The $25 billion between India and a crisis
India needs medium-term reforms to overcome its economic problems
Premium(Illustration by Jayachandran/Mint)
The rupee reacted violently on Tuesday afternoon, after Reserve Bank of India governor D. Subbarao said at a press conference that the central bank was not in favour of a sovereign bond issue at this juncture, when a weak Indian economy is buffeted by global tempests. He said that such a bond could “compromise our financial stability". His statement was at odds with what New Delhi has been saying in recent weeks, that all options to attract foreign capital into India are on the table.
The sharp reaction in the foreign exchange market is because of what can be called the $25 billion challenge. India is expected to have a current account deficit of around $85 billion in the current fiscal. The stable capital inflows through foreign direct investment, trade credits and NRI deposits should be around $60 billion. The uncomfortable question of how the remaining $25 billion will be financed casts a lengthening shadow over the economy because the stability of portfolio flows into Indian equities and bonds cannot be taken for granted in case the US Fed actually begins to reduce its extraordinary monetary stimulus, perhaps as early as September.
A sovereign bond issue is one way the government can bridge the gap, though it must be said that the Indian central bank has never been a big votary of this option even in earlier episodes of balance of payments stress. The other options are also well known: further liberalization of the foreign investment limits in select sectors, administrative measures to reduce imports of select consumer goods, negotiating swap lines with foreign central banks in case there is a run on the rupee in the coming months, and even opening discussions with the International Monetary Fund.
Each of these options—though necessary—come with risks. Subbarao has already spoken about the implicit costs of a sovereign bond. The negotiation of bilateral swap lines could be seen in the markets as a sign that the balance of payments are deteriorating to the point that the Indian government is seeking a global lifeline.
The political economy of import controls suggests that they are very difficult to withdraw once the situation improves; it is worth remembering that the maze of import controls that choked the Indian industry till the coming of economic reforms had begun as a temporary measure to deal with the balance of payments stress in 1957.
The Indian government—both the finance ministry and the central bank—seem to have a very tough few months ahead of them. Much of the current public discussion is focused on immediate responses to the problem of how to fund the current account deficit—and rightly so. But it must also be understood that there are policy responses needed over the medium term and the long term as well. The medium-term strategy to reduce the current account deficit will have to be some combination of higher real interest rates, a fall in the real exchange rate, fiscal discipline and domestic demand destruction. The net effect on growth will depend on the extent to which higher foreign demand (from a weaker rupee) will balance out lower domestic demand (from higher interest rates and a lower fiscal deficit).
The big issue in the long term is how to address signs that the Indian economy is losing competitiveness. The benefits of the splendid productivity wave across shop floors during 1995-2005 are now over, as data on total factor productivity growth and the incremental capital-output ratio clearly shows. A new round of economic reforms is needed to address the fundamental problem of whether India can earn enough dollars to buy its imports, a question that was implicitly at the root of the reinvention of industrial policy in the 1980s.
Finally, to get back to the immediate fires that policymakers are trying to douse. Confusing signals by the authorities has raised doubts in trading rooms about the efficacy of policy. The best example of this is the strange decision by both the finance minister and the governor to announce that the recent measures to tighten liquidity are temporary, which has skewed market expectations. Such crosstalk has done no good. The authorities have decided to use interest rates to quell an attack on the rupee, quite correctly in our view. They should now stick to the strategy unless it is shown to be a total failure.
Can India fund its current account gap in the months ahead? Tell us at views@livemint.com
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