Budget 2023-24: Fiscally conservative but lacking economic strategy

Budget 2023-24: Fiscally conservative but lacking economic strategy, Ideas for India, February 27, 2023.

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.

Breathe easy when the rupee falls

Times of India, October 13, 2022

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.

Why weaker rupee isn't all bad news

Times of India, July 22, 2022

Over the last few months, the exchange rate has come under intense pressure, falling to nearly Rs. 80 to the dollar, its lowest level ever. Some observers have argued that this pressure can be managed easily, since the country can simply sell a portion of its foreign exchange war chest, which amounts to a healthy $580 billion. Unfortunately, currency management is not that simple. In fact, it is not obvious that dollar sales will be sufficient to resolve the exchange rate pressure – or even whether preventing depreciation is the right strategy for the economy at present.

Let’s start by considering why the rupee has been under so much pressure. A key reason is that the US Federal Reserve has begun to tighten monetary policy aggressively to control inflation, which is at a four-decade high. The Fed has already raised interest rates by 150 basis points so far this year and is expected to tighten by a further 75 basis points later this month. When the Fed raises interest rates, global investor funds shift their portfolio allocations towards US financial markets, taking the money out of other countries. In India’s case, the net sales of foreign portfolio investors have amounted to a sizeable $31 billion in 2022 so far, according to data from NSDL.

The inflow of money into the US has led to an appreciation of the dollar. The dollar index (DXY) has strengthened against its trading partners by more than 11 percent this calendar year, reaching levels last seen in 2002. The counterpart to this appreciation has been a depreciation of the pound sterling, the euro, and nearly all Emerging Market (EM) currencies. In the case of the rupee, the depreciation has amounted to a relatively modest 7 percent since January 2022.

In fact, the rupee’s depreciation has been surprisingly modest, considering that at the same time that capital has been flowing out of the country, India’s current account deficit (CAD) has also been widening. Typically, the CAD increases when aggregate demand grows so rapidly that imports rise faster than exports. However, aggregate demand in the Indian economy has been tepid since the onset of the Covid-19 pandemic and the recovery has been slow and gradual at best. So why is the CAD worsening?

Much of the answer lies in the rapid growth of import prices. India is heavily dependent on imports of petroleum (which cover 80 percent of the country’s needs) and other commodities. And supplies of commodities have been disrupted since the Russia-Ukraine war started in February 2022, causing the prices of petroleum, fertilisers, edible oils, and other products to soar. This has automatically inflated the import bill, pushing the monthly trade deficit to an all-time high of $26 billion in June 2022. On current trend, the CAD for the fiscal year could reach 3-3.5 percent of GDP.

This has put India in a difficult situation. Just when the country needs more financing to cover a widening CAD, capital has started to flow abroad. That is why the rupee has taken a tumble.

So what can be done?

Without doubt, India can utilise some of its ample foreign exchange reserves – and indeed, it has already done so. However, this is not a complete solution. When the central bank sells foreign reserves, commercial banks need to give rupees in return, draining them of liquidity. Consequently, when reserve sales become large, the liquidity drain becomes sizeable, potentially tightening the money supply far more than what is appropriate, thereby endangering economic recovery.

To address this problem, the foreign exchange intervention can be “sterilised” if the central bank buys government securities from the banks. In that case, banks will receive rupees, thereby replenishing their liquidity. But if the central bank purchases large amounts of bonds, this could push G-Sec rates down to inappropriately low levels, thereby endangering the inflation target.

For these reasons, there is a limit to the amount of foreign exchange that the central bank can sell without jeopardising its other targets. And there is a further problem: since investors know that there is a limit to the foreign exchange sales, they will be tempted to try to purchase as much as they can right now. In that way, a policy of foreign exchange sales can sometimes – paradoxically – increase the pressure on the exchange rate.

In view of the complications arising from the strategy of selling reserves, it might help to go back to fundamentals and ask a deeper question: do we really want to prevent the rupee from depreciating?

After all, if the rupee fails to follow when other EM currencies are depreciating, then India’s exports will lose competitiveness. Already, the rupee has appreciated significantly against other Asian currencies such as the South Korean won, the Thai baht and the Taiwanese dollar. If competitiveness is further eroded just when the global economic environment is turning difficult, export growth could really suffer. And that might be a big problem.

The two most important drivers of growth for an emerging economy like India are investment and exports. Private sector investment has been sluggish for several years. Last year’s recovery was highly dependent on exports, which fortunately grew exceptionally rapidly. If this engine of growth starts to sputter, so might the economic recovery.

Of course, there are costs to a weak rupee. In particular, depreciation will push up prices at a time when inflation is already a problem. But there are other mechanisms for addressing inflation, such as increases in the repo rate, which indeed are already happening. In contrast, there are no other ready mechanisms to safeguard export competitiveness, apart from the exchange rate.

In sum, reserves can indeed be used to stabilise the rupee – but only to a certain extent. And there are some important advantages to allowing the rupee to weaken, as a way of supporting India’s economic recovery process. Striking the right balance is going to be a challenge not only for India, but for all emerging economy central banks.

How open is India's capital account?

How open is India's capital account?, Ideas for India, July 16, 2021.