Opinion Just do it

India’s woes over the last two years,for the most part,may be traced back to one thing: weak policy. The slowing growth,declining corporate investment,high and rising inflation,and now the sliding rupee,stem from the erosion of investor confidence in India’s policies. History is replete with countries that have grown at a frenetic pace for a few years,promising to reach escape velocity,only to stutter thereafter. What began as a cyclical slowdown in mid-2008 is now threatening to become a structural malaise.

A lot has been said and written about policy paralysis. A lot has been blamed on the political quagmire the ruling coalition is in and its travails with recalcitrant partners. But one has a sneaking suspicion that,at least on macroeconomic policies,the problem is not political constraints. Rather,it is the insistence of the authorities on blaming global conditions for the mess at home rather than acknowledging that running loose monetary and fiscal policies for three straight years almost always turns inflation rabid and pushes the exchange rate into a free fall.

The authorities have already got the inflation dynamics terribly wrong for the last two years by insisting that it is all because of supply side problems that will go away soon enough. It hasn’t and it won’t.

The RBI’s experimental medicine of cutting rates in April rested on a big gamble. India’s growth rate in the December quarter was 6.1 per cent. The RBI expects growth to rise to average 7.3 per cent this fiscal year,but expects inflation to remain in the 6-7 per cent range. And this is based on a belief that,although India’s “potential” growth has declined as the global environment has turned hostile,it is still above 7.3 per cent such that capacity constraints in India will slacken and manufacturers will find it difficult to raise prices.

Since 2008,equipment investment has dropped 4 per cent of GDP,resulting in productivity growth plummeting from the 3.5 per cent average of 2003-08 to 0.5 per cent. Thus,India’s “potential” growth is more likely running closer to 6.5 per cent and not 7.5 per cent. Growth needs to slow below 7 per cent just to ensure that capacity is not tightened further and inflation does not flare up. Maybe the RBI is right. But inflation in the very first month of this fiscal year is running above the RBI’s upper limit of 7 per cent.

Why is this important? Because the inability to control inflation is seen by investors as the result of policy failure. And as long as investors believe this,their confidence will continue to erode and investment will languish.

But now the authorities are getting the exchange rate dynamics wrong too. It is true that currencies of almost all emerging market economies with a current account deficit,such as Brazil,Mexico,South Africa,Turkey and India,have suffered similarly since last August as global risk has turned off,then on and off once again. But since March,long before rumours of a potential Greek exit from the eurozone began doing the rounds,the rupee and the Brazilian real had started a race to the bottom on domestic policy risks.

Since 2000,India’s GDP relative to its trading partners has risen around 65 per cent. As it happens in most countries,this led to a 15 per cent appreciation in the real value of the rupee. This should have led to a nominal appreciation. Instead the trade-weighted nominal value of the rupee has depreciated 25 per cent! The reason? You guessed right,it is India’s inflation. Since 2000,prices in India relative to its trading partners have risen an astounding 60 per cent. And as long as India’s inflation does not come down substantially,the rupee will continue to weaken just to keep growth,inflation and the real exchange rate in balance.

I’m not saying that inflation is India’s only problem. It isn’t. But it is the most visible symptom of weak policies,just as the falling rupee is of the macroeconomic instability stemming from those policies.

So what can be done? We seem to have accepted the argument that under the current political imbroglio nothing can be done on the policy front let alone on the reform agenda. But that’s not true. There is a vast array of measures the authorities can take that is unlikely to even register on the political radar.

But it all starts with the authorities acknowledging that our problems are not caused by Greece. The next step is to dust off the playbook that every central banker has on what to do when the currency is threatened. Rule one in that playbook is to raise interest rates. How much? As much as needed. Remember Turkey. It flirted with unconventional monetary policy in 2011,only to see the lira falling off the cliff. Ultimately,Turkey reversed course raising policy rates massively in early 2012. Since then the lira has appreciated and has withstood the current risk-off environment. Raising rates obviously hurt investment,but is continuing with the macroeconomic instability helping?

Since last December,the RBI has imposed several retrograde measures to curb speculation. It is difficult to assess whether these measures have worked,but the proof of the pudding is that the rupee has touched new lows after they were implemented.

Perhaps it is time to implement measures that are actually desirable,not just acts of desperation. First,raise the FII limit on government securities from the present $10 billion to a sufficiently large $50 billion with no strings attached. Much of the inflows would be hedged and thus their impact would be limited. But there will be an impact. Second,eliminate the withholding tax on all government securities and corporate bonds. This is an irritating tax,most other emerging market economies have done away with it and no discernible revenue is generated in the first place.

Third,while much of the fundamental strength of the economy has remained intact,some corporates,especially in the telecom and power sectors,have been hurt because of rising cost and leverage. In the past,the RBI had very successfully used its corporate debt restructuring mechanism to help revive corporate India. It is time the RBI did that again.

These measures aren’t foolproof but they stand a good chance to start restoring investor confidence,reduce macroeconomic instability and get capital inflows back into India. There is no substitute for reforms,but just because these are not happening doesn’t mean nothing else can be done.

The writer is India chief economist,JP Morgan Chase. Views are personal
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