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India: The fire this time - What might follow the run on the Rupee

by Aseem Shrivastava, 26 October 2013

print version of this article print version - 26 October 2013

That the tail of finance wags the dog of the real economy is a contemporary truism that is valid across the world. The tails in the different economies – some short, some really long – are tied together in increasingly intricate ways, exerting complex pressures on them. They are referred to in the business pages as ‘the markets’, distinct from the real economies which they control. The long tails are sometimes so long that they can not only wrap themselves around the real economies of the countries they belong to, but also around those of far and distant lands (sometimes strangling them). This is especially true for one of them – it has the power to determine the destiny of many an economy in a remote part of the world!

Rightly or wrongly, as the confidence that US policymakers place in their economy has grown, the Federal Reserve has, for the first time since the crash of 2008, been gradually withdrawing the stimulus and tightening monetary policy (by reducing its monthly purchase of bonds), resulting in higher interest rates. This has prompted global investors to start withdrawing large chunks of their assets from emerging markets like India, Indonesia, Brazil, South Africa and Turkey, and moving them into US assets. While the latest Fed announcement (Sep.18) appears to go contrary to expectation about the tapering off of the monetary stimulus, overall Fed policy is heading in that direction and it is very likely that at its next few meetings during 2013, the Fed will resume the policy stance which has prompted such anxiety not just in India, but as much in other emerging markets.

Coupled with the steady deterioration in India’s current account deficit (CAD), this has had a dramatic impact on the Rupee: it has sunk to lifetime lows, having lost almost a fifth of its value during just the last 4 months, and nearly half its value over the last two and a half years. Again, if it appears to have got some “breathing room” (in the words of the New York Times), it is because of what is likely to be a temporary respite in the Fed’s tightening of money.

Capital flight from emerging markets is likely to be repeated after meetings of the Fed in the near future, in which further announcements of ‘tapering’ off of the monetary stimulus are expected to be made. In fact, given how closely global financial markets are networked, every time the Fed cuts its purchase of bonds, there will be significant outflows of capital from India and other emerging economies – except, notably, China, which has strong capital controls. Each such time there will be a panic. There are well-founded fears of a resurfacing of the global crisis if the Fed continues to raise interest rates. India is part of a larger pack which might be falling.

Such appears to be a large part of the story behind the Rupee panic in which the Indian economy finds itself sinking, rendering the government and the RBI – clutching at straws now – virtually helpless. Recall that during the 2008 crisis too, the Prime Minister had said “we’re not in complete control.” There is the predictable loss of effective sovereignty over economic, especially monetary, policy.

What makes matters significantly more serious this time is that as exports have failed to keep pace with burgeoning imports, there has been a rapid widening of the CAD from 2.5% of the GDP at the time of the 2008 crisis to a perilous 4.8% in 2012-13. Even more alarmingly, thanks to this and the massive foreign borrowings by Indian big business (adding up to $140 billion, something which severely imperils the domestic credit system), India’s reserve coverage (the ratio of its foreign exchange reserves to near-term international payments – the latter being the sum of the current account deficit and the short-term debt) has fallen sharply from over 300% to a little over 100% in these last five years. (For comparison, one may think of China’s reserve cover of over 800%.) The reserve cover has halved from 14 months to 7 months during the past five years. While India’s reserves have fallen to $275 billion, its financing needs over the next year have grown to $250 billion. The gap is narrowing. $250 billion is the largest amount that any emerging economy needs over the next year and is hardly going to come easy, especially with a falling domestic currency. The climate has changed. How will India finance its deficit and service its debt?

The other half of the explanation for the rapid decline in the value of the Rupee is being laid at the doorstep of the RBI. Being anxious about inflation (which many economists believe is rooted in supply-side factors, rather than cheap money), it has kept interest rates too high to allow the economy to borrow, invest and grow at levels adequate to sustain business confidence. Moreover, policy paralysis in the wake of so many scams involving the ruling party has led to a rapid decline in growth since 2010. It is also believed that popular resistance to land and environmental clearances has slowed down growth. All these developments have made business expectations about India negative. It has also meant that even Indian businesses have been more interested in investing abroad than at home. Furthermore, FDI has receded, as have portfolio funds. Together with rapidly rising imports (especially of oil and gold) and the limited growth in exports, this has prompted the flight from the Rupee.

