Walking A Tightrope

We have been seeing turmoil in the financial markets. India has emerged reasonably unscathed from this crisis so far, allowing its policymakers to focus on what they perceive to be their enemy number one — inflation. The Reserve Bank of India governor has reiterated the RBI’s commitment to fight inflation. Politicians of the ruling party as well as others have been saying that inflation will come down soon. It is no doubt important to tackle the problem of inflation, especially if it is expected to be temporary. This is because temporary inflation, if it filters into people’s expectations by making wage claims higher, can become durable. But should inflation be the sole concern of macroeconomic policy? Or are there other almost equally pressing problems that are being neglected or even being exacerbated? If one is to believe the figures quoted in the 2008-09 economic outlook of the Prime Minister’s Economic Advisory Council, the trade balance deficit will be 10.4 per cent of GDP in the current year. The government intends to tackle this by demand compression and by raising interest rates. There is an anti-export, pro-import bias in the policies to combat inflation: put a cap on currency depreciation because otherwise it will feed into inflation in the prices of imported goods; ban the export of rice, steel, cement etc to keep domestic prices from rising. But as a result, imports that were expected to run ahead of exports in excess of 10 per cent of GDP will do so by an even larger magnitude. A significant part of the trade deficit is made up by remittances and invisibles that constitute about 7 per cent of GDP. Thus the current account of balance of payments is expected to be in deficit by a little over 3 per cent (more than double that in the last fiscal year). A 3 per cent deficit on the current account is by itself a matter of concern. But what is really worrying is the casual attitude of the government towards remittances and invisibles. The balance of payments account of any country captures the actions of private players through the current account, which records the sale and purchase of goods and services, transfers etc, and the capital account, which records sales of assets. There is always a potential tension between those who buy and sell goods and services and those who buy and sell assets. For the balance of payments, this manifests itself as follows: the sale and purchase of goods takes place at a point in time and hence those engaged in these activities look at the current exchange rate. A depreciation of the exchange rate reduces imports by making them more expensive and increases exports. Asset holders, on the other hand, necessarily also look at the value of the exchange rate at the end of the period over which they wish to hold the asset. If the domestic currency is expected to depreciate then people will not want to hold rupee-denominated assets. Those who hold these assets would want to sell them; those who were thinking of buying these would wait till the depreciation has occurred. As people sell rupee-denominated assets and there is a dearth of buyers, the rupee will actually depreciate. This is an example of a self-fulfilling expectation in asset markets. In reality, of course, payment for goods may be made after a time lag. So even those involved with current account transactions may have to guess what the currency’s value will be when the payment is actually made. In the last month there were reports that several Indian exporters guessed wrongly as the rupee depreciated more than they had expected. But this distinction between agents engaging in trade and in asset markets becomes blurred if there is a widespread feeling that a currency will depreciate. Exporters will drag their feet when it comes to converting foreign currency into rupees. Similarly the BPOs and Indian labourers in the Gulf will wait before selling dollars. For example, if one is sending money to one’s mother in India from abroad and one expects that the rupee will depreciate by 3 per cent in the next month — that is an annualised rate of return of over 36 per cent — then notwithstanding one’s mother’s urgent needs for funds, one would be tempted to postpone the remittance in order to generate a higher rupee value. This is tenable since over the last month the rupee has depreciated against the US dollar by over 10 per cent. Normal flows, therefore, take on a speculative hue in turbulent times. It would be a folly to think that because invisibles and remittances are usually stable, they would always be so. Thus it is imperative that the powers that be should take the external constraints on the fight against inflation seriously. There is no room for India to divert potential exports to the domestic market or augment domestic production with more imports, a luxury that China has, given its huge current account surplus. Moreover, the rupee must be allowed to depreciate so that the trade balance improves, notwithstanding the inflationary bias of such a move. The currency depreciation has to be orderly, so that people do not start to speculate against the rupee. Even at the best of times such a policy involves walking a tightrope. Having allowed the trade deficit to become as large as we have, implementing such a policy will require all the skills that the policymakers can muster. The choice is between an orderly retreat and a market-driven scuttle. Of course, going by past experience, nothing of the sort will happen.