India's CAD reveals the need to increase exports

Indian Express, December 17, 2022

There seems to be a considerable amount of optimism about India’s near-term growth prospects, now that the major global energy and commodity shocks have subsided. But how will this growth be sustained? And even if these shocks have subsided, India still faces one big problem—its large current account deficit (CAD). How will this be managed? It turns out that the answer to both questions lies in one word: exports.

Let’s start with the second problem. Over the past year, the post-pandemic normalisation has caused the current account deficit to swell to exceptional proportions. At home, normalisation has spurred a renewed demand for imported inputs. But abroad it has had the opposite effect, leading to a decline in demand. Foreign households are no longer demanding so many goods now that the lockdowns that kept them in their houses and the fiscal stimuli that gave them the money to spend, have both ended. So, India’s imports have soared just at a time when its merchandise exports have started to fall.

Looking ahead, the situation seems set to worsen. Foreign demand will slow further as advanced countries slip into what now seems like inevitable recessions. In that case, India’s CAD could widen even further, possibly to 4 percent of GDP in 2022-23, double the level that the Reserve Bank of India (RBI) traditionally regards as “safe”. How should India respond?

One possibility would be to attract foreign capital inflows worth at least 4 percent of GDP. But is this realistic? The world is currently facing unprecedented levels of uncertainty. Following two years of a pandemic, we are now witnessing a land war in Europe, the highest inflation in the developed world in the last four decades, the fastest pace of interest rate hikes in the history of the US Federal Reserve, an energy crisis in Europe, and a slowdown in China that continues to struggle with Covid-19. In such an uncertain environment, foreign investors prefer to invest in safe assets such as US government bonds rather than emerging markets like India. This trend has become all the more acute now, since the persistent rate hikes by the Fed have made US financial assets even more attractive. As a result, India has witnessed large outflows of foreign capital in 2022-23.

If India cannot attract the required amount of capital inflows, the RBI’s foreign exchange reserves could be deployed to pay for imports. But this strategy is neither appropriate nor sustainable. The country’s reserves are meant to tide the country over short-term problems, such as commodity price spikes. The large CAD, however, is not a short-term problem: it is a long-term problem requiring a long-term solution. In particular, India’s merchandise exports have been structurally weak, stagnating for the past decade, until the pandemic induced a short-lived boom.

This means that something fundamental needs to change. Ultimately, India’s CAD reflects a mismatch between the demand and supply of foreign exchange; we are demanding more dollars than we have access to because we are importing more than we are exporting. To restore balance, first and foremost, the price needs to adjust, i.e. the rupee needs to depreciate. When this happens, exporting becomes more profitable, inducing more and more firms to explore foreign markets. Meanwhile, foreign demand improves, because the rupee depreciation makes India’s products more price-competitive. As a result, exports increase—and the CAD falls.

Exchange rate depreciation is helpful for another reason: it can help sustain growth.

The recovery of the Indian economy from the pandemic was largely fuelled by exports. In the April-January period of 2021-22, India’s merchandise exports grew at a staggering rate of 46 percent compared to the same period in the previous year. But with exports now declining, this crucial source of growth has now become uncertain for India.

This is deeply worrisome, since prospects for the other drivers of long-term growth seem cloudy. Private sector investment continues to be sluggish and is unlikely to pick up in an uncertain economic environment. Nor is there room for fiscal stimulus, since the high levels of government deficits and debt need to be reduced. And even though the Indian economy is regarded as consumption-driven, private consumption by itself cannot sustain a growth rate of 7 percent, especially when all other sources of growth are underperforming.

Strengthening the export sector is therefore critical for sustaining growth. True, the task will be difficult, since the global economy slowing down. But it is still feasible, since India’s share in global exports is very small and there is ample scope to expand this share.

Over and above a rupee depreciation, this will require structural policies—indeed, a fundamental shift in India’s economic strategy. Policy needs to become significantly more export-oriented and less protectionist. Over the last few years, average import tariffs have gone up. In a world where manufacturers are dependent on global supply chains, levying stiff import duties hampers exports. And this obstacle cannot be overcome by providing subsidies to a selected few producers.

In sum, the need of the hour is four-fold: allow the rupee to depreciate, encourage foreign firms to produce in India by letting them access their supply chains, encourage domestic firms to step up to the competition, and create a level playing field for all players.

