Ramnath Goenka was instrumental in highlighting the excesses of the Emergency, which probably contributed to Indira Gandhi’s defeat when she lifted it. He continued to be a tireless scourge of corruption and government high-handedness, and was responsible for unsettling many a minister and business tycoon. It would be fitting in a lecture in his memory to speak about the efforts we are making in India today on increasing transparency and curbing corruption. However, I have said what I needed to on that elsewhere. Instead, I will speak today on India’s engagement with the global economy, and how best to manage it in these turbulent times.
The global economy is finding it hard to restore pre-Great Recession growth rates —every report of the IMF seemingly downgrades its previous growth forecasts. Why has the recovery been so slow? The immediate answer is that the financial boom preceding the Great Recession left industrial countries with an overhang of debt, and debt, whether on governments, households, or banks, is holding back growth. While the remedy may be to write down debt so as to revive demand from the indebted, it is debatable whether additional debt-fuelled demand is sustainable. At any rate, large-scale debt write-offs seem politically difficult even if they are economically warranted.
But perhaps the debt overhang points to a deeper cause; the debt-fuelled demand before the Great Recession, which has led to the debt overhang now, hid a fall in global potential growth, perhaps because of the difficult-to-understand consequences of population ageing across the industrial world, and the slowdown in productivity growth. Structural reforms, typically ones that increase competition, foster innovation, and drive institutional change, are the way to raise potential growth.
What should India do?
What should India do in this environment where the international investor is manic depressive in his behaviour and all countries are striving for extra growth? Importantly, when global growth is uncertain, we should make sure that our domestic environment promotes strong, sustainable, and stable growth. This requires a firm platform of macroeconomic stability.
The recent central budget emphasised fiscal prudence and adhered to past commitments, even while allocating resources towards capital spending and focusing on structural reforms, especially in agriculture. The subsequent fall in government bond yields suggests that market investors were calmed by the government’s overall message. Fiscal consolidation, combined with lower commodity prices, has also led to a lower current account deficit. Inflation is also clearly down since the days of double-digit CPI inflation not so long ago. The RBI’s inflation-focused monetary framework will be strengthened by the constitution of the monetary policy committee mooted in the finance Bill.
The last leg of the stabilisation agenda is to clean up the stressed assets in the banking sector so that banks have the room to lend again. The problem in the past was that banks simply did not have enough powers to force promoters to pay, or to put stressed assets back on track. Unlike more developed countries, we do not have a functioning bankruptcy system, though a Bill is currently before Parliament. Therefore, we first had to create an effective out-of-court resolution system. Having done that, we are now working with banks to recognise and resolve stressed assets, even while getting them to raise capital where necessary. Our intent is to have clean and fully provisioned bank balance sheets by March 2017.
…Given the inhospitable world economy and two successive droughts in India, either of which would have thrown the economy into a tailspin in the past, our focus on macroeconomic stabilisation must be part of the explanation why we have over 7 per cent growth, low inflation, and a low current account deficit, unlike some of our emerging market counterparts. Now, we have to build on this sound base. What will be particularly important is how we engage with the world economy.
For the first time in decades, global trade has consistently grown more slowly than global output. There are a number of possible explanations; as countries get richer, non-traded services constitute a greater fraction of GDP, causing GDP to grow faster than trade. Also, with trade-intensive capital good’s investment muted because of global overcapacity, trade grows more slowly than GDP. Finally, as industrial countries become more competitive, and as China moves up the value chain, more of the inputs going into final products are being sourced from inside a country rather than from outside the country. Some global supply chains are therefore contracting. For all these reasons, the heady days when Indian trade in goods and services was expanding at a double digit pace will probably only be a memory for some time.
It is useful to examine recent trade data to see how India compares with rest of the world. …It suggests that the growth of Indian exports of goods and services broadly mirrors that of emerging markets.
Most recently, of course, emerging market commodity exporters have been hit by lower prices. Nevertheless, Indian goods exports seem to be doing worse recently than goods exports from emerging markets (see figure 1).
