In a 2007 paper (published in 2009), I argued that India should have an asymmetric foreign exchange policy whose central objective was to dampen the adverse effects of external capital flow volatility while taking full advantage of lower cost long term debt and risk capital to accelerate growth. It appears that we have had the reverse policy since 2009, resulting in faster real appreciation when inflows surged and to slower depreciation when inflows slowed. This would have the effect of slowing growth and increasing the probability of external crisis.
India’s External Position
The conventional wisdom in India is that a current account deficit above 2.5% of GDP must be viewed as a danger signal requiring urgent corrective action. Partly as a result of the global financial crises which hit in the middle of FY 2008-9, CAD jumped to 2.3% that year and to 2.8% in 2009-10. But thereafter it jumped further to 4.2% in 2011-12 and has remained at unprecedented levels.
Between March 2009 and March 2013 the total external debt of the country has gone up by over 70%, with Short term debt and ECB increasing even more rapidly (100% & 90%). As a ratio to GDP, however, it has remained at about 20%, indicating that the debt per se is not the problem, but its structure. 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 the average annual inflow during 2009-10 to 2012-3 compared to the inflow in 2007-8 was 10% lower for FDI and 30% higher for FII.
At the same time the real effective exchange rate of the rupee appreciated by an average 14% between 2007-8 and 2009-10. This real appreciation was still not fully corrected till 2012-13 (-11.9%), with expected negative effects on the Balance of Goods and Services.
The net effect of this policy stance is summarized in the Net International Investment Position (NIIP) of the country, which worsened from -$207 billion in March 2011 to -$307.3 bi in March 2013, a deterioration of 50% in two years. This implies that the probability of external crisis has increased substantially
Exchange Rate Policy
The time pattern of capital flows may have confused analysts. The surge in capital inflows occurred in 2007-8, with private inflows (FDI+FII+ECB+NRI) doubling from $37bi in 2006-7 to $78bi in2007-8, because of un-professional forecasts of India moving to double digit growth. The global financial crisis hit India around August 2008 and lowered these flows back to $38 billion in 2008-9. With Global monetary easing, these flows surged back to an average of $ 72 billion a year during 2009-10 to 2012-13. This level of inflows represented an unsustainable surge because even a realistic assumption of a trend growth of 8 to 8.5% assumed that fundamental structural reform would continue at the average pace of the 1991 to 2003 period. In the absence of policy reforms and some anti-reform actions, the growth rate declined sharply in 2011-2012. The capital inflows needed to be recognized and managed as a temporary surge along the lines suggested in Virmani(2009): That is through partial sterilization that limited the capital surge and ensured a real depreciation of the rupee (given the adverse external trade environment) and ensured against undue volatility in domestic real interests avoiding a precipitous rise or fall.
It is not possible to ignore history or to act now as we could have in 2009-10 to 2011-12. Given the deterioration in the Macro-economic picture and the CPI inflation, the choices are heavily circumscribed and the trade-offs very adverse. Even though relationship between the deterioration of the external balance to deterioration in the internal government balance (fiscal deficit & revenue deficit) is imprecise, there is no other solution left but to reduce the rate of growth of government consumption expenditures (& transfers) and the revenue deficit. This will increase domestic saving, take pressure of non-tradable goods inflation and allow an increase in government and corporate investment without putting pressure on the current account.
Along with this fiscal correction, monetary policy has to 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 less than 2.5%, an expectation spiral that results in overshooting of the rupee-dollar rate would not be desirable. Therefore an “interest rate twist” has to be attempted along with “fiscal-macro pivot” (i.e. a “pivot-twist”): That is to try and raise short term interest rates while lowering the long term rates, so as to minimize 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 entire energies of the government machinery must be directed at removing administrative bottlenecks and policy constraints to corporate investment.
Cost of Delay
If government does not act urgently and decisively on the structural reform and jointly with RBI on macro economic recommendations, and on the contrary government consumption expenditures increase, then we are likely to see a combination of the following: (a) A further slowdown of the Indian economy, (b) A rise in nominal interest rates, (c) A continuing depreciation of the rupee and a halt or reversal in the downtrend in inflation. (d) A higher probability of a BOP crisis if there is a major external shock like a Grexit (Greek exit from the Euro).
An anotated version of this Article appeared on the Editorial page of the Indian Express on Friday 9th, 2013 under the banner "An Interest Rate Pivot." http://www.indianexpress.com/news/an-interest-rate-pivot/1152981/
 Virmani, Arvind, “Macro-economic management of the Indian Economy: Capital flows, interest rates and inflation,” Macroeconomics and Finance in Emerging Market Economies,Vol. 2, No. 2, September 2009, pp 189-214. 11. Virmani, Arvind, “Macro-economic Management of Indian Economy: Capital Flows, Interest Rates and Inflation, Working paper No. 2/2007-DEA, Ministry of Finance, November 2007. http://finmin.nic.in/WorkingPaper/index.html.