By adopting this strategy, India could potentially solve its two most important macroeconomic problems—reducing the large CAD and securing rapid, sustained growth. Will this change come about? Unfortunately, there are no such indications so far.

Below 6% but 5 problems

Times of India, December 13, 2022

The latest data release for November 2022 shows that inflation is now within the RBI’s target range. This is undoubtedly good news. However, some major issues persist. Inflation remains much too high. And there is no clarity yet on how the central bank plans to bring it down to the target level.

Headline CPI (consumer price index) inflation came out to be 5.9 percent in November, down from 6.8 percent in October. This is the lowest inflation since December 2021. At the same time, global commodity prices have been falling, softening inflationary pressures. But that is pretty much where the good news ends. There remain at least five major concerns.

First, while it is true that inflation has slipped below the upper threshold of the RBI’s inflation targeting band, it is important to remember that 6 percent is not the RBI’s target. The RBI is legally mandated to aim for 4 percent inflation. This implies that there is still some way to go before CPI inflation reaches its target level.

Secondly, the decline in headline inflation did not reflect any fundamental change, but a steep fall in the price of vegetables. If one excludes vegetables, CPI inflation would infact have increased, to 7.2 percent.

Third, measures of underlying inflation indicate that price pressures remain stubbornly strong. Core (i.e., non-food, non-fuel) CPI inflation continues to be around 6 percent—the same level that it has been at for nearly three years now. This signifies that high inflation is deeply embedded in the system.

Why is core inflation so persistent, despite the easing of commodity price pressures? Most likely, because the economy is locked into a wage-price spiral. As the economy has opened up after two years of pandemic-induced restrictions, firms have had to pay higher wages to workers to bring them back, to compensate them for the price increases (for example, in fuel and transport prices) that occurred while they were away. Also, the depreciation of the rupee would have made it costlier for firms to import inputs. In both cases, firms seem to be passing these increases in costs on to the consumers in the form of higher prices.

Fourth, global inflation is still quite high. While inflation in the US has receded to 7.7 percent in October from 8.2 percent in September, inflation in the UK is 11 percent and rising, while that in the European Union has increased to 11.5 percent. As a result, India is importing high global inflation. This problem could intensify, if the rupee depreciates further, as advanced country central banks continue to tighten monetary conditions by raising interest rates.

Finally, cereal inflation remains exceptionally high, at 13 percent. It is difficult to understand why this is happening, since the government has been augmenting supplies by providing grains under its free food scheme (PM Garib Kalyan Anna Yojana) to all families holding a ration card. One possibility could be that traders are worried that the government’s buffer stocks are running low and that the winter harvest might prove disappointing.

Adding up all these factors makes it clear that it is way too early to declare victory on inflation. So, what is the strategy to bring inflation down?

It is true that the RBI has been consistently raising the policy repo rate since May 2022. The repo rate has gone up from 4 percent to 6.25 percent. The RBI has also been withdrawing surplus liquidity from the system to restrain the money supply. The Monetary Policy Committee (MPC) also seems more focused on inflation now compared to 2021-22. These are all steps in the right direction. But to break the persistence of the core inflation and bring inflation down to the target level of 4 percent, more effort might be required.

The RBI has predicted inflation to fall to 5.4 percent in the second quarter of 2023-24. But it has not yet indicated when it expects inflation to reach 4 percent—or what it plans to do to ensure that this target is achieved in a reasonable timeframe. Does it think that the current level of interest rate—which is only marginally higher than the underlying inflation rate—is sufficient to deliver the target in the next one year or so, implying that the RBI will continue to soften the pace of rate hikes or even end the tightening cycle soon? Or will further and steeper rate increases be necessary to ensure that monetary policy exerts sufficient downward pressure on inflation? It may help to provide some clarity on these issues.

Once the sanctity of a rule-based system is ignored for a while, it becomes more difficult to restore the credibility of that system. In India, a glaring example of this is the Fiscal Responsibility and Budget Management (FRBM) Act. After persistent deviations from the fiscal target for years, this institution has now ceased to be relevant and we may have normalised a high level of fiscal deficit. Inflation targeting should not suffer the same fate.

