Wednesday, June 26, 2013

Rupee Depreciation: Treat The Problem Not the Symptom


 The sharp depreciation of the Rupee during the last thirty days has set off a flurry of comments, discussion and articles on the rupee.  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 Rupee depreciation is not the problem but merely  a symptom of the underlying problem.  Think of it as a red flag or a red alert that has arisen to warn us of the need for correctly identifying and addressing 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.  The external actions can provide only temporary palliatives  and give us more time and/or space to solve our internal problems.

The Problem

What is the problem? The fundamental problem is a creeping loss of competitiveness that needs to be reversed. 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 a 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 historical standards of the country as well as in comparison to current account deficits currently prevailing in other countries. Third, an excessive growth in credit resulting in an increase in potential and actual Non-performing assets.  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 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/offset the earlier “real appreciation” of the rupee.  Though this correction will have positive effect on the current account deficit the need to address the underlying saving-investment imbalances and distortions remains. Underlying the rise in NPA s and the fall in private credit are governance and regulatory actions (and in some cases inability to take actions) that have increased the controls, constraints and regulatory burden on the corporate sector reducing its competitiveness.


There are three underlying problems that need to be addressed to attain a stable macro-economic environment in which the economy grows at a sustained high rate despite global risks and uncertainties (QE3 withdrawal, Euro/EU depression)  that are present today and are likely to persist for several years.  These are, to
(1) Reduce the high growth of  government consumption (Cgd) and thus reduce the governments (departmental) Saving-Investment imbalance, through a reduction in distorting subsidies(energy, fertilizer), inefficient current expenditures and ineffective transfers.  If done successfully it will manifest itself in a reduction in the fiscal and revenue deficits and play a vital role in reducing inflationary pressures and the current account deficit (CAD).
(2) Ease monetary policy and reduce the nominal interest differential with global capital markets.  A reduction of the domestic Investment-saving gap will reduce the incentive for short term capital inflows, reduce the real interest of the economy and thus allow a non-inflationary reduction in the nominal interest rate.
(3) Raise the growth of corporate investment, through structural/policy reforms. These will attract enough long term foreign capital to finance any sustainable current account deficit. There are two dimensions of reform that require action: One is an effort to identify and reverse/remove controls, regulations and administrative-bureaucratic measures, particularly those  introduced over the last five years, that have increased the costs or risk of investment. These include tax laws, rules and procedures. The second are 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 completely abolished through a cabinet decision, even though implementation of legal changes may take some time.  Similarly the cabinet should take a decision to denationalize coal and railways and ask the coal ministry to draw up an implementation plan to introduce competition.  

The combination of (1) and (2) is what I have earlier called (in the IE)  the, “Macro-Pivot.” They are intimately linked, in that the second cannot be successfully undertaken without the first.   (3) Is what I recommended in a post-budget IE article as an essential third phase of economic policy reforms for restoring growth to a higher level.  International developments since then, as manifested in reduced capital flows and a depreciation of the rupee, have made even stronger action on all these fronts more urgent.

This article appeared on the Op Ed page of the  Indian Express on Wednesday, 26th June under the banner, “Unlucky Dip”.

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