At the same time, the growth of Indian service exports seems to be doing somewhat better, perhaps because countries like the United States that we export services to are recovering more strongly. Of course, these differences are over very short periods, so it is probably unwise to draw strong conclusions from them. What one can probably take away is that India is not alone in suffering a fall-off in trade.
It is at these times of slowing trade that our pundits look at the exchange rate and argue it is overvalued. Of course, I have just argued that we are not alone in experiencing a fall in trade, but let us examine the exchange rate.
The exchange rate
When most people think about the exchange rate, they think of the rupee’s value against the dollar. The rupee seems to have weakened by about 6% against the dollar since the beginning of 2015, approximately the time our relative underperformance on goods exports started. This depreciation should have helped our exports, though the effects of depreciation show up only after a lag.
But we should note that other currencies have depreciated against the dollar also. So while we have gained an advantage versus US producers, other foreign producers may have become even more competitive because their exchange rate has depreciated more. Economists therefore advise looking at an index of the nominal effective exchange rate, which compares the rupee’s value versus other exchange rates, weighing each by their share in trade.
By this metric, the rupee has remained relatively flat since early 2015. What we have given up against the dollar, we have gained against the Euro or the Real, so overall, in trade-weighted terms, the rupee has been flat.
But wait a minute, our economist friends will say. Inflation in India is higher than inflation in most other countries. This affects competitiveness. If a widget cost a dollar to make a year ago in the United States, and Rs 63 in India then, the Indian producer would have been competitive with the United States because the dollar was worth Rs 63. But if inflation in India is 5% and zero in the United States, it would cost the Indian manufacturer Rs 66.2 to make it today. If the rupee stayed at Rs 63 to the dollar, the Indian manufacturer would have become uncompetitive today — the US producer would be able to manufacture the widget at a cost equivalent of Rs 63 only. In other words, to retain competitiveness, the rupee has to depreciate by the inflation differential vis a vis a trading partner. An index of how competitive we are is called the “real effective exchange rate”. Think of that as the nominal effective exchange rate adjusted for inflation. The higher it is, the less the exchange rate has depreciated to offset inflation, and the more uncompetitive we are.
Figure 2, where I plot the real effective exchange rate, shows the age old truth that interpretation is in the eyes of the beholder. If a columnist wants to blame the exchange rate for our export slowdown, she can look at the index from the low point of September 2013 and argue it has appreciated 20% (based on the IMF measure). Of course, it would be hard to argue that the low point our exchange rate reached in September 2013 represented an equilibrium rate. Moreover, our exports were doing quite well relative to emerging markets for much of that period. Indeed, over the last year when goods exports have slowed, the real effective exchange rate has been rather flat. So someone who wants to absolve the exchange rate of blame will point to the recent period.
But there is another reason to absolve the exchange rate of accusations of overvaluation. The real exchange rate is only one measure of competitiveness. Productivity also matters. In a rich country, firms are already at the productivity frontier, so they typically can improve productivity only through innovation. In a poor country, productivity can be improved simply by reducing existing bottlenecks or by moving a little closer to the productivity frontier through the adoption of already-known best practices. Productivity in India, for example, can improve simply if a better road is built from a factory to the rail head, or if the firm manages its inventories better.
The bottom line is that even though Indian trade has been slowing, the slowdown is similar to what has been happening elsewhere, with a significant portion due to a fall in commodity prices, and a smaller share due to a fall in trade volumes. While goods exports may have suffered a little more over the last year, it is too early to discern a clear pattern, and certainly hard to pin the slowdown on the exchange rate.
The Goldilocks rate
If the RBI could press a button and get the exchange rate it desired (as some economists imagine is possible) should it aim for a strong rupee or a weak rupee? Non-economists typically advocate a strong rupee — not only does it convey national strength, but you can buy more stuff with your rupee when you go abroad, and imports are cheaper. The non-economist is consumer focused.
