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A domestic problem

New RBI governor must change policy. Government must also get its act together.

Written by Bhaskar Dutta |
September 5, 2013 12:15:46 am

New RBI governor must change policy. Government must also get its act together.

The wild gyrations in the external value of the rupee continue unabated. Just a few months ago,the US dollar was worth just over Rs 50. A few days ago,one needed more than Rs 68 to buy a dollar. Some sanity was restored to the foreign exchange market when the rupee appreciated sharply and a dollar fetched just over Rs 65. But on Tuesday,a false alarm that the US and Israel had launched missiles against Syria sent the rupee plummeting to a record low. It will take considerable courage to bet even a single vastly depreciated rupee on what its external value will be when this article sees the light of day.

The dramatic decline in the external value of the rupee has naturally attracted a great deal of media attention. All the opposition parties have also been scathing in their criticism of the government,accusing it of gross incompetence. Foreign fund managers have “voted with their feet” by withdrawing funds from the Indian stock market. Virtually all forecasters have also predicted that the short-term future will only get gloomier. All this has prompted even the normally reticent prime minister to depart from his usual habit of remaining silent. Manmohan Singh has provided the government’s interpretation of the current economic crisis,essentially claiming that the fall of the rupee was largely due to global unrest and the fear that the US Federal Reserve was on the verge of ending its easy money policy. He barely acknowledged that the soaring current account deficit also played a role in the rupee crisis.

The PM is right — but only to a very limited extent. The fact that global forces play a role in determining the value of the rupee was underlined when news of the supposed missile attack on Syria caused a sharp fall in the value of the rupee. The rupee’s current woes have also been triggered by the US Federal Reserve Board chairman’s announcement that the era of quantitative easing was likely to end soon. Once this happens,US financial institutions will withdraw a large fraction of their investments from emerging market economies. Since the original inflows propped up many of these currencies,the prospect of sudden outflows has caused a precipitous fall in their external value. India and Turkey have been hit the hardest,with the rupee and the Turkish lira touching their historical lows.

However,the global unrest has only been a catalyst. We would not have witnessed this turmoil in our foreign exchange market if the fundamentals of the domestic economy were stronger,and if the government and the RBI had not been so complacent in their management of the economy.

Consider,first,the RBI’s record. For a long time,the external value of the rupee was more or less stationary,hovering in the range of Rs 50-55 to a dollar. During the same period,the rate of inflation in India was around 10 per cent. This is roughly four times more than the inflation rate in the US as well as in much of Europe. So the real exchange rate of the rupee had been going up quite steeply during this period. This could not have been an accident. The RBI must have taken a conscious decision to let the rupee appreciate in real terms.

This ensured that the rupee was maintained well above its “equilibrium” rate. An obvious consequence was that Indian exporters found it increasingly difficult to sell their products in international markets as these were relatively more expensive than the products of their rivals. Conversely,foreign products became relatively cheaper in Indian markets. Add to this the domestic economy’s insatiable,and more or less inelastic,demand for imported crude oil. India’s current account deficit has been building up steadily to unmanageable limits. It needed only a tiny spark for the explosion to occur — this came by way of the Fed chairman’s announcement.

Of course,the government’s economic management team should have been aware that they were sitting on a powder keg. They could have undertaken a number of measures to relieve the pressure on the rupee. For starters,they could have “persuaded” or cajoled the RBI into letting the rupee slide downwards much earlier. Failing that,the government could also have taken some direct measures. Very high up on this list must have been efforts to increase foreign direct investment,so as to make the economy less vulnerable to sudden withdrawals of foreign portfolio investment.

Unfortunately,the government has done nothing other than pay lip service to increasing foreign direct investment. There has been a total lack of reforms designed to make the Indian economy more attractive to foreign investors. A bankrupt government,surviving on public debt,has not been able to increase investment in infrastructure. New constraints,such as those in land,have crept in. The rate of growth has dipped alarmingly. Even domestic producers have cut back their investment plans. Why should foreign investors take the plunge? They are well aware that the Indian growth miracle is a thing of the past.

The RBI now has a new governor,one who is as aware of what needs to be done as anyone else that we can think of. Hopefully,the change in governor will bring about a welcome change in the RBI’s policies. Unfortunately,no change in central bank policies will help if the government does not get its act together. The signs are not very promising — some of the measures that the government has come up with seem to signal panic rather than clearheaded thinking. For instance,controls designed to prevent domestic entrepreneurs from taking their money outside India do nothing to make the domestic economy more attractive. Similarly,does the government really believe that an increase in the customs duty on air conditioners will make an appreciable dent on the current account deficit?

The writer is professor,Department of Economics,University of Warwick,UK

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