Given these dual objectives, however, policymakers must have at least two instruments to satisfy Tinburgen’s assignment problem of there being as many instruments as objectives. Johnson (1958) and Cordon (1960) labelled these as “expenditure-control" and “expenditure switching". The former is the traditional Keynesian use of fiscal and monetary policy to achieve internal balance—expansionary if output gaps are negative and inflation below target and, contractionary, in the opposite scenario. In comparison, “expenditure switching" is to change the relative attractiveness of the tradable versus non-tradable sector, typically through changes in the real exchange rate. A real devaluation should increase the attractiveness of the tradable sector vis-à-vis the non-tradable sector, while a real appreciation should do the opposite. Consequently, a real depreciation—by boosting exports and disincentivising imports—should help external imbalances, while a real appreciation should achieve the opposite. Policymakers can therefore rely on two instruments (“expenditure control" and “expenditure switching") to simultaneously achieve the twin objectives of internal and external balance.
Theory versus Practice
While sound in theory, several questions jump out in practice. Can the exchange rate really constitute a separate target for an inflation-targeting central bank? And, even if so, do central banks have sufficient instruments to influence the exchange rate? Isn’t the latter simply a function of monetary policy when the capital account is reasonably open (the classical trilemma)? As research has shown, however, sterilized foreign-exchange intervention by emerging-market central banks does create a second instrument for central banks to influence the exchange rate. Consequently, central banks can use policy rates to focus on their inflation mandates and sterilized intervention to influence the nominal exchange rate (and, therefore, real exchange rate, in the short run, given nominal price and wage rigidities). In the long run, of course, the real exchange rate is a function of productivity differentials, capital flows and the terms of trade.
Policymakers can therefore use both “expenditure control" (fiscal and monetary) and “expenditure switching" (exchange rate) policies to achieve the twin objectives of internal and external balance. Sometimes, these are self-reinforcing. If domestic activity is languishing below potential, but external imbalances are unsustainable, a real depreciation of the currency will help achieve both objectives. It will narrow external imbalances and its expansionary nature will boost domestic output. But often the trade-offs are more acute. If activity levels are already above potential, but external imbalances are getting larger, a real depreciation will help reduce external imbalances, but exacerbate internal imbalances. Then expenditure-switching will need to be complemented by heightened expenditure-control to restore domestic balance.
The recent run of data confirms both internal and external balances are coming under pressure. Core consumer price index (CPI) inflation accelerated to a three-year high of 5.6% in June, while core wholesale price index (WPI) inflation is at a six-year high. The last few quarters have simultaneously seen domestic growth recovery and a variety of cost-push impulses (oil, rupee) that are pressuring core inflation. With inflation now forecast to breach 5% in 2018—vis-à-vis the medium-term target of 4%—internal balance is coming under some pressure and will likely induce more monetary tightening. Fiscal policy will have to play a crucial part, too. With the Centre pausing on fiscal consolidation in 2017-18 and state deficits continuing to widen, the consolidated fiscal stance (net of asset sales ) was actually expansionary last year by almost 0.5% of gross domestic product (GDP),n. Fiscal and monetary policy will have to tighten to restore internal balance.
Of more immediate concern, however, are signs of growing external imbalances. The June monthly trade deficit was the highest in more than five years. But arguably this has been a long time coming. India’s real exports have slumped over the last six years— growing at just 4% between 2011 and 2017—compared to 15% over the previous decade. Meanwhile, imports have firmed up such that the underlying trade-balance (oil and gold) has deteriorated by almost 2.5% of GDP since 2014. On the back of this, if oil averages $75 per barrel, we expect the CAD to widen toward 3% of GDP or $80 billion in 2018-19.
As we are finding out, this will not be easy to finance in the current global environment. India’s more stable flows (foreign direct investment plus non-resident Indian deposits) can be expected to account for about $50 billion. Even accounting for some cyclical flows, this will still leave a sizeable balance of payments deficit. And if portfolio outflows continue, the balance of payment (BoP) pressures will only get more acute. We estimate that India’s BoP deficit in the April-June quarter was at $10-12 billion, the highest in seven years. External imbalances will therefore have to be reined in. Monetary and fiscal tightening—to help achieve internal balance —should help compress domestic demand and imports. But they will do nothing for exports. More fundamentally, relying only on expenditure compression to squeeze CAD may need excessive tightening, disproportionate to the current state of the domestic business cycle.
Exports and the Rupee
Instead, to go back to the wisdom of Meade and Johnson, “expenditure switching" through a real depreciation of the currency will likely be more efficacious since it simultaneously impacts both exports and imports. This presumes, however, that the exchange rate elasticities on exports and imports are non-negligible and, therefore, exchange rate depreciations are not contractionary (wherein adverse balance sheet from depreciation effects swamp limited trade elasticities).
In a recent paper presented at the India Policy Forum, Toshi Jain and I find that the long-run exchange-rate elasticity of exports is much larger than previously thought. Our empirical estimates, using quarterly data from 2004-17, reveal that every 1% change of India’s 36-country real effective exchange rate impacts non-oil exports by 1.4% in the long run. This finding is robust to various specifications and controls.
To be sure, these elasticities have attenuated over time, reducing from 1.9 in 2004-11 to 1.1 in 2011-17. This should not be surprising because the import content of India’s exports is rising. With the domestic value add of exports correspondingly falling, it is unsurprising that exchange rate elasticities have gradually come down, but are still economically meaningful.
Consequently, our empirical findings can explain the bulk of the export slowdown in recent years. We find the slowdown is attributable both to more sluggish external impulses (weaker partner country growth and lower demand elasticities) and to the near 20% appreciation of India’s trade-weighted exchange rate during 2014-17. As argued in these pages before, however, the sharp real appreciation of the last four years is the upshot of the large positive terms-of-trade shock from the collapse in oil prices.
Delicate balance needed
Now, the shoe is on the other foot. The rise in crude prices is creating pressures for a real depreciation of the rupee in the new equilibrium, operationally manifesting itself through higher CAD and BoP pressures. Indian policymakers should not fight that. It will facilitate the much-needed “expenditure-switching" that the Indian economy needs to help improve underlying competitiveness and, therefore, reduce external imbalances over time.
But at least two caveats are in order. A real depreciation will likely engender more inflation pressures, particularly given the state of domestic output gaps. That would need to be countered through tighter fiscal and monetary policy.
Second, any rupee depreciation, especially in the current global environment, needs to be calibrated and gradual, through the use of foreign exchange reserves, to ensure currency expectations don’t get unhinged and result in a self-fulfilling spiral as in 2013. Policymakers seem to be adopting this approach. Since the global stress began in April, the rupee has weakened against the dollar only as much as other emerging market currencies have, thereby ensuring the rupee is stable on a trade-weighted basis. The bulk of the 6% trade-weighted real depreciation witnessed in 2018 occurred earlier in the year and only partially offsets the appreciation of previous years.
Equity and bond markets often squirm at the prospect of a depreciating rupee. That is their nature. But with external and internal balances under simultaneous threat, the economy needs “expenditure-switching" offset by heightened “expenditure control" to offset the expansionary effects of the former. The new equilibrium will, therefore, need to entail a weaker rupee, higher interest rates and tighter fiscal policy. This policy mix may create unique political-economic challenges in a pre-election year, but remains the only antidote to navigating an increasingly challenging global environment.
Sajjid Z. Chinoy is chief India economist at JPMorgan.
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