… An undervalued exchange rate might have made sense in the past for countries that had weak firms and small domestic markets. India is in a very different position today from the export-led East Asian tigers when they embarked on their growth path. The ideal exchange rate for us is neither strong nor weak, it is just right. Typically, market forces get you to this Goldilocks rate. Yet there are circumstances where rapid capital inflows or outflows can move the rate to a level that is unlikely to be supported by fundamentals. While the RBI would not claim to know precisely what the equilibrium level of the exchange rate is at any given point in time, we intervene to moderate adjustment whenever we believe the movement is extreme, driven by sentiment, and likely to be reversed. Our intent is to prevent overshooting and undue volatility, rather than to stand in the way of the needed adjustment.
We should focus on attracting stable capital flows that will stay for the long run. This means resisting the temptation to open up too much to short-term as well as foreign currency denominated debt flows in good times, no matter how low an interest rate they charge. In the last few years, we have limited foreign portfolio debt investment in short term rupee debt instruments….At the same time, we have steadily expanded investment limits for foreign investors in government bonds, and will continue doing so.
Our new External Commercial Borrowing rules encourage infrastructure projects and other projects that have limited foreign earnings to either issue rupee Masala loans, or to borrow really long term tenors. This limits the risk that they will be required to repay when the exchange rate has moved adversely against them.
Finally, the Government has been encouraging foreign investors to “Make in India”. One offshoot of this campaign has been a sizeable rise in foreign direct investment, the most stable sort of investment. With two months left in the year to go, net FDI is already at the second highest level ever, and higher than the current account deficit.
The bottom line is that our policy towards foreign capital flows is one of steady liberalisation, where we try and not be tempted by cheap finance, but draw in the risk-bearing capital we need to finance our growth. We intend foreign investors to get decent returns and we do intend to continuously ease both entry into and exit from the country.
How to increase exports
So if the exchange rate is unlikely to be a helpful tool in our quest to increase what we make in India, how should we export more? The answer is simple — improve productivity by building our infrastructure; improve human capital with better schools, colleges, vocational and on-the-job training; simplify business regulation and taxation; and improve access to finance. Fortunately, all this is what the government is focused on.
I am often asked, “What industries should we focus on, what should we encourage?”
Learning from our past, I would say let us not encourage anything; that might be the surest way of killing it. Instead, let us make sure we create a good business environment that can support any kind of activity, and then let our myriad entrepreneurs figure out what new and interesting businesses they will create. In the 1990s, the IITs that Pandit Jawaharlal Nehru created, to supply engineers to the commanding public sector heights of the economy, instead supplied managers and programmers to body shops focused on dealing with the Y2K bug. These in turn evolved into our world-beating software giants. While the government did not create the software industry, it was not inconsequential by any means to its emergence and development. Similarly, let us enable business activity but not try and impose too much design on it.
Ideas and analysis
Today, it is an unfortunate reality that international meets are still dominated by the old powers. But it is less through brute power politics and more through the power of ideas, agenda setting, and organisation that they dominate. Agendas in the G-20 are still largely set by elements of the old G-7, and often we find that they have already agreed on their preferred approach. It is only when the big powers disagree that the rest of us have some hope of influencing outcomes.
The fault is not in the power structure, it is in us. Unless we amongst the emerging world put forward our agenda, build the intellectual and analytical basis for pushing it, and create coalitions to support it, we will have no chance of moving forward. Encouragingly, the BRICS do discuss policy issues and try and develop common approaches, but we need to do more.
We also need to build coalitions with sympathetic industrial countries. In India, we need to build capacity in our think tanks and universities to inform our policy makers on how to approach and shape the international policy agenda. We need to be well prepared when we negotiate bilateral and multilateral treaties, so that we do not wake up too late to the fact that we have given away the house with little in return. With careful analysis, engagement, and coalition-building we will be able to influence the global agenda, and will stop being seen as an obstructionist but ultimately powerless country that we may have been in the past.