Should there be more capital outflows after the next few Fed announcements, and the Rupee continue its fall (to levels well beyond Rs.70 or even 75 to a dollar), imports (such as oil and electronic items) will continue to become more expensive, fuelling domestic inflation and putting further pressure on the CAD, unless exports revive strongly with the depreciating Rupee. The chances of the latter happening are uncertain because of the possibility of a resumption of the global recession. Things are further complicated due to anxieties about the international price of crude, should the US actually commit the lunacy of launching missiles at Syria.

Is this a repeat of 1991?

It is true that this is the worst crisis the Indian economy has faced since 1991 (for various reasons, it escaped relatively unscathed in 2008). But the Indian economy is at a very different point in its growth trajectory, compared to 1991. 22 years ago, the RBI tried in vain to defend a fixed exchange rate for the Rupee. Today, the rate is a floating one. The RBI intervenes directly in the foreign exchange market only if adjustment is inadequate or too sluggish. So it has a bit more elbow-room – though, given inflation, not much more. In 1991, official exchange reserves had been wiped out (could cover barely two weeks of imports) and the government was insolvent. Gold was shipped out and an IMF bailout had to be arranged. Today there is no immediate threat of a sovereign default, though the extraordinarily high short-term foreign debt of many prominent Indian companies is likely to bankrupt some big private players, taking business expectations down with them, other than perhaps transferring effective control of these companies to some foreign entities.

And yet, while the reserve cover today is not zero, as already observed, it has been falling rapidly during the last few years. The scale of economic activity – and thus of economic crises – has grown dramatically. Moreover, India’s involvement in the global economy (or more precisely, the latter’s involvement in India) has grown even faster. Trade as a proportion of GDP was just 14% in 1991. It is three times as much today. Imports were just 8% of GDP then. They are four times as much now! And while foreign debt as a fraction of GDP has fallen a bit since 1991, it has risen significantly in absolute terms and markedly since 2008, even as currency reserves have diminished with the recent outflow of funds. In a crisis of the scale we are in, absolute numbers do matter.

In short, even if there is no risk of sovereign default, India’s exposure and vulnerability to the moods of the global financial markets as well as the policy changes in the US is hugely greater now than in 1991. Inflation, already in double digits, is likely to get far worse as the Rupee depreciates, and will likely have political repercussions in this election year. High unemployment (of the educated and the illiterate), which has been an abiding concern since the early reform days, is going to persist and get much worse, as the economy slows down further, downsizing becomes the norm, hiring stops, and layoffs rise. All indications are of a spiralling down of economic activity as investment shows no signs of reviving, especially given the stagflationary environment and receding domestic demand, as disposable incomes fall, or fail to rise fast enough.

Enduring structural features of India’s growth strategy

What has led India to this precipice? One can give answers – and they abound these days – that give a symptomatic diagnosis, and hence a symptomatic line of treatment. They leave too much room for the deep-seated problems to remain, and for crises to recur. It will not do, for instance, to have clever schemes for the monetization of the stock of gold in Indian hands. Money is not the same thing as income, and problems rooted in economic flows do not have long-run answers given by manipulation of stock variables. Process-related problems do not have one-shot solutions.

To explain the growing crisis, another common line of reasoning in prominent media these days runs like this. In 2008, despite Western economies going into the severest downturn since the 1930s, India not only escaped the crash virtually unscathed, it actually grew very fast all the way till 2011. This time, in 2013, with signs of a recovery in the West, India’s exports should have been growing. Therefore, if India’s growth is faltering seriously today, at a time when growth in the West, particularly the US, has picked up, it must be on account of the failure of the Indian government to provide investors and manufacturers with adequate incentives. This includes, for instance, the fact that land and environmental clearances for many an infrastructure or mining project have been hard to obtain.

There is a major fallacy in this line of reasoning. It fails to appreciate the degree to which the Indian growth strategy since the mid-1980s has been premised on an externally oriented set of policies, leaving a good part of our economic destiny in the hands of powerful players and decision-makers abroad. Two things for which India is utterly dependent on the rest of the world, especially the West, today are demand for exports and for hard currency investments to finance its growing trade deficit. Despite all the talk of decoupling at the time of the 2008 crisis, no serious thought has been given, let alone concrete measures taken, to insulate the Indian economy from the vicissitudes of the Western and the world economies.

A corollary of this dependence is that impatient financial investors abroad, faced with a limited market in India (on this, more later), are likely to be very sensitive to relative changes in things like interest rates across countries. So it is no surprise that as American interest rates have begun rising from virtually nil, investors are transferring funds to US bond markets. If India alone was experiencing problems, why would currencies of countries like Brazil, South Africa, Indonesia and Turkey also be declining as they have?

