While the Indian economy has started recovering from the pandemic, the global economy has begun to decelerate. This has complicated the task of finding an appropriate policy mix that can deliver growth amidst multiple global headwinds. Existing domestic imbalances such as high inflation and a large stock of government debt have already imposed constraints on the authorities’ ability to manouver. Now the constraints are likely to worsen as India’s export prospects have dimmed and current account deficit seems set to widen. In such a situation, is there any policy space left to support growth? It seems there is a powerful arrow in the RBI’s quiver: the exchange rate.
There are widespread concerns about an impending recession in developed economies, as they struggle to deal with the worst streak of inflation in four decades. The US Fed has already raised its policy rate by 3 percentage points since March 2022, the most aggressive monetary contraction since the 1980s. It has now signalled that this tightening cycle will last longer than previously expected. The European Central Bank and the Bank of England have also embarked on monetary contraction in order to bring inflation down to their target levels of 2%.
As if this sudden shift in the monetary environment were not enough, Europe is currently facing an energy crisis as Russian supplies of natural gas dwindle, while China’s economy is dealing with an abrupt end to the real estate boom that had been powering that country’s economy for the past decade. Owing to these developments, the IMF has lowered its forecast of global growth for 2022 to only 3.2 percent, far below the 4.4 percent it predicted at the start of the year. As a spillover effect, already India’s pandemic-time export boom has ended. In fact, September 2022 witnessed a fall in exports, with declines being particularly sharp for apparel and engineering goods.
This situation has put domestic policymakers in a bind. Ideally, they would react to the fall in external demand by stimulating domestic demand. But the policy space available to do so is highly limited. The fiscal deficit in 2022-23 is budgeted to be around 6.4 percent of GDP and the debt to GDP ratio continues to be very high, close to 90 percent. This restricts the fiscal space available to the government to provide any kind of stimulus.
On the monetary side, the RBI has now begun tightening policy to bring inflation back to the target level. The RBI’s medium term inflation target is 4 percent, whereas the CPI inflation has been averaging at 6-7 percent in 2022 so far. While oil and commodity prices have been softening, erratic monsoon is pushing up food inflation leaving no room for the RBI to go easy on the rate hikes.
This implies that using fiscal or monetary policy to support growth at this juncture will only worsen the existing macro imbalances: the high levels of inflation, government debt, and the current account deficit (CAD).
The CAD is especially a problem now. On current trends it could reach the exceptionally high level of 4 percent of GDP in 2022-23. Such a high CAD would be very difficult to finance. In fact, capital is flowing the other way, with rising US interest rates encouraging investors to take money out of Indian capital markets and deploy it instead in the US.
Given the circumstances what can the RBI do? The most obvious strategy would be to try to bridge the gap between rising CAD and falling capital flows by using its foreign exchange reserves. Indeed, that is exactly what it has been doing. However, there are limits to what the RBI can or should do. Bridging this gap using reserves makes sense only if the gap is small and temporary. It has turned out to be neither.
Reserves have now been falling for an entire year, by a staggering $110 billion between September 2021 and early October 2022. The pace of reserve loss seems set to accelerate as India’s CAD widens and the US continues to increase interest rates.
Clearly, other strategies are needed. The RBI could try to stem capital outflows by raising rates to reduce the interest differential with the US. But given that the US Fed has signaled that it will increase rates by another 125 basis points (and might do more), this strategy might require much more aggressive rate hikes on the part of the RBI than what is warranted by domestic inflation. Such a strategy could end up hurting the nascent economic recovery even more.
That leaves the exchange rate. The RBI could allow the rupee to respond to market forces, and depreciate. Such a strategy would have a number of advantages. Most obviously, it would reduce the need to spend so much of the foreign exchange reserves; these can be preserved for situations when the country is faced with temporary and unforeseen external shocks, rather than chronic drains on the balance of payments.
A second advantage of allowing the rupee to depreciate is that it would enhance the competitiveness of Indian exports. This would be a powerful way – more powerful than targeted subsidy programs -- of ensuring that India would be able to gain some of the global market share that China has been giving up. And in doing so, it would ensure that exports, the key motor of India’s post-pandemic growth, does not seize up at such an early stage of the recovery.
Of course, a currency depreciation could add to the inflation problem, by increasing the rupee price of imported goods. But the effects would likely be minor, as long as monetary policy remains tight.
In other words, the benefits of this strategy are likely to far exceed the costs. The good news is that the RBI already seems to be on this path. After a period of trying to stabilise the currency, the RBI has recently allowed the rupee to depreciate. Rupee has reached an all-time low of nearly 83 against the dollar.
For the first time in several decades US inflation exceeds Indian inflation. Looking forward, as long as the Fed persists with rate hikes, there will be pressure on the rupee to depreciate. In response, the RBI should continue to let the rupee respond to market forces. This policy should be accompanied by appropriate government support, such as moving away from protectionist policies, and taking steps to create a more export-oriented environment so that firms can reap full advantage of a weaker rupee. These policy actions may in turn help turn the growth cycle around for India, and help cement its position as a fast-growing economy.
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