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.

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.

What the term premium is (or is not) telling us?

(with Harsh Vardhan) Bloomberg Quint, October 6, 2022

An important and usually reliable measure of the future economic outlook is the yield curve in the bond market. It is particularly useful when the overall economic environment is highly uncertain, such as now. The yield curve shows the yields of government securities (G-Secs) of various maturities. The steepness of the yield curve is often used as a proxy for market expectations about future interest rates, and hence future inflation and growth. In recent times however, the reliability of the yield curve and its information content have come into question.

One simple way to measure the steepness is the term premium. It is the difference between the yields at the short end and at the long end of the yield curve. In India, the long-term yield considered is typically the 10 year G-Sec yield while for the short-term, it is usually the yield on one-year treasury bills. Monetary policy has an important impact on the term premium. The actions of the central bank directly affect the short-term interest rate. The bond market interprets the central bank’s actions and statements and transacts long dated bonds setting the long-term rates.

Since May 2022, the RBI has been hiking the policy repo rate in response to the rise in CPI (consumer price index) inflation which averaged at 6.8% between January and August 2022. Accordingly the short-end of the yield curve has gone up from 5.1% in early May to 6.7% now. This is a move of around 160 basis points in the 1 year G-Sec yield.

The RBI has also been highlighting in its monetary policy statements the significant upside risks to inflation that remain a concern. It has specified that it will continue to withdraw surplus liquidity from the system which is consistent with a contractionary monetary policy. Its CPI inflation forecast for FY 2022-23 is 6.7%, much higher than its inflation target of 4%. This implies that monetary policy may need to be tightened in a calibrated manner for the next few quarters.

Moreover, monetary policy tightening in the US has led to a strengthening of the US dollar and accordingly an 11% depreciation in the rupee-dollar exchange rate in 2022 so far. This has been the fate of currencies across the world, not just in emerging economies, and has led to central banks raising interest rates in order to defend the exchange rates. There are talks among the analyst community in India that the RBI might follow suit. Given that the Fed has said it might increase interest rate by another 125 basis points by the end of 2022, any attempt to use monetary policy to defend the rupee’s value may require the RBI to raise rates significantly.

Given the circumstances, one might expect the yield curve to steepen i.e. long-term yields should go up alongside the short-term ones, reflecting market’s expectation of higher interest rates in the future.

What we see instead is that the rates at the long-end of the yield curve have gone up by only around 30 basis points – from 7.1% in early May to 7.4% now in comparison to the increase in the short end by about 160 bps. As a result, the term premium has come down to around 50-70 basis points from a long-term average of over 90 bps. This has led to a remarkable flattening of the yield curve which seems counterintuitive.

Such a flat yield curve implies that the bond market believes that the rate actions taken by the RBI would help control inflation, which in turn would lower the chances of future interest rate hikes. In other words, the market does not agree with the RBI as far as assessment of risks to inflation are concerned. It also means the market does not expect the RBI to raise rates to match the monetary policy tightening being undertaken by the US Fed.

If the long-term yields remain as steady as they have been over the last few months, and the RBI continues to tighten the short-term rates, we may soon see the term premium moving close to 0. For an economy growing roughly at 5-6% on average with an inherent inflationary impulse, such a flat yield curve implies that the market is anticipating a severe growth slowdown and hence monetary policy easing.

Is that indeed the case? The answer is: it is not possible to answer this anymore by looking at the yield curve. Let's understand why.

During the pandemic the RBI had expanded its balance sheet by around 25%. It bought long-term G-Secs and the 10Yyields were held steady around 6%. Since October 2021 it has stopped its bond buying program. At its peak the RBI’s balance sheet was around Rs 65 trillion in October 2021. Between then and September 2022 the balance sheet has shrunk marginally to around Rs 59-60 trillion. This means that while the RBI has been withdrawing short-term liquidity using the SDF and reverse repo facilities, it has not been selling long-term G-Secs.

Typically, the RBI withdraws long-term liquidity through open market operations (OMOs) or by selling dollars from its reserves. In the former case, the stock of G-Secs goes down, and in the latter, reserves fall. The RBI has lately been relying on the second mechanism - selling dollars - to reduce liquidity (and to stem the rupee depreciation). When the RBI’s GSec holdings were small, this did not matter. Now the RBI potentially holds around Rs 15 lakh crore worth of G-Secs which is tad below 20% of all outstanding G-Secs, compared to its peak holding of Rs 15.8 trillion in September 2021. In contrast, between 2011 and 2020, the average RBI ownership of G-Secs was roughly 11% of the outstanding. As long as the RBI continues to hold such a large amount of G-Secs, the long-end of the yield curve is unlikely to respond freely to economic conditions.

A natural way for the term premium to shrink is if inflation comes down or growth slows down. But if in some part of the market there are no transactions, and a large chunk of the supply of long-dated bonds is cornered then this hampers price discovery. All interest rate sensitive securities are directly or indirectly priced with reference to the yield curve. Any such distortion of the yield curve therefore will translate into an economy wide pricing distortion. This also hampers transmission of monetary policy along the yield curve.

