by Shubho
Roy and Ajay Shah.
The macroeconomic setting
India's macroeconomic
woes consist of high inflation, low GDP growth and a drop in
asset prices. The loss of momentum is visible in the seasonally
adjusted data:
| Indicator | Early 2009 | Latest |
| GDP growth (QoQ, saar) | 9.83 Q2-2009 | 4.25 Q4-2011 |
| Inflation (CPI-IW, pop, saar, 3mma) | 7.5 Feb 2009 | 12.9 Mar 2012 |
| INR/USD | 48 Jan 2009 | 56 May 2012 |
The picture is not uniformly bleak. The most important asset price
of the economy, Nifty, has not dropped across this period. On 1
January 2009, Nifty was at 3033. Today, it is at 4920, which is a
good 62% higher. More generally, stock prices have held up rather
well so far. The trailing P/E
of the broad market index, the CMIE Cospi, stands at 17.3, while
the median value across its full history (from 6/1990 to 4/2012) is
17.83. We may think that conditions in India are difficult, but the
stock market is saying that they're roughly median conditions in
terms of the outlook for earnings growth.
The current account deficit
In recent years, the fiscal condition of the government + PSUs has
worsened. This has led to a large gap between savings and investment. The worsening in public finance has diminished savings. There is an
accounting identity: The gap between savings and investment is
the amount of capital that has to be imported. This is the current
account deficit. We have a capital shortfall within India, so we are
importing capital.
It is likely that in the coming year, we will have a current
account deficit of 4% of GDP, or $80 billion a year, or Rs.1700 crore
a day. This means that we have to worry about how foreign capital
views India. Under these conditions, if there is even a short hiccup
in capital inflows (as appears to have come about after the government
proposed to modify the Mauritius route, and more generally with the
problems of governance in India), it yields sharp rupee
depreciation.
We import a lot of capital; government policy actions interrupt
that flow of capital; the rupee depreciates. This is not
mis-behaviour of the financial system. The system is not
malfunctioning; it is behaving as it should.
What should the responses be?
There are five sensible paths for government to take, in this
situation:
- We need to see that at heart, this is a problem of
macroeconomics. The root cause of the current account deficit is the
fiscal deficit. If we want a lower CAD, we need a lower fiscal
deficit.
- To ensure the smooth flow of Rs.1700 crore a day into the
country, we should not spook foreign investors. We should not interfere with the
de facto residence-based taxation framework which India is
giving foreign investors, as long as they come through
Mauritius. This policy framework is, in fact, in
India's best interests.
- Deeper problems about the loss of confidence of foreign investors,
owing to governance problems, need to be solved by strengthening
governance. They are important (do not ignore them), but there is no quick fix other than improving governance. - In the face of these difficulties, it would make little sense
for RBI to trade in the currency market, to try to block the rupee
depreciation. There is good reason for rupee depreciation; the
currency market is doing a pretty good job of translating the
fundamentals into a price. And, in any case, even if RBI desired to
do something about it, its weapons are puny when compared with the
size of the currency market and the Indian economy.
- It is an opportune time to continue with the liberalisation of
the capital account. However, it is useful to think deeply about how
to proceed with this. Some kinds of liberalisation can be
dangerous. It is important to think about sequencing, and at all
times, to worry about unhedged currency exposure. A good deal of
expertise has built up on the subject, through the Raghuram Rajan Committee and the UK Sinha Working
Group which worked out the medium-term and short-term sequencing of reform.
An evaluation of what has been done
There are three features of recent policy responses which
appear to be on track:
- By and large, RBI's trading on the currency market appears to
be at a low scale, nearing zero in many recent months. This is
wise. It increases respect for the brainpower at RBI.
- The government raised the price of petrol, so as to cut the
fiscal deficit. This increases respect for the brainpower and
political capabilities of the government.
- The government decided to defer the attack on the Mauritius
treaty by a year (though not to shelve it altogether). In the
absence of clear policy statements about the importance of
residence-based taxation, this shelving does not increase respect
for the government.
Apart from these three good moves, a slew of dubious ideas have
been afoot.
