The triggers for the rupee fall are external. The solutions lie within
The sharp depreciation of the rupee over the last several weeks has set off a flurry of comments,discussions and articles. Some of it is confused and confusing. The purpose of this article is to clarify the issues and the solutions. The most important thing to understand is that the depreciation of the rupee is not the problem but merely a symptom of the underlying problem. Think of it as a red flag or a red alert that warns us of the need to correctly identify and address these underlying problems. The second thing to understand is that though the trigger for the depreciation is external (global capital market reaction to anticipated changes in US monetary policy),the fundamental problems and solutions lie within,not outside,the country. External actions can provide only temporary palliatives,and give us more time and/or space to solve our internal problems.
What is the problem? The fundamental problem is a creeping loss of competitiveness,which needs to be reversed. The experience of countries in Eastern Europe and Latin America has taught us that there are three visible symptoms of this loss of competitiveness. One is high inflation relative to our trading partners,coupled with low nominal depreciation,resulting in a real appreciation of the rupee. Second,a sustained increase in the current account deficit to levels that are high by the historical standards of the country as well as in comparison with current account deficits prevailing in other countries. Third,an excessive growth in credit resulting in an increase in potential and actual non-performing assets (NPAs). All these symptoms,with the possible exception of high credit growth,have been present in India in the recent past. In the case of credit growth,the ambiguity arises because,in the last year or two,the expansion in credit to the government and the public sector has been partially offset by slower growth of credit to the private corporate sector,moderating total credit.
The recent depreciation of the rupee has substantially,if not entirely,corrected or offset the earlier real appreciation of the rupee. Though this correction will have a positive effect on the current account deficit,the need to address the underlying saving-investment imbalances and distortions remains. The factors that lie behind the rise in NPAs and the fall in private credit are governance and regulatory actions (and in some cases,the inability to take action),which have increased the controls,constraints and regulatory burden on the corporate sector,reducing its competitiveness.
There are three underlying issues that need to be addressed to attain a stable macro-economic environment in which the economy grows at a sustained high rate despite the global risks and uncertainties (QE3 withdrawal,euro/EU depression) that are present today and are likely to persist for several years.
First,the high growth of government consumption needs to be curbed. This would reduce the governments (departmental) saving-investment imbalance. It can be done by cutting down on distorting subsidies (energy,fertilisers),inefficient current expenditures and ineffective transfers. If done successfully,it would manifest itself in a fall in the fiscal and revenue deficits and play a vital role in reducing inflationary pressures and the current account deficit.
Second,monetary policy must be eased and the nominal interest differential with global capital markets must be reduced. Shrinking the domestic investment-saving gap will reduce the incentive for short-term capital inflows,lower the real interest of the economy and thus allow a non-inflationary reduction in the nominal interest rate.
Third,the growth of corporate investment needs to be raised through structural or policy reforms. These will attract enough long-term foreign capital to finance a sustainable capital account deficit. There are two dimensions of reform that need to be addressed. One is an effort to identify and reverse or remove controls,regulations and administrative-bureaucratic measures,particularly those introduced over the last five years,which have increased the costs or risk of investment. These include tax laws,rules and procedures. The second includes measures that will increase the opportunities and incentives for investment. For instance,sectoral FDI limits have outlived any utility they had earlier. These need to be abolished completely through a cabinet decision,even though implementation of legal changes may take some time. Similarly,the cabinet should take a decision to denationalise coal and railways. It should also ask the coal ministry to draw up an implementation plan to introduce competition.
The combination of the first and second measures is what I have earlier called the macro-pivot. They are intimately linked,in that the second cannot be successfully undertaken without the first. And I had recommended the measures to increase growth of corporate investment in a post-budget article in these pages (Reform,phase two,IE,March 1,goo.gl/Z5TJZ) as the essential next phase of economic policy reforms for restoring growth to a higher level. International developments since then,as manifest in reduced capital flows and a depreciation of the rupee,have made even stronger action on all these fronts more urgent.
The writer is former chief economic advisor,Government of India,and former executive director,IMF. He now heads ChintanLive.com
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