In the fortnight beginning August 12, the rupee depreciated 12 per cent against the US dollar. That is quite steep. It made headlines; I got phone calls from friends asking what was going to happen to their country. No doubt, the prime minister got similar frantic calls. He rose from his seat and made a statement in the Lower House of Parliament on August 30. That does not solve the crisis, but we do have an opportunity to share the government’s understanding of it.
Ben S. Bernanke, chairman of Federal Reserve, gave testimony before the economic committee of the US Congress on May 22. According to him, the US economy needed stimulus because the rates of unemployment and underemployment were too high. Interest rates could not be lowered because they were already close to zero and could not be reduced further (Japan, faced with the same situation, has chosen to turn real interest rates negative by engineering inflation). So the only instruments available were the fiscal balance and money supply. Fiscal balance was under the control of Congress, which was intent on reducing the deficit — just the opposite of what the macroeconomic situation called for. That left only one other instrument, namely money supply. The Federal Open Market Committee (which Bernanke chairs) decided in September 2012 to expand it every month by purchasing $40 billion of government securities and $45 billion of mortgage-backed securities. Bernanke was aware that excessive money supply could lead to financial instability: financial firms that found they could earn little from government securities might be tempted to take on more credit risk, duration risk or leverage than was safe (as they did in 2008-09). So the purchases would be discontinued as soon as macroeconomic conditions improved.
The purchases have had two effects: they have kept US interest rates low, and they have put cash in the balance sheets of US financial firms. They have used it to buy other assets, including Indian bonds and shares. The end of the stimulus, when it comes, is likely to have the opposite effect: it would end the purchases of such securities. That could lead to a slump in the prices of Indian stocks and bonds.
So it has. The prime minister, in his speech to Parliament, blamed a certain statement emanating from “the US central bank” last May — obviously, Bernanke’s testimony to US Congress. The policy of monetary expansion that the Federal Reserve introduced in August 2010 and Bernanke explained to FOMC last May continues unchanged till today. He told the FOMC that he would stop injecting money into the eco-nomy once unemployment was brought down. But it is only creeping down; the day when the stimulus would end is far away. The prime minister attributed the fund outflow from India to the fear that this day was nigh; but it is nowhere in sight. I think the PM’s logic is weak.
For one thing, if flow of funds from other countries to the US caused depreciation of their currencies, it should have caused appreciation of the dollar. It did not go up in terms of the currencies of advanced countries; its exchange rate in terms of the euro, Swiss franc, British pound, Japanese yen, Canadian dollar etc has varied no more than 6 per cent from its level at the beginning of May. So there seems to be no flight of funds from everywhere else to the US.
Nor have they flown from developing countries; the exchange rates of South Korean won, Singapore dollar, Nigerian naira or Taiwan dollar have not depreciated. Nor is it BRICS currencies; the Russian ruble and Chinese yuan have not depreciated. Depreciation is not confined to the Indian rupee; it extends to South African rand, Brazilian real, Indonesian rupiah and Malaysian ringgit. But they do not constitute a group with anything in common. The Indian officials have tried assiduously to attribute the rupee depreciation to international factors beyond India’s control. But those factors are fictitious.
So it makes more sense to attribute the rupee depreciation to India-specific factors. The balance of payments is part of the explanation. But it has been adverse for many years; it cannot explain the fall of the rupee in the last four months. The fall is due to outflow of foreign funds; foreign investors’ assessment of risks — arising from both the economic downturn and possible currency depreciation — outweighed expected returns. Much can be written about what scared them off. But it would all be guesswork; even asking the investors would not necessarily get an honest answer.
The finance minister has worked hard since the beginning of 2013 to reassure foreign investors. He has travelled extensively and spoken volubly. He failed; that is one reason why the prime minister also spoke. Will foreign investors be reassured by what he said? They may well be; I am not.
The PM said that the finance minister had taken steps which he was sure would keep the payments deficit below $70 billion now and 2.5 per cent of GDP in the long run. Economists divide the deficit by GDP for comparison over long periods of time; but the ratio has no relevance to policy. A country may thrive on a 10 per cent deficit or go bankrupt on a 1 per cent deficit; all that matters operationally is the deficit in terms of foreign currency.
Whatever he might assert, not even Chidambaram can keep the deficit below X; there is no arithmetical relationship between his policy measures and the precise reduction in the deficit. Positing one only shows his lack of competence. And there is nothing sacrosanct about $70 billion. The government should aim to eliminate the payments deficit in the medium term —say, in three years’ time.
It is fashionable to rant against the Indian love of gold. But the PM ought to recognize that the people disagree with him about gold, and that he can neither persuade them to give it up nor control its imports. Chidambaram has restored profitability to gold smuggling, which will be resumed in full vigour in the medium term — unless his ill-conceived restrictions on gold are removed. In general, the government ceased to make trade policy for particular commodities in the last decade, and must not reverse its course; commodity-specific trade policy is the way to feed and fatten the corrupt customs department. The only worthwhile trade policy relates to the exchange rate.
But primarily, the action required to tackle the balance of payments is domestic: the government must reduce costs and use macroeconomic disinflation, and introduce incentives to persuade entrepreneurs to produce more exports and import-substitutes. In the few lines left, let me suggest the five most important things it can do: first, replace state government monopolies in electricity by free, nationwide competition; second, construction of a dozen artificial harbours all along the coast with a minimum draft of 12 metres; third, ring roads around all major cities, and hubs on the ring roads where intercity transporters can meet intracity transporters; fourth, replacement of the public distribution system by a buffer stock mechanism; and finally, teaching ministers and bureaucrats to be curious and question their cherished beliefs.