These are tough times for Indian policy makers. One way to explain the macroeconomic concerns that have pushed the rupee down to record lows against the US dollar in recent weeks is as follows. India is finding it difficult to pull in enough foreign savings to cover the shortfall in the domestic savings needed to sustain economic growth at existing levels. More than $75 billion of foreign savings—aka capital inflows—will be needed to fund the estimated current account deficit for the fiscal year that will end in March 2019.
There were two initial policy responses from the authorities last month. First, the Reserve Bank of India (RBI) eased rules on foreign exchange borrowing by Indian companies, issuance of masala bonds denominated in rupees and mandatory hedging of foreign exchange loans taken by infrastructure companies.
Second, the government increased import tariffs on a range of consumer goods in a bid to reduce their imports. The imports that are sought to be curbed include refrigerators of a certain size, air conditioners, washing machines, speakers for music systems, footwear and diamonds.
Both policy responses are palliatives rather than cures. The move to ease foreign exchange borrowing is an attempt to fund the current account deficit rather than reduce it. It also increases dependence on dollar debt that is of shorter maturity, which is the most volatile form of foreign exchange borrowing, as the history of two decades of financial crises shows. Some market participants continue to expect some sort of special bond or deposit scheme for overseas Indians, as was done in 1998 after the Asian crisis and in 2013 during the taper tantrum.
The move to increase tariffs not only raises fears that India is moving away from the trade reforms of 1991 but is also likely to be ineffective. Here is a quick calculation. The annual import bill for the goods that will now attract higher tariffs is ₹ 86,000 crore, or around $12 billion. Let us assume that the import elasticity of these exports is two, so that a 10% increase in prices because of higher tariffs will reduce these imports by 20%. What this means is that the impact of the recent tariff hikes will be a reduction in the current account deficit by $2.4 billion—and even lower in case the import elasticity is less than two. That is a small fraction of the anticipated current account deficit for the fiscal year.
The import tariffs are more an attempt to switch demand from the foreign market to the domestic market. What is needed right now is not such demand switching but demand compression to bring down the current account deficit. The classic methods to compress domestic demand is through some combination of higher interest rates and a lower fiscal deficit. There are important complications on both fronts at this juncture.
The Indian central bank has formally been given an inflation target that is to be met through changes in interest rates. There are underlying inflation pressures that should lead to two more rate hikes by the end of 2018, but it is worth seeing whether interest rates will be used for a full-fledged defence of the rupee when inflation is not too far from its desired level. The minutes of the monetary policy committee (MPC) meeting this week will be interesting to read in this context.
A drastic fiscal compression is also unlikely just before a national election. It will take immense political confidence to cut government spending when any regime is seeking reelection. Both New Delhi as well as Mumbai thus face constraints—because of political logic or the legal mandate, respectively. However, it is still likely that the RBI will have to do most of the heavy lifting in the coming months in case the pressure on the balance of payments gets worse. The market for overnight indexed swaps is already pricing in two more rate hikes before the end of December.
Thankfully, India right now has far greater internal macro stability than during previous episodes of balance of payments stress such as 1991, 1998, 2008 and 2013. These were the years when there was a crisis in balance of payments combined with domestic imbalances such as high inflation and/or high fiscal deficits. Inflation is right now within the RBI target, while the fiscal deficit of the central government is at its lowest level since the global financial crisis.
The uncomfortable question is how rapidly the Indian economy can expand in the long run without running into a balance of payments problem. Srinivas Thiruvadanthai of the Jerome Levy Forecasting Center recently pointed out the importance of assessing the balance of payments neutral growth rate that India can maintain. The English economist Anthony Thirwall said in a 1979 book that any country that has to maintain a current account equilibrium with a constant real exchange rate should grow at a rate equal to the ratio of the growth of exports to the income elasticity of demand for imports. A simpler explanation is that economic growth over the long run for a country that cannot easily fund its current account deficit is constrained by its export growth on the one hand and the income elasticity of its imports on the other.
Maybe Indian policy makers need to bring this insight back into their assessments of how rapidly India can grow without tipping into periodic balance of payments problems—to complement the usual discussions about the potential growth rate that keeps inflation close to the mandated target.
Niranjan Rajadhyaksha is research director and senior fellow at IDFC Institute.
Comments are welcome at email@example.com. Read Niranjan’s previous Mint columns at www.livemint.com/cafeeconomics