- A. Enlarging the scope for dollar-denominated borrowing by Indian firms
- On 20th April, 2012: external Commercial Borrowings
regulations were amended to:
- Increase the limit on power companies to refinance their borrowings in Rupees
with foreign currency loans (also called External Commercial
Borrowings or ECBs). - Allow companies to borrow in foreign exchange to make capital
expenditure for maintenance and operations of toll systems
(See here) - Companies were allowed to refinance their ECBs
with subsequent ECBs at higher interest rates
(See here).
Evaluation: Do we really want Indian firms to hold dollar
denominated debt? In particular, firms in the field of
infrastructure who have cashflows in rupees? Sensible
firm should see the high ex ante currency volatility and
stay away from borrowing in dollars without hedging; so the
impact upon capital flows will be small at best. And firms that
do borrow in dollars and keep it unhedged are probably
not going to fare well. - Increase the limit on power companies to refinance their borrowings in Rupees
- B. Enlarging the scope for dollar-denominated borrowing by banks
- On 4th May, 2012: The maximum interest payable on
forex deposits by NRIs in Indian banks was increased (See here):
- For deposits between 1 to 3 years the increase was 75 basis points.
- For deposits between 3 to 5 years the increase was 175 basis
points.
Evaluation: Banks are disaster-prone 19th century
institutions. Do we really want them to hold more unhedged foreign
currency exposure? Of all places in the economy, this is the worst
place to keep unhedged currency exposure. The wise ones will not
borrow in this fashion, so the impact upon capital flows will be
small at best. And the unwise ones, that borrow in dollars and
keep it unhedged, are probably not going to fare well. - For deposits between 1 to 3 years the increase was 75 basis points.
- C. Reducing the economic freedom of exporters
- On 10th May, 2012: the right of exporters to hold foreign exchange was
reduced by 50% (See here):
- Exporters were allowed to keep their forex earnings in
special accounts called EEFC accounts. They were not mandated to
convert it into Rupees. This allowed them the ability to fund
imports for their business without going through costly conversions.
- Now only 50% of their export earning will be allowed to be kept
in forex. The rest will be converted into Rupees against their
wishes.
Evaluation: In the old India, FERA made ownership of
foreign exchange an exotic and rare thing. Many businessmen in
India engaged
in import/export misinvoicing and tried to hold assets outside
the country. In the early 1990s, C. Rangarajan's RBI embarked on a
modern arrangement. Exporters were given greater economic
freedom. We are now rolling the clock back by 20 years; we are
tampering with current account liberalisation.
The number "50%" has not been justified in the RBI
notification. Any exporter, with significant raw material import
cost will now pay unnecessary transaction charges. In global
trade, where every country takes the utmost effort to keep their
exports competitive, any small distortion impacts on export
competitiveness; this is pushing in the other direction - it is an
attempt to reduce India's export competitiveness.
This is a new low in Indian economic policy. Every internationally
oriented household in India will now be more keen to hold assets
and liquid balances outside India, safe from the clutches of
Indian capital controls. This measure will thus exacerbate
capital flight and worsen the problems of the rupee. Success in
the marketplace will tend to accrue to businessmen who break laws
as opposed to the law-abiding ones. - Exporters were allowed to keep their forex earnings in
- D. Damaging the currency futures market
- On 21at May, 2012: restrictions were put on
exchange-traded derivatives (See here):
- The net overnight open positions that the banks hold shall
not include positions in the exchanges.
- The positions in exchanges cannot be used to offset
positions in the OTC market for
- The position of banks in currency exchanges shall be
limited to $100 million or 15% of the market (whichever is
lower)
Evaluation: The world over, there is a clear understanding
that the exchange is a superior way to organise financial
trading. When compared with the OTC market, the exchange has
superior transparency and risk management. Policy makers need to
continually modify policies so as to favour a migration of all
standardised products away from the OTC market to the
exchange-traded contracts. RBI's moves go in the wrong direction.
