What should India do and why?

Arvind Subramanian (Peterson Institute) and Devesh Kapur (Centre for the Advanced Study of India at the University of Pennsylvania) have written two of their proposed three part series on addressing India’s current problems. In this post, this blog (The Gold Standard – TGS) examines their diagnosis (mostly part 1) and proposals (part 2).

In the first installment of three-part series, they wrote the following:

Indian macroeconomic policy seems to be afflicted with exchange rate pessimism, the notion that depreciation cannot boost exports and reduce imports. High levels of intermediate inputs and foreign indebtedness may dampen and delay the positive impact of exchange rates. But all the experience around the world suggests that there will be positive effects. If it does not, that would amount to saying that prices change behaviour with the notable exception of the most important price, the exchange rate.

As academics, they should not have failed to note that changes in price affect demand, other things held constant. Global growth is one factor that is not constant and not in India’s control. Other countries’ competitiveness gains in the meantime (many currencies have depreciated too, along with the rupee) both through productivity and currency depreciation also determine how far India can take advantage of the weaker rupee.

The second point that they make could have also been more thoroughly thought through:

Another measure to finance the current account promoted by the financial community has been to defend the currency via tighter policy. The government and the Reserve Bank of India have – fitfully and half-heartedly, to be sure – accepted this advice. Not only does this action further stress private sector balance sheets, it also overlooks the fact that the currency depreciation will be less damaging than in the Asian crisis because of lower levels of external indebtedness.

They make the assumption that currency depreciation will be less damaging than in the Asian crisis because of lower levels of external indebtedness. The stock of external debt might be low in comparison to other countries in other times but the staggering increase in external debt in the last four + years, especially combined with weak corporate financials (top and bottom line) and strains on bank assets create a lethal combination for policymakers to take the risk of allowing the rupee to find its own level.

Further, ruling out monetary tightening, as they do in the second installment of their essay, and recommending an across-the-board import surcharge does two things: it raises prices all around (because some imports are inelastic – of course, they recommend exempting crude oil and coal from their import surcharge proposal) and the demand switching towards domestically produced goods (esp. when India’s supply side has been weak in the last several years) will also add fuel to inflationary pressures.

TGS agrees with the two authors when they rule out Prof. Kaushik Basu’s proposal for a fiscal stimulus to address the growth situation. At the present juncture, addressing economic growth directly through stimulus is the last thing that India should be doing.

However, much as the two professors promise to come up with a unique policy mix, their second instalment of the tri-part series does not exactly deliver that unique policy mix.

First, the text  could have avoided some simple confusion. Here is an example:

Macroeconomics 101 suggests that reducing the current account deficit requires two actions: switching demand away from, and encouraging production of, domestically produced goods; and reducing aggregate demand to essentially compress imports.

After the ‘from’, there should have been this: ‘foreign goods’.

Otherwise, the sentence leaves us one befuddled: switching demand away from domestically produced goods and encouraging production of domestically produced goods! That is a recipe for glut and further corporate distress!

TGS  agrees with their suggestion that there should be a overall reduction in aggregate demand. That, in simple terms, means lower economic growth near-term (4 to 6 quarters or slightly longer).

But, to achieve that, they recommend a short-term, time-bound import surcharge except on crude oil and coal import. I am not persuaded of this recommendation given its essentially backward looking nature and the potential for side-effects on inflation in a supply-constrained domestic economy.

Of course, TGS fully agrees with their final suggestion that some ‘important policy change’ needs to accompany their proposed import surcharge:

Given the government’s eagerness to go ahead with the food security Bill (and resulting increases in subsidy), it is important that the proposed import surcharge be coupled to at least one important policy change signalling resolve to reduce the deficit – be it fuel or fertiliser subsidies, whichever is politically least unpalatable. Simultaneously, the government must add ballast by expending its scarce political capital in pushing through the Constitutional Amendment Bill on the goods and services tax in the next session of Parliament.

The reason they opt for this is that they think that the political atmosphere does not permit two things: a monetary policy tightening and a fiscal spending compression.

That is precisely the problem. The Congress Party’s political compulsions and priorities over the last nine years have not only brought us the crisis but also are effective in preventing India from charting a way out of the crisis.

The speed with which we are able to reconcile to this reality is scary because this government can last another 7 months. That is too long a time in the current situation.

Final observation on their second installment. They note that there are two costs to the recent rupee depreciation that need to be addressed:

Of course, the recent rupee depreciation will have costs that will need to be addressed. Two costs need highlighting: additional inflation and the adverse effect on companies that have borrowed in foreign currency, and hence on the banking system.

But, the rest of the article does not deal with the second of the two costs they identify above – namely foreign currency borrowing and the banking system. May be, they will deal with it in the third installment.

Let us recap what needs to be done, in the view of TGS

(1) Draining liquidity and monetary tightening: RBI embarked on it in mid-July but, disappointingly, have backtracked on two occasions after that – at the monetary policy meeting of July 30 and then when they announced buying longer dated government securities. In the parlance of the two academics, this is about reducing overall demand. Growth has to be sacrificed for now, to restore it with vigour and sustainability later.

(2) Cash-flow management: government’s announcements on Indians’ outward remittances fall in this category.

(3) Fuel price reform: just remove the government totally from pricing of hydrocarbon fuels, especially in the retail price of diesel, petrol, kerosene and cooking gas. This has become very critical and urgent not only because of (what appears to be) an imminent attack on Syria but also what the Fed could do with its ‘forward guidance’ on interest rates if and when it reduces its monthly asset purchases. The price of crude oil could rule firm or even firmer in global markets. A weak and weakening rupee with higher crude oil price could be the final kiss of death for India. 

(4) Work on a war footing (policy and legal fronts) to resume coal and iron ore exports

(5) Send the land acquisition bill and the food security bill once more to Parliament select committees with external experts joining the select committees. After all, these laws are supposed to remain in perpetuity. Three-month delay won’t hurt. Recast them thoroughly to address genuine needs of the industry and the poor.

Even if (3) to (5) are pipe dreams in the current environment, the failure to credibly stick to (1) and, if necessary, add more muscle to it has been the biggest causal factor for the continued onslaught on the Indian rupee. 

In an interview to Business Standard, Ramesh Damani says that the market would bottom out within 48 hours if the government announces elections. Very astute observation and one that TGS has no difficulty in seconding.

However, since the dissolution of the Lok Sabha by the President requires the government’s recommendation and since that won’t be forthcoming, can the President cite the economic emergency and dissolve the Lok Sabha suo moto? Will this President do it as partial atonement for his role (as the Finance Minister) in India’s current sorry state?

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