Put another way, consider the counterfactual in which the government was able to deliver speedy land and environmental clearances to investors. The Rupee would still get shorted. In a world of the sort we have come to live in, it is hard to imagine otherwise, given the sway of the US currency and the power of the Fed. Perhaps it is hard for our elites to accept that India has lost effective sovereignty over key policies on account of the growth strategy that has been embraced by them.

One abiding problem is that India has been living beyond its means for decades now. It is true that exports have been growing. But imports have been growing much faster, constantly raising the CAD. It has been $88 billion in 2012-13, 4.8% of the GDP. In fact, the last time (and remarkably, the only occasion since 1947) that India had a trade surplus was in 1976-77! The contrast with China – which has been running a trade surplus for over three decades now – could not be sharper. These growing deficits have to be financed, else the economy – dependent on imported oil and machinery – falters in quick time.

The enormous anxiety that Indian policy elites have about the inflow of capital from abroad (and the risk of its outflow) has to do with this obstinate fact – for which they themselves are responsible in significant measure. If capital inflows begin to recede, sand is thrown into the gears of the inner workings of the economy from month to month. The Rupee panic this year has only brought to the surface what has been latent throughout. Policies have always been made in a state of undisclosed panic, and have had an external orientation for at least two decades for this very reason. Everyone in the media appears to be clamouring for FDI and other forms of foreign investment, without ever pausing to wonder why this is so essential to India’s fortunes. If they probed the question, they would hit upon what is in fact an open secret among the policy elites.

One might ask: but why does a country of India’s size and importance have to become so dependent on two things from abroad (exports and capital inflows) over which it has so little influence, seeing as they are variables determined by foreigners, unresponsive beyond a point to incentives ever more attractively offered by Indian governments? We may have reached a point whereby interest in investment in India has become unresponsive (inelastic) to incentives offered by the government – like a drug administered once too often loses its efficacy. After all, what is uppermost in the minds of investors and corporations is the market for their products which is profoundly limited by long-standing poverty and the skewed distribution of income in India. Why does every Indian government have to surrender so much sovereignty over economic policy and bend over backward to provide ever more incentives to foreign investors and brighten the climate for (their) investment? Why does it have to be so sensitive to the credit rating that India has with well-known agencies like Moody’s and Standard and Poor?

Why not find a growth and development strategy which is less dependent on whether foreigners will buy Indian goods or will be willing to lend or invest their capital here? After all, things like exports of goods and services to foreigners, or investments by them in India depend also on economic conditions abroad, something over which India has virtually zero influence at the best of times. This has been brought out sharply by the present ongoing crisis.

The answers to the above questions have not been sought through open public discussion. We are constantly being told that “the fundamentals” of the Indian economy are strong. What exactly does it mean? That India, one of the world’s emerging markets, also has one of the highest growth rates? That therefore, overseas investors ought to see India as having an excellent climate for their investment?

Perhaps the answer to these questions is ‘yes’. But equally, what is true is that most of the Indian consumer market of interest to large Western transnationals is in the top 10-15% of the population, a market that is already quite saturated, when set against the levels of disposable income and consumer loans even this fortunate class has access to. There is already a large volume of consumer debt. Moreover, India’s external payments situation has never been secure, a fact which surely affects the country’s credit rating adversely, since it keeps the Rupee weak. No overseas investor wishes to keep their investment for long in the form of assets denominated in a currency which lacks adequate credibility and stability. This is the reason that there is talk of opening up the capital account to foreign investment, to allow investors the freedom to move their money at high volumes and speed in the event of a run on the currency. In a world in which aggressive private trading by big private financial players rules the roost, it should be obvious how dangerous this could be for India’s economy.

The reason why India will continue to suffer from crises in the balance of payments is that the factors driving the CAD are structural. They are not going to go away in any foreseeable future. Most of the world has been in recession since 2008. Demand for Indian exports has been slow to pick up the pace in such an environment. The competition to sell in the markets of the West is, in general, fierce (Indian share of world exports has hardly grown and is well under 2%, China’s is 11%). China has a long-term lead, followed by countries in East and South-East Asia. Meanwhile, demand for imports (especially of oil and capital goods, not to mention gold as a line of investment) into India will continue to grow as the economy grows. So the trade balance will only get worse in the regime of import liberalization India has been following under the present growth strategy.

Time for an alternative growth and development strategy?

