The challenge is to increase short-term rates,while keeping long-term rates low
I have previously,in 2007,argued that India should have an asymmetric foreign exchange policy,whose central objective is to dampen the adverse effects of external capital flow volatility,while taking full advantage of low cost long-term debt and risk capital to accelerate growth. We have had the reverse policy since 2009,resulting in fast real appreciation when inflows surge and slower depreciation when inflows slow. This has the effect of slowing growth and increasing the probability of external crisis.
The conventional wisdom in India is that a current account deficit (CAD) above 2.5 per cent of the GDP is a danger signal that requires urgent corrective action. Partly as a result of the global financial crises,the CAD jumped to 2.3 per cent in 2008-09 and to 2.8 per cent in 2009-10. Thereafter,it jumped to 4.2 per cent in 2011-12 and has remained high ever since.
Between March,2009,and March,2013,the total external debt of the country went up by over 70 per cent,with short-term debt and external commercial borrowings (ECB) increasing even more rapidly (100 per cent and 90 per cent respectively). As a ratio to GDP,however,it has remained at about 20 per cent,indicating that its not the debt per se,but its structure thats the problem. On the one hand,monetary policy has forced domestic corporates to source funds from abroad,while government policy has made it easier for short term funds to flow into the country. Thus,compared to the inflow in 2007-08,the average annual inflow between 2009-10 and 2012-13 was 10 per cent lower for FDI and 30 per cent higher for FII.
At the same time,the real effective exchange rate appreciated by an average 14 per cent between 2007-08 and 2009-10. This was still not fully corrected till 2012-13 (-11.9 per cent),with negative effects,as expected,on the balance of goods and services. The net effect of this policy stance is summarised in the net international investment position of the country,which worsened from -$ 207 billion in March,2011,to -$ 307.3 bn in March,2013,a deterioration of 50 per cent in two years. This implies the probability of external crisis has increased substantially.
The time pattern of capital flows may have confused analysts. The surge in capital inflows occurred in 2007-08,with private inflows doubling from $ 37 bn in 2006-07,to $ 78 bn in 2007-08,because of favourable forecasts of double-digit growth. The global financial crisis hit India around August,2008,and lowered these flows back to $ 38 bn in 2008-09. With global monetary easing,these flows surged back to an average of $ 72 bn a year between 2009-10 and 2012-13. This level of inflow was unsustainable,because even a realistic assumption of a trend growth of 8- 8.5 per cent assumed that structural reforms would continue at the pace of the 1991 to 2003 period. In the absence of policy reforms,the growth rate declined sharply in 2011-12. The capital inflows needed to be recognised as being temporary,and managed by limiting their surge and ensuring a real depreciation of the rupee.
Given the deterioration in macroeconomic fundamentals and the consumer price index inflation,our choices are heavily circumscribed. Even though it is difficult to relate the deterioration of the external balance to the deterioration in the fiscal and revenue deficits,there is no other solution but to reduce the growth rate of government consumption and transfer expenditures. This will increase domestic saving,take pressure off inflation,and allow an increase in government and private investment without putting pressure on the current account.
Along with this fiscal correction,monetary policy must be eased to stimulate private investment (macro-pivot). Though the rupee should be allowed to depreciate in nominal terms to a level necessary for,and consistent with,a CAD of more than 2.5 per cent,an expectation spiral that results in the overshooting of the rupee-dollar exchange rate would not be desirable. Therefore,an interest rate pivot must be attempted along with the fiscal-macro pivot. That is,to try and raise short-term interest rates while lowering long-term rates,so as to minimise speculative financing while stimulating consumer durable purchases and corporate investment. Global experience shows that it is extremely difficult to engineer and sustain an interest pivot. In the meanwhile,the energies of the government must be directed towards removing administrative bottlenecks and policy constraints to corporate investment.
The writer is former chief economic advisor,ministry of finance,and former executive director (for India),IMF firstname.lastname@example.org