It is reassuring that the RBI has recently said that it has an “Arjuna’s eye” on inflation. It should now follow up by spelling out a strategy to ensure that Arjuna’s arrow hits its target.

On inflation, we are not out of the woods

Hindustan Times, December 5, 2022

The macroeconomic landscape in India seems to have suddenly changed. For most of this year, the main problem was surging prices, which had pushed consumer price index inflation far above the Reserve Bank of India’s target of 4 percent. In recent months however, inflation seems to have subsided. And now there is a new problem, as India’s export-led recovery is being threatened by weaking demand in the advanced countries, which seem to be slipping into recession. As a result of this shift in the landscape, some analysts have urged the central bank to shift its priorities, declaring victory over inflation, and focusing instead on the task of reviving growth.

At first blush, this shift seems reasonable. But we need to ask two questions. Is the inflation problem really over? And if not, what are the costs and benefits of shifting the policy stance?

Let’s understand the first question. It is true that inflationary pressures are softening. CPI inflation came out to be 6.8 percent in October, down from 7.4 percent in September. Alongside this, wholesale price index (WPI) inflation fell to 8.4 percent from an average of 14.9 percent in the previous nine months. It remains unclear though, whether these developments represent the start of a new trend or a temporary low. After all, core (i.e., non-food, non-fuel) CPI inflation has been running around 6 percent for the past three years, implying that inflation has become deeply ingrained at a level higher than the RBI’s target of 4 percent.

Moreover, there are still significant risks to the inflation outlook.

First, there has been a big spurt in the prices of cereals. Cereal inflation has gone up from 11.5 percent in September to 12.1 percent in October. In particular, the price of rice has gone up by 10 percent and that of wheat by more than 17 percent on a year-on-year basis. These developments are puzzling, considering that the government has been flooding the market, for some time, with cheap grains under both the PDS (Public Distribution System) and the PMGKAY (PM Garib Kalyan Anna Yojana) free food scheme that was launched in March 2020 as a Covid-relief measure. The latter scheme provides 5 kg of free foodgrains (wheat or rice) per person, per month for a family holding a ration card, and covers a significant portion of the population.

Why are cereal prices going up despite this massive free provision? One possibility could be that the government has used up much of the grains in its stock, and now the stocks are running low. If, on top of this, the winter wheat crop suffers, say due to the unseasonal October rains, then high cereal inflation could persist, thereby feeding a demand for higher wages, which would then translate into high general inflation.

Second, global inflation is still not under control. While inflation in the US has receded to 7.7 percent in October from 8.2 percent in September, inflation in the UK is 11 percent and rising, and that in the European Union has increased to 11.5 percent.

Third, the rupee may well remain under pressure in the coming months. As long as advanced country inflation remains high, their central banks will need to continue to raise interest rates from their historically low levels. Economists are currently expecting the US Federal Reserve to raise its policy rate by 100-150 basis points. The Organization of Economic Cooperation and Development (OECD) has recently indicated that rate hikes in the European Union would need to be even larger. These higher rates abroad will discourage capital inflows into India, which will be problematic for the rupee since India needs the inflows to fund its large and growing current account deficit.

For all these reasons, international and domestic, we can’t be sure yet that inflation in India is headed back to 4 percent. And this leads us to our next big question: should the RBI stay focussed on the inflation problem or should monetary policy instead focus on reviving growth? Consider the benefits and drawbacks of shifting its stance.

In principle, the main benefit of lowering interest rates is that it would encourage domestic investment. But it is far from clear that investment is being held back by high interest rates. In fact, private sector investment has been sluggish for the past decade, regardless of whether RBI policy has been tight or stimulative. As a result, it is difficult to believe that another shift in the RBI’s policy stance will make much of a difference.

Consider now the potential costs of such a shift. The most obvious cost is that stimulating the economy could worsen the inflation problem. However the biggest cost is perhaps much more subtle: when analysts urge the RBI to try to revive growth, they distract attention from the deeper policy actions that are required on the part of the government, namely the task of creating an economic framework that encourages firms to take risks and expand capacity. As a result, the reforms needed to revive investment are not undertaken.

In summary, we are still not out of the woods as far as inflation is concerned. Hence, we should let the central bank do its job, its legally mandated task of bringing inflation down to 4 percent. And we should encourage the government to focus on its mandate, of creating a supportive environment for investment and growth.