave up a liberal capital account, but managed exchange rates and had independent monetary policies. There were no major crises in this era.

In the past three decades, the developing world has been pressured to give up managed exchange rates in favour of a liberal capital account. The result: ask Mexico (1994-95), East Asia (1997-98), Brazil (1998) and many other countries.

In short, if managing the exchange rate requires capital controls, so be it.

But let me end by quoting Keynes: “We are determined that, in future, the external value of the sterling shall conform to its internal value,…without interference from the ebb and flow of the international capital movements, or flights of hot money. Thirdly,…we abjure increase in unemployment as a means of forcing the domestic economy into line with external factors." (Collected Works of John Maynard Keynes, Volume 27)