Is rupee devaluation the best answer to India’s problems with a rising current account deficit (CAD), which clocked in at an all-time-high figure of 6.7 percent of GDP in the December 2012 quarter?
The answer, given partially yesterday, is that devaluation could be one option. But I must hasten to add that in isolation it may not work as well – because no reform works in isolation.
The twin rupee devaluations of 1991 gave us the desired results because we went ahead and ended the old licence raj and liberalised the economy. We fired up the animal spirits of businessmen and created a climate for investment.
This is still the right way to go, but my argument in favour of a rupee devaluation has drawn the usual fears that it can only stoke inflation and slow down growth. Of course, it will, in the short term.
In 1991, reforms and devaluation brought down growth from 5.4 percent in 1990-91 to 1.4 percent in 1991-92, but growth rebounded to 5.4 percent the very next year – almost like a jack-in-the-box – and kept rising every succeeding year till the reforms stopped coming.
The truth is any real response to our current crisis of the twin deficits – the government’s fiscal deficit and the external current account deficit – will involve short-term price increases driven by cost-push. The related problem of high inflationary expectations calls for policies that bring down inflation, not artificial inflation suppression.
Consider the alternatives:
#1: One answer to the problem of twin deficits is to end domestic subsidies of oil and coal, and free their prices. This will bring down the fiscal deficit, but raise domestic prices, forcing the economy to adjust to a changed market dynamic. But higher prices for fuel will stimulate both a search for alternatives and greater production – as we can see in the US shale gas revolution – as long as the production policies are favourable. Over time this will bring prices to market-clearing levels and stimulate growth.
In this scenario, inflation will moderate because free markets will enable supply and demand to find their own balance. Higher fuel prices will force industry to look to conserving fuel (a good goal to pursue in any case) and make alternative sources profitable (the solar and wind energy subsidies will come down). Industry will invest more in energy-saving technology and co-generation solutions.
#2: The other policy option is to push up interest rates. When inflation is high, and the rupee is weak, higher interest rates will do two things: one, they will force producers to pass on interest costs – and thus raise prices – and economise on capital. And two, higher domestic rates will stimulate capital inflows, which, in turn, will help stabilise the exchange rate. Higher interest rates will force the government itself to borrow less, but this is not happening because in India the finance ministry wants to control everything – interest rates, exchange rates, prices of fuel, everything. This is unsustainable. If you want to control domestic rates, you should not be trying to control the exchange rate as well. In fact, the only thing you should be targeting is inflation rate and inflationary expectations.
#3: Another alternative to devaluation is to free up capital controls – but this can be highly volatile. If any Indian or foreigner can bring in or take out capital freely, we cannot truly know whether money will flow out or in in the short-term. If foreigners are sure that the policy will not be given up at the first sign of trouble, they will bring in capital, since they are assured they can take it out. And they know that India will always grow faster than the developed world.
Indians who currently hoard their money abroad for fear of financial repression and high tax rates back home will try and bring it in – cautiously at first, and in torrents later. But this policy needs a lot of gumption, since we have to give up the idea of managing exchange rates completely. The rupee-dollar rate will be volatile, and so will capital flows.
#4: The other alternative to external rupee devaluation is internal devaluation. This is what we are seeing in the eurozone, where uncompetitive economies such as Greece, Spain, etc, cannot devalue their currency and finance their deficits by printing money. If you cannot devalue the euro selectively for specific economies, you have to opt for an “internal devaluation” – which is to cut jobs, spending, prices, etc. When you devalue a currency, foreigners can buy more of your stuff than earlier. When you cut jobs, costs, and prices domestically – the internal devaluation – it means much the same thing: the same euro will buy more goods in Greece than in, say. Germany.
In India, the alternative to external devaluation is internal devaluation by cutting subsidies, jobs and prices. But this is not happening fast enough. Diesel subsidies will take two years to end, and, who knows, if global oil prices rise, even that won’t happen. Governments can aid internal devaluation by cutting public sector jobs and expenditures, but after one year of drastic cuts in plan expenditure, P Chidambaram actually plans to raise it in 2013-14, and his budget numbers are anyway flawed. They overestimate revenues, and underestimate costs, including the cost of new subsidies for ensuring food security.
As for cutting jobs, no government has ever managed to do it. The Railway Minister is planning to recruit 1.5 lakh more people this year, when the railways are already overstaffed. The net central government employment – even excluding defence forces – is going to rise in 2014 by 300,000 compared to two years ago.
This leaves the issue of either a planned devaluation, or allowing the rupee to find its own level, without official props like inviting short-term capital flows.
The main criticism of this idea is that if the rupee falls, domestic prices will rise. True, but, as we noted above, that will be the case anyway. You cannot avoid short-term inflation and slowdown.
It is, however, worth considering all the implications of letting the rupee fall and/or allowing it to fall without artificial props. These are the short- and long-term consequences.
One, domestic oil prices will have to rise – or adjusted faster. This will push up short-term inflation or increase subsidies, or both. Since the government wants to cap subsidies, one can assume that prices will be adjusted faster. This will force energy conservation over the medium term, and stimulate investment in oil and gas exploration. This calls for policy changes to enable this. Allowing oil, gas and coal prices to be market-determined will rejuvenate the economy in the medium term, but slow down growth in the short run.
Two, exports will get an immediate leg up, and the prospect of higher export gains could initiate investment in building new export capacity. It will also stimulate investment in import substitutes. For example, Indians may purchase cars with a lower import content, since they will be cheaper. You might buy Himachal apples instead of Washington or Chilean apples. You will also buy less gold as domestic gold prices rise to compensate for a higher dollar exchange rate. (Chidambaram should be happy.)
Three, companies will see two-way movements in profits. Those with dollar earnings will benefit, and those with high import dependence, will be squeezed. But companies with high foreign loan components will be forced to bring down their loan exposures. In fact, letting the rupee fall will impact precisely those companies that are benefiting now from the government’s short-term policy of encouraging foreign borrowing. They will have to rebalance their loans – and some could default, as has already happened with some big FCCB (foreign currency convertible bonds) borrowers.
Four, a lower rupee will force existing foreign investors – both short-term and long-term ones – to lock their money into India, though it may impact their immediate preference for India. But long-term investors will see benefits from investing in their subsidiaries since the dollar cost of investing in the rupee area will fall. You could see both increased FDI and FII flows, too, once the policy stabilises.
An unintended bonus: Indian money held abroad clandestinely will start flowing back on the basis of a favourable dollar-rupee rate.
With reforms to back it all, a free-floating rupee and/or a managed devaluation today will, over the medium term, guarantee a stabler rupee, lower inflation and a stronger economy.
As economist Ajay Shah says, “There are two paths to inflation control: changing the structure of expectations and reducing aggregate demand. The former is almost a free lunch. It only requires institutional change. The latter is hard work; it inflicts pain.”
The bottomline is simple: easy options are over.