How do we ensure that the price on a financial market is driven by
fundamentals? The answer : We must have a deep and liquid market, and a
broad array of sophisticated speculators. RBI's actions are going
in the exact opposite direction. They are trying to make the
market illiquid. But it is in an illiquid market that we will get
market inefficiencies and weird behaviour of the price. They are
increasing the chance that something nutty happens on the rupee.
This circular is also a reminder about poor legal process at
RBI. Every action by a regulator must articulate a
rationale. Financial regulations are motivated by exactly two
possibilities - consumer protection or micro-prudential
regulation. The government agency that wields the power of
financial regulation must show the clear rationale, describing
what is the market failure that this regulation is seeking to
address. The government agency must show the cost-benefit
analysis, explaining why the costs of this action outweigh the
benefits. As is typical of financial regulators in India today,
RBI's documents show no rationale.
It is possible to conjure one conspiracy theory. The attempts at
damaging the liquidity of the currency futures market should be
seen in connection with previous
work on damaging the liquidity of the OTC market. Perhaps
there is a grand plan here. The scale of RBI's trading on the
currency market is implausibly small when faced with the size of
the Indian economy, with the size of India's cross-border
interactions and the size of the currency market (both onshore and
offshore). Perhaps these recent moves are designed to damage the
liquidity of the market, so as to get to a point where RBI
intervention can make an appreciable dent on the
price. Perhaps the game plan is to gnaw away at the capability of
the currency market through a series of moves, and then take off
doing large scale manipulation of the market. If this is the game
plan, it reflects very poorly on the economic policy capability at
RBI. It would also generate massive profit
opportunities for the speculators of the world, who would short
the rupee when the large scale manipulation commences. - The net overnight open positions that the banks hold shall
Rumours about other bad ideas abound. E.g. it is suggested that RBI
will sell dollars to exporters directly. How is this different from
selling dollars on the market?? It is suggested that the currency
futures and the OTC markets should be completely cutoff by banning the
arbitrage. How would this solve the macroeconomic problems which
bedevil the rupee?
Microeconomic distortions are not a good way to address
macroeconomic problems
What does one make of this spectacle? A simple principle worth
reiterating is:
Problems rooted in
macroeconomics must be addressed using macroeconomic
instruments.
We got into this mess because of inappropriate fiscal and monetary
policy. We need to solve these -- monetary policy must get back to the
business of delivering low and stable inflation, we have to fight
inflation until we see y-o-y headline inflation (i.e. CPI-IW
inflation) going to the 4-to-5 per cent range. Alongside this, fiscal
policy needs to correct itself. Each of these has a clear direction to
move in, and movement on any one is valuable regardless of what the
other does.
A big element in the picture is the loss of confidence, in the eyes
of the private sector, on an array of issues ranging from ethical
standards to the sophistication of fiscal, financial and monetary
policy. This is an important problem and it needs to be addressed. The
spectacle of a government flailing at the macro problems using micro
instruments is worsening matters. Perhaps there is constant pressure
to announce `new measures' to solve the problem. Deeper solutions are
hard, and there is enthusiasm for `doing something' (large or small)
[example].
We've seen this movie before. In the last decade, again and again,
RBI tried to wield capital controls as a tool for macroeconomic
policy. They
failed. It is disappointing to see the lack of learning.
Some of the moves above have come out of the reflexive socialism
that lurks within the Indian bureacracy. Perhaps, in a crisis
environment, the ordinary immune system within each government agency,
which keeps the sub-clinical socialism under check, is not working as
well. This hurts from two points of view. It betrays the lack of
capability of these government organisations; it reminds us that the
Indian State is strewn with people who have a low knowledge of
economics and a taste for dirigiste. It also reminds us of the
policy risk: Precisely when the best capabilities are required (in a
crisis), we seem to be slipping into the lowest quality policy
initiatives.
Everyone who sees the government / RBI engaged in one ill thought
out measure after another gets worried about India's future. How can a
$2 trillion economy flourish while such immense powers are placed with
individuals and institutions with such weak capabilities? This further
damages confidence, which deepens the macroeconomic crisis.
Acknowledgements: We are grateful to Apoorva Ankur, Sumathi
Chandrashekaran, Pratik Datta and Kaushalya Venkataraman for useful
suggestions.
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