There is another structural feature of the Indian economy which will abide in the future, not only limiting prospects for the multitudes, but also impeding the growth of the economy. This has to do with the nature and volume of effective demand in the economy. While orienting the policies of the country towards foreign investors, no government in the last two decades has seen it their part to develop policies to build the home market. And the reason this has not been thought of has to do not only with government reluctance to alter significantly the distribution of income (through appropriate taxation and tax collections), but also because the policy advice the government gets is from economists who, despite Keynesian training, evidently do not see the powerful link between income distribution and the nature and volume of aggregate effective demand in the economy.

What is the reason, after all, that corporations, even when they are Indian, are so reluctant to invest in India beyond a point, despite such open-door investor-friendly policies? Many false reasons are often given, such as inhibiting labour, land or environmental legislation. Few have pointed out the bleeding obvious: the overwhelming consideration for potential investor corporations is not the availability of resources or incentives to invest but the scale and depth of the home market – not in notional, but in actual, practical terms of purchasing power. Thanks to the growth strategy adopted, the home market is not only very limited (much more so than China for instance, despite comparable populations), but clearly segmented into two parts, with income inequalities worsening. The top 10-15% of the population (going by optimistic estimates made by consultants like McKinsey) are eyed by the big firms. The rest are off their radar: they, the dominant majority (over 85-90% of India’s working families) draw their incomes from the low-wage unorganised sector, of little interest to the big companies. Their needs, to the extent they are met, are met from the informal economy.
It is partly because no attempt has been made to build the home market that export markets are sought. Moreover, there are many areas of production (such as capital goods and electronics) where greater self-reliance, and thus a lower import bill, could have been achieved had the home market been on the radar screens of our policy-makers. This would have kept in check the need for hard currency to finance the external deficit. It would have also allowed a far greater degree of sovereignty over economic policies.

It may be salutary to do a short thought experiment and consider what an alternative growth and development strategy might look like. Only some of its elements can be discussed here. Such a strategy would pay a lot more attention, for instance, to agriculture and related forms of traditional livelihood, making sure that not only do farmers get their due but their growing incomes serve as a major stimulus to the demand for the products of industry and services. (Things are at such a low ebb today that many see agriculture as the rallying sector of the economy!) This could only be ensured if the state invested at least as heavily in support of agriculture and traditional livelihoods (proportionate to populations) as it invests for the growth of industry and modern services. It would mean, for instance, far greater investment in irrigation, technical and marketing support for farmers. Lessons have to be drawn from the kind of attention and support that agriculture in the Western world manages to get from the governments there.

The way most economists typically think about (income) distribution is flawed. Mainstream thinking separates the questions of distribution, value and growth. But, properly speaking, they are not separate. How things are valued depends on who values them, which in turn is dependent on income distribution (and consequent political power), and has consequences for the nature and rate of investment and growth. To keep a complex discussion simple and tractable here, it is worth contemplating how differently the outputs of agriculture (say, grain) and industry (for instance, steel), would be valued if the terms of trade between the two sectors were set by farmers rather than by industrialists (or their lobbies and representatives in government), and what consequences such valuation would have for distribution and growth.

We would be living in an altogether different world! It would be much more self-reliant, more sensitive to ecological imperatives (since the strategy would focus on the countryside), it would not fetishize trade – while not falling into the dogma of refusing it altogether. There would be a far greater chance of rooting out the causes of long-standing mass poverty and deprivation.

Failing a concerted attempt to build the home market (which even many corporate observers are now beginning to realize is the key), with the help of a shift in the income distribution, India will be left with the same – default – strategy of relying on debt mechanisms to sustain demand artificially that is causing such huge problems elsewhere (consumer debt in the case of the US financed by the Chinese and loans made by German banks to Southern Europe in the case of the EU). China is learning, alas too late perhaps, the danger of letting its domestic market languish while relying for so long on export-led growth. Apart from anything else, Indian policy elites will not succeed in convincing overseas investors to leave their money in India if it falls into this trap. The latter are all too aware of the failure of debt-driven growth strategies in economies far stronger than India’s.

Inequality, and the consequent shortfalls in aggregate demand, is one of the main reasons for the global slowdown during the last half-decade, though the underlying fact has been operative for a much longer time. (As Henry Ford knew well, his cars were hard to sell if workers were not being employed in large numbers and being rewarded well for their efforts.) The same is, in an increasingly apparent way, true of India as well. The political and economic imperative for a structural change in the economy is not being understood by our policy elites.

An economic and political system that fails to work for most citizens is not sustainable in the long run. As belief in the liberalized market economy erodes over time, the legitimacy of existing institutions and arrangements will be increasingly questioned, with vast political consequences.
The alternative to austerity and blaming the crisis on the popular resistance to land and environmental clearances is to make due public investments in the future. It would mean bringing about the necessary structural changes in the economy and investing in projects which are both job-generating and environmentally necessary. Other ways of responding to the growing crises will exacerbate problems.

