The finance ministry’s economic review for May seems to acknowledge that the West Asia crisis may cause India prolonged pain. As hope of a quick return to normalcy fades, policymakers are on alert for good reason.
The review flags how long the Strait of Hormuz remains disrupted as the “single most consequential variable for India’s external and price outlook.” It notes a rise in inflation risk, with high wholesale prices expected to push retail prices up even as weak monsoon rainfall looks likely to combine with the Gulf war’s oil shock against price stability.
The Reserve Bank of India (RBI) has a tough task as it reviews monetary policy this week, given this year’s headwinds against growth. In a world that is staring at stagflation, or stagnation amid inflation, how resilient India’s economy proves will depend not just on the severity of today’s external adversity, but also on its macro-level responses.
The Centre has made moves on many fronts within its close range of control. Yet, India faces what can be described as a ‘perfect storm’ of risks. The capital flows scenario was adverse even before the Gulf war and the horizon remains clouded by uncertainty.
The rupee has been in freefall, even as investment flows into both the real economy and asset markets dry up, making India’s trade gap that much harder to finance. Although the rupee may be undervalued on a trade calculus, a view that RBI seems to hold, its exchange rate is highly susceptible to jerky and unpredictable capital movements.
A debate has arisen over whether its value needs a drastic drop for Indian asset prices to get reset and look globally attractive again. After all, lower inflows than outflows can be traced to a crushed spread between yields on dollar and rupee assets, mixed with portfolio-loss fears of a slowly weakening local currency. A sudden reset could also keep speculators off bets against what they might see as an RBI-propped rupee.
Since sudden depreciation would be widely disruptive, alternative ideas include taxing mutual funds to push down stock prices so that foreign buyers find them less overpriced. The ‘hot money’ of portfolio investors, however, is too fickle for us to predict the results of such wilful resets. If ‘big bang’ moves are the need of the hour to make the world’s investors sit up, we must focus instead on a reform agenda guided by clear principles.
A convincing argument for a weakened rupee, for instance, would be if its free-float level can do a good job as a price signal to help us regain a better external balance overall. But local market rigidities could get in the way. Notably, fuel and fertilizer pricing is firmly in the government’s grasp, with prices given no role in helping us adjust to an import cost flare-up. For market-oriented reforms, the Centre must first liberate these sectors of stiff price controls.
Our broad aim should be to let prices regulate demand and supply across a wider spectrum of economic activity. Without this, an optimal balance is harder to reach.
Capital curbs would be a bad idea; they fan panic and make news as statist moves. Tax relief for foreign investors could be justified if it reverses a put-off that’s peculiar to the Indian market for assets.
Since the principal perplexity we face right now arises from capital scarcity, reformers also need to address feeble net inflows of foreign direct investment. If an outward tilt is partly traceable to an uneven local playing field, for example, then that would call for a renewed thrust in favour of greater competitive intensity.