India needs to restore the faith of the people and investors in its economic policy frameworks.
Since early May,India has been the economy most affected by concerns about the US Federal Reserve reducing quantitative easing. Its currency is among the worst-performing,while confidence in its economy and policies is at a historic low. The problems lie in deep-rooted macro imbalances. India has been running nearly double digit inflation on the CPI for over three years,and among the worlds highest fiscal and current account deficits. This has made the economy heavily dependent on external inflows. If these inflows became scarce,as seems likely in the years ahead,then the economy can continue to face severe headwinds. The tactical approach followed thus far of increasing sources of ca-pital inflows or weakening the currency can actually exacerbate problems. Instead,India needs a broad strategy that entails shrinking the CAD to a sustainable level,restoring faith in the monetary and fiscal policy framework and vigorously pursuing structural reforms.
What is a sustainable level for the CAD? A sustainable level seems to be 2.5 per cent of the GDP,or about $50 billion. This is the amount of long-term inflows of FDI and corporate borrowings that India can attract on average,which are less volatile. It is also the level that can keep our external debt to GDP from rising. The RBI also finds this to be an appropriate level.
How does India reduce its CAD from 4.5 per cent of GDP to 2.5 per cent? We have,at our disposal,monetary and fiscal policy,exchange rate policy,trade policy and structural reforms. If only monetary policy were to be used to reduce private domestic demand,and thereby imports,it could mean a hit to the GDP of about 6.6 percentage points (ppt) by our calculations. If fiscal policy alone would do the adjustment,then the hit to growth could be about 5.6 ppt.
We need a combination of policies: fiscal and monetary tightening,and trade policy,to get to a sustainable level on the CAD. Clearly,putting too much pressure on one policy tool to do the adjustment could impose large costs on the economy. There is a role for trade policy in the short term to reduce imports and increase exports. Trade policy could provide a 1 ppt improvement in the CAD. Even the impact of trade policy measures announced thus far,primarily on gold,could be 0.7 ppt of GDP.
Fiscal policy needs to bear some burden. India continues to run one of the largest fiscal deficits in emerging markets. This has been a key source of vulnerability,by reducing domestic savings and increasing the current account. Raising domestic fuel prices,especially diesel,reducing fertiliser subsidies,increasing revenues by better tax administration,could help reduce the deficit. According to our calculations,for a half per cent improvement in the current account,the fiscal deficit would need to shrink by 2 ppt. While there will be a short-term negative impact on growth,this would confer other benefits,like reduce the risk of a sovereign ratings downgrade,improve the allocation of resources and put downward pressure on bond yields.
What should the RBI do? Given how weak demand is,there are limits to using interest rates to squeeze demand further. Manufacturing growth has turned negative recently,and there is little demand for credit. So,tighter monetary policy could further reduce already weak demand,without large gains in reducing the CAD. A more important risk is that too much tightening,if it leads to a sharp slowdown in growth,can cause outflows from the equity markets.
Unfortunately,there are no easy solutions. If tight monetary and fiscal policies are followed,growth will suffer in the short term. But if they are not,the alternative could be much more painful. Without a current account adjustment,there could be a currency crisis which can potentially destroy corporate and bank balancesheets and lead to several years of weak growth.
How about letting the currency depreciate to resolve the imbalances? There is no evidence of currency depreciation helping reduce the current account. Indeed,the INR has been depreciating since mid-2011,but the CAD has continued to be high. A candidate explanation could be Indias high dependence on energy imports,whose demand is inelastic to changes in currency. This is true in other emerging markets as well depreciating currencies in Brazil and South Africa have actually led to a worsening of the current account.
There have also been proposals that India attract more short-term inflows,such as by entering global bond funds. These would accentuate the problem by increasing Indias vulnerability to capital outflows and raising external debt,rather than force any sort of correction on the macro imbalances driving current market turmoil.
What is the longterm solution to the current problems? India needs to restore faith among investors and the public in its monetary and fiscal policy frameworks and pursue structural reforms to improve competitiveness. The publics inflation expectations have become unhinged as a result of very high inflation since late-2009. The recent exchange-rate depreciation is further eroding purchasing power. This is leading to a flight of domestic savings into gold and worsening our external balance. Unless trust is re-established in the monetary framework,which stabilises inflation and the exchange rate,it will be difficult to shrink the CAD. A change in regime is a good time to re-establish that trust by signalling a change in the framework. What is needed is an immediate move to an inflation target,with a well-articulated strategy for bringing consumer price inflation under control. In conjunction,India needs a successor to the fiscal responsibility law discussed above. Markets need to see demonstrable action that the government and RBI are serious about resolving the twin fiscal and current account deficit problems,and anchor inflation expectations. Introducing the GST,labour reforms to increase flexibility,reducing bureaucratic delays and resolving bottlenecks in coal and power are all necessary to boost competitiveness. This is the right time to push through those reforms a crisis is too good an opportunity to waste.
The writer is managing director,Goldman Sachs India. Views are personal.