A tale of two gaps3 min read . Updated: 13 May 2012, 08:49 PM IST
A tale of two gaps
A tale of two gaps
When currency and foreign exchange issues become a bigger concern than the slowdown in domestic economic growth, the change must be seen as the revival of structural constraints rather than some temporary aberration in the foreign exchange market that can be alleviated by regulator’s market interventions.
It is the failure to understand this rather simple distinction that is forcing the Reserve Bank of India (RBI) into making a series of coordinated errors; cutting interest rates and then having to follow it up with interventions to shore up the rupee.
Adding to the policy dilemmas are dwindling reserves, declining inflows and a global environment that is uncertain. Instead of being adventurous, it would have been better if the script had been followed.
Perhaps even unknown to itself, and more by default than by design, the government’s economic policy responses over the last year or so do fall into a pattern. Reading together the seemingly disparate reactions, delayed actions and disjointed events—widely characterized as policy paralysis—policies in the last one year or so seem to follow a set pattern that can be safely characterized as orthodox stabilization.
Looked at closely, almost all the ingredients of a stylized International Monetary Fund (IMF) package have been implemented during this period: monetary contraction, increases in interest rates, currency depreciation and now a fiscal tightening not through direct expenditure compression but via resource mobilization. As and when the assumptions underlying the budgetary numbers are translated into policy action—Rs10 rise in diesel prices, Rs23 increase in kerosene and Rs44 in LPG—it would be a classic IMF-type stabilization sans deindexation.
If there is anything that is missing from the package, it is the conditionality-based loan component. With that element missing, the focus obviously was on foreign inflows in whatever form they flow, be it debt or equity. Unless there are inflows of more than $2 billion a month, the rupee will continue to be under pressure. And thanks to the retrospective regulatory overzeal that has increased India risk by more than a couple of notches, these inflows are drying up.
Come to think of it, the macroeconomic situation today is almost identical to what it was in the mid-1970s. It might be recalled that in 1973-74, a drop in output was accompanied by a sharp escalation in inflation which surged from 7.5% in 1970-73 to 20% in 1973-75, much of the increase coming before the oil price rise. Then, as now, the current account balance was at a decadal high and there was a similar deterioration in the trade balance.
However, the similarity ends with the problems. The turnaround in the mid-1970s was caused largely by highly favourable exogenous developments, internal and external. None are on horizon at the moment.
An important part in alleviating the problems in the mid-1970s was the assistance given by IMF. India was able to obtain relatively easy access to external funds to meet the increased trade deficit caused by higher oil prices.
At a more analytical level, through these decades of the 1970s, economic policy was struggling to cover two gaps: the savings gap and the foreign exchange gap with the former being an operative constraint and the latter a structural one.
Now, even after the nature of economic regime has changed and the economy has “globalized", the structural gap of “foreign currency" continues. And to make matters worse, the operative “savings gap" has been replaced by another structural gap; the raw material gap (akin to the “food gap"). Both these are structural in the sense that they originate from rigidities in the specific production sector.
The raw material gap and its covering through imports is destroying the profitability of manufacturing enterprises. The growing “raw material gap" is changing the macroeconomics of India.
These two gaps, unlike in the past, are mutually reinforcing: larger the foreign exchange gap, more constricting is the raw material gap for growth. This adds another interesting dimension to the “two gap models": a generic demand gap becoming binding because of the supply rigidities. In the present scenario, it is not agriculture that is a binding constraint but the primary sector as a whole.
As such, it is important to recognize that unlike the interplay of savings gap and foreign exchange gap, a higher level of reserves is unlikely to resolve the emerging constraints. The solutions lie elsewhere.
Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at firstname.lastname@example.org
Also Read | Haseeb A. Drabu’s earlier columns