23-29 August 2013 #670

The mighty fall

Ashoka Mody

The Indian rupee has weakened rapidly in recent months, with the exchange rate against the US dollar dropping by 15 per cent to Rs 64, since early May. As a symbol of India’s economic strength, the rupee’s fall has provoked more than the usual hand-wringing and angst at home and abroad. But the slide has been long in coming and recent market uncertainty has merely been a wake-up call.

The reason for worry is that India has lost international competitiveness and has been buying time by borrowing from fickle lenders. Growth momentum has fizzled and with inflation persistently high, Indian producers are struggling to compete in world markets. The current-account deficit is increasing relentlessly, owing to a widening trade deficit (now at 13 per cent of GDP), raising the danger of a balance-of-payments crisis.

Indian GDP grew at heady rates of 8-10 per cent per year between 2004 and 2007, a period that seemed to herald a decisive break from the anemic ‘Hindu rate of growth’. Reforms had unleashed new entrepreneurial energies and the prospect of a brighter future lifted people’s aspirations.

With foreign manufacturers piling in to satisfy a new hunger for consumer durables, India turned its gaze outward. The global economy – in a phase of buoyant expansion – welcomed India’s information technology services. Bangalore (the information-technology hub), Bollywood, and yoga became symbols of India’s soft power. That was the moment to invest in the future.

But the opportunity was wasted. Infrastructure did not keep pace with the economy’s needs. And, more deplorably, educational standards lagged. And, even when times were good, India never gained a foothold in the global manufactured-goods trade. Today, domestic investment has plummeted, exports are languishing, and GDP growth is down to around 4.5 per cent per year.

Moreover, India has developed a tendency for chronic inflation, owing to an unhappy combination of supply bottlenecks (caused by poor infrastructure) and excessive demand (thanks to persistent public deficits). Budget deficits offered what appeared to be a free lunch, as the resulting inflation eroded the real value of public debt, while the government had privileged access to private savings at near-zero real interest rates.

With so much largesse to spread around, the government became a source of contracts with annuity-like earnings, which offered robust returns for those with political access. That weakened the incentives for entrepreneurship. And, as India’s external position deteriorated, the rupee became significantly overvalued between early 2009 and late 2012, trading in a narrow range while domestic inflation galloped ahead in a global environment of relative price stability.

Amid weakening competitiveness, the rupee was propped up by increasingly unstable foreign sources of funds. Traditionally, nearly half of India’s trade deficit has been financed by remittances from Indian expatriates. Part of this flow is steady, because it supports families at home; but much of it is opportunistic investment seeking real returns. According to recent data, remittances have slowed or even fallen slightly.

Similarly, long-term foreign investors have had reason to pause and the country has been left to finance its external deficit increasingly through short-term borrowing, the most capricious form of international capital.

To avert a disorderly fall, short-term macroeconomic management requires officially engineered depreciation through administrative methods and restraints on external borrowing. A depreciated rupee should help revive Indian exports and lift growth. But, in the absence of complementary action, depreciation – whether engineered or market-driven – will make matters worse.

Ashoka Mody is visiting professor of International Economic Policy at the Woodrow Wilson School of Public and International Affairs at Princeton University.


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