The RBI itself has been advocating an “orderly evolution of the yield curve”, but its own decision has important consequences for the market in general and the yield curve in particular. The current compression of the term premium suggests that the yield curve is anything but orderly.

Playing it safe

Indian Express, August 5, 2022

The RBI's latest Financial Stability Report (FSR) has given the banking system a reasonably clean bill of health. It's a significant achievement, considering the stress of the previous decade, the shock of the pandemic and the associated slowdown of the economy. However, the improvement in banks' financials presents a glass half-full picture. It is still unclear whether the banking system is healthy enough to provide the sustained credit growth needed for a strong economic recovery.

Two key indicators demonstrate the banking system’s progress. Successive waves of recapitalization have given banks enough resources to write off most of their bad loans. As a result, they have been able to bring down their gross NPAs from 11 percent of total advances in 2017-18 to 5.9 percent in 2021-22. NPAs for industrial credit have been reduced even more dramatically, from 23 percent to 8.4 percent. Even after these large write-offs, most banks retain comfortable levels of capital.

This financial turnaround has given banks the space to resume their business of extending credit. During the decade when banks were under stress, non-food bank credit growth had been declining, reaching just 6 percent in 2020, its lowest point in six decades. Since then, credit growth has nearly doubled.

These are the visible signs of a healthier banking system. However, the broad aggregates conceal a worrisome picture, raising questions about the role bank credit will play in supporting GDP growth. The problem is that very little of this credit is going to large-scale industry or for financing investment.

Consider first the sectoral distribution of credit. Over the last decade, banks have increasingly shifted away from providing credit to industry, favouring instead lending to consumers. Consequently, the share of industry in total banking credit has declined from 43 percent in 2010 to 30 percent in 2020, while that of consumer loans has increased from 19 percent to 29 percent. This trend is continuing: in the year ending March 2022, consumer loans grew at 13 percent, whereas loans to industry grew at just 8 percent.

Bulk of the industry loans has been extended to the smaller firms (MSMEs), which benefitted from the credit guarantee scheme offered by the government in the wake of the pandemic. Loan growth for MSMEs went up from 3 percent in 2020 to 31 percent in 2022. In contrast, lending to large industries has been stagnant in nominal terms during the last two years, implying that it has declined sharply in real terms.

A related problem is that there has been little lending for private sector investment. Over the last one year, bank lending to infrastructure has grown by 9 percent, up from 3 percent in 2020, but this was fuelled mainly by public sector capital expenditure. Meanwhile, much of the lending to private industry has been in the form of working capital loans, necessitated by the increase in commodity prices, which has led to a sharp rise in the cost of holding inventories.

Why is there so little lending for investment by large firms? Both demand and supply side factors seem to be at work. On the demand side, private sector investment has been sluggish for nearly a decade. The boom-and-bust of the mid-2000s had saddled firms with excess capacity, giving them little reason to expand their production facilities. In addition, the Global Financial Crisis had shown the dangers of ambitious expansion supported by excessive borrowing, leading firms to conclude that it would be prudent to scale back their plans and instead focus on reducing their debts.

On the supply side, banks have learned similar lessons. During the period 2004-2009, rapid GDP growth in the Indian economy was fuelled by an unprecedented lending boom. Credit doubled within the span of a few years, primarily on the back of lending to large infrastructure projects. Subsequently, many of those loans turned bad, leading to high levels of NPAs on bank balance sheets. As a result of these financial problems, banks for a decade were unable to extend much in the way of credit. Even when their health improved, they remained wary of lending to large-scale industrial projects, preferring instead to shift to smaller-scale and less risky consumer lending. This situation of risk aversion on the part of firms and banks has not changed perceptibly during the post pandemic recovery.

On the positive side, firms seem to have finally used up much of their spare capacity. But on the negative side, the fundamental problems that led to the difficulties of the past decade still have not been resolved. There is still no framework that will reduce the risk of private sector investment in infrastructure, certainly not in the critical and highly troubled power sector. Nor is there any reassurance for the banks that if problems do develop, they can be resolved expeditiously, since the Insolvency and Bankruptcy Code (IBC) has been plagued by delays and other problems. Now, heightened global macroeconomic uncertainty, growing geopolitical tensions and uncertain recovery prospects of the domestic economy are likely to make matters worse.

In other words, a healthy balance sheet of the banking sector is a necessary but not a sufficient condition for economic growth. The important question is whether banks and firms will once again be willing to take on the risk of investment in industry and infrastructure. And this seems unlikely unless there are deep structural reforms – to the infrastructure framework, the resolution process, and indeed in the risk management processes at the banks themselves. In the event that these reforms do not materialise, there may continue to be shortfalls in credit, investment, and ultimately in economic recovery and growth.

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.