Ashima Goyal

Global risks and domestic response

ASHIMA GOYAL | Updated on June 13, 2012

Letting wages rise to support local consumption may actually help Indian manufacturing.

Developing domestic markets and boosting trade and capital inflows from within the Asian region are useful diversification strategies in the current environment.

Global risks have risen again, in the background of the political backlash in Europe against austerity.

The primary impact on India from this is the drying up of portfolio inflows, as capital switches to a risk-off mode. That makes India's current account deficits (CAD) difficult to finance. S&P lowered India's sovereign credit rating outlook because of its high CAD and declining investment activity in the economy.

The situation is not like 1991, however. Then, we had neither high growth rates nor the forex reserve levels of today.


Europe will continue to fester, since a resolution of the underlying structural problems there is quite unlikely. China is also slowing down and the US recovery is set to run into a debt ceiling.

It is, therefore, necessary to build up domestic