What might be in store

The crises - in all dimensions - are more serious and all-pervasive now than in 1991, when India embarked on the present course.

But most of those who are seeing a recurrence of 1991 are failing to make one point: just like the policy elites used the payments crisis then to alter the very framework of economic policy, there is every likelihood of the same happening this time. Because of far greater aspirations all around, the levels of potential despair are much higher and can prompt decision-makers at the top to take some bold (read ’rash’) decisions.

One says this with the benefit of the knowledge that something some observers had feared years ago has now come to pass: an IMF man, not even an Indian citizen, is now the Governor of the RBI, perhaps the institution (despite all the criticism it has garnered recently) most responsible for keeping the Indian economy somewhat stable hitherto. The conservatism of the RBI hitherto has been a thorn in the flesh of global financial markets, eager to play with the Rupee. If the global elites succeeded in opening up the Indian economy in the 1990s, they are now beginning to make a bid for the complete opening up of financial markets.
The elites may use the crisis this time too, to make fundamental policy shifts - and perhaps put in place something which has been tabled by an RBI committee twice before (and Rajan is on the side of financial liberalization), but stymied each time by a major financial crisis in one part of the globe or another - making the Rupee convertible on the capital account. The full convertibility of the Rupee will greatly ease the movement of international capital, both into and out of the country.

It may transpire that the decision-makers hold off on this extreme step till the elections (keeping a close watch on inflation), and then pull the plug and let the Rupee face the global music. As the money rolls in from abroad, it may even be pleasant to hear for a while, but can only spell disaster for India ultimately.

In the contemporary world, utterly dominated as it is by the US dollar, not even China has felt confident to let its currency become a plaything for private global speculators. As some observers have noticed, it was Malaysia which managed to cut its costs most in the 1997 crisis. And it was because they instituted capital controls, much to the annoyance of the markets and the IMF.

If there is a ’mini-Modi-wave’ at the 2014 polls, and he manages to make a government with a mandate for major next-generation reforms, this form of extreme financial liberalization is not too remote at all. The move needs to be anticipated publicly and no major changes in policy should be permitted without due debate - something which we still rue about the way things happened after the 1991 elections.

From the ecological perspective, financial liberalization and the full convertibility of the Rupee may have implications for the environment which are not being mentioned anywhere.

The impact that the accelerating financialization of the economy has been having on the commodification and monetization of nature has been going largely unnoticed. So many are misled by the belief that better, ’green’, accounting of GDP, valuation of ecosystem services, and so on, is a step in the right direction.

It is hardly so clear that such market environmentalism will actually not end up making matters a lot worse. The ’shadow pricing’ of nature (essentially by powerful players, since so many key things are not priced by the market and perhaps cannot be) is not necessarily an index of their greater valuation of nature. On the contrary, by rendering nature transactable without limit, they can ransack the planet more speedily and systematically. If money becomes the sole yardstick of value what is to prevent someone who can pay a high enough price from destroying some part of the Earth he wants resources from? The policy climate in India today is such that if a global corporate major makes a serious pitch for, say, a large rainforest, there will be a price at which any ruling government may bend.

If they enact further reforms (before or after the 2014 elections) which are in the direction of greater financial liberalization, there is every chance that India will be welcoming more metal and commodity exchanges into the country, allowing upgraded forms of trading and speculation, in addition to allowing faster land and mining clearances.

In such a situation - when large global players are making serious bids on Indian resources, might be bringing in large volumes of capital and withdrawing them at will - one can expect the environment to deteriorate much faster. The links between the globe’s financial speculators, extractive industries, and the ecological crises around us would be quite clear and explicit to everyone then.

There is, of course, a short-term dimension to India’s financial crisis which also bears mention. The environmental consequence of the growing CAD and the Rupee crisis is this. As the Rupee loses value vis-à-vis the dollar, and the pressure to grow export revenues increases with the rising CAD, there is going to be a predictable acceleration in the extraction of resources and minerals from the country, as they become cheaper for foreigners to buy.
For all the above reasons, everyone in India (and not just the wealthy) needs to worry about the fate of the Rupee as it dances to the tune of the music coming from the US Fed.

Aseem Shrivastava is a Delhi-based writer and economist. He is the author (with Ashish Kothari) of Churning the Earth: The Making of Global India (Penguin Viking, New Delhi, 2012).