Given the reluctance to tighten fiscal and monetary policies, there can be no escaping currency depreciation, if the current account deficit is to be brought down.
From time to time, macro-economic policy has to give greater emphasis to one segment or the other. At the present time the worry lines are manifold — high consumer price inflation, a large fiscal deficit, low growth, flat industrial production and a balance of payments current account deficit (CAD) of 5.0 per cent of GDP (a staggering $90 billion) in 2012-13.
All these call for correction, but the immediate correction of the CAD overrides all other priorities.
Norm for CAD-GDP Ratio
The Rangarajan Committee on balance of payments (1991-92) had enunciated that the tolerable CAD should not exceed 2.0-2.5 per cent of GDP. This has been the policy polestar for many years. In recent years, we have been deviating from this salutary guideline and face the peril of punishment from international financial markets.
Hard issues are being obfuscated by brilliant analysis, by Indian economists of impeccable standing, that there are valid reasons for deviating from the guidelines and that there would be an automatic correction of the large CAD, which would obviate the need for painful measures.
CAD-Current Receipts Ratio
The appropriate CAD-GDP ratio varies from country to country, depending on the country’s interface with the international economy. Hence, a better indicator is the CAD-Current Receipts (CR) ratio. With a CR-GDP ratio of 25 per cent, the present CAD of 5 per cent of GDP translates to a 20 per cent CAD-CR ratio which leaves India very vulnerable.
The Reserve Bank of India (RBI) which, for a very short period in the latter half of the 1990s, revealed the CAD-CR ratio, has quietly buried this figure in its mass of balance of payments data. The RBI should highlight the trends in the CAD-CR ratio in its forthcoming Annual Report.
As Y.V. Reddy has perceptively commented recently, one cannot have a single CAD-GDP ratio which is appropriate over the cycle. If the CAD-GDP ratio is 5 per cent at a low point of growth how much higher would it be when growth gets back to a trend line of, say, 8 per cent?
A country has a choice of a combination of policies to correct a large CAD. First, monetary policy could be tightened by raising interest rates and tightening reserve requirements.
Secondly, the economy could be deflated, or if inflation is already high there could be disinflation, by a sharp reduction in the fiscal deficit. Thirdly, the exchange rate could be depreciated. Fourthly, there could be recourse to direct controls.
Indian Policy Response
Unfortunately, at the present time, the authorities seem to reject all policy options. A sharp reduction in the fiscal deficit is ruled out. Powerful industry lobbies have been effectively arguing for relaxation of monetary policy, so any tightening, though desirable, appears unlikely.
Our macho spirits would not countenance a depreciation of the exchange rates; in fact there are respected analysts who predict an appreciation of the rupee! Of course, the government would not want to go back to the pre-1991 system of direct controls.
A staggering 43 per cent of external debt on a residual maturity basis is accounted for by short term debt of one year or less, and this is equivalent to 50 per cent of forex reserves. The forex reserves now cover only six months of imports.
At the present time the authorities are freely encouraging short-term debt and a rating downgrade will trigger an exodus of foreign capital. Any further widening of the CAD is bound to trigger a forex crisis.
Minimal Package of Measures
There should be no further monetary easing (interest rates or reserve requirements) till the CAD comes down significantly. Secondly, the gross fiscal deficit (GFD)-GDP ratio should not exceed 5.3 per cent in 2012-13 and 4.8 per cent in 2013-14 and this should be attained without recourse to clever financial engineering. Thirdly, the short-term external debt should be tightened by elongating the minimum maturity.
Exchange Rate Depreciation
Fourthly, if on political economy considerations, all the above-mentioned minimal measures are not acceptable, something has to give and that will necessarily be the exchange rate.
A few weeks ago, when I stated that, adjusting for secular inflation rate differentials, the nominal exchange rate of $1=Rs 54 needs to be gradually depreciated to $1=Rs 70, there was consternation in some policy circles. As a partial modification of the current policy of ‘controlling volatility’, the RBI should buy on the slightest sign of rupee appreciation but refrain from selling when the rupee depreciates.
The Big Boys at the G-20 High Table may frown at a depreciation of the rupee, but we need to recognise that a depreciation of the rupee is an ineluctable necessity if the CAD is to be brought down.
In the absence of a calibrated depreciation of the rupee, the current critical CAD cannot be reduced and we should be prepared to face the mother of all forex crises in 2014-15.
(The author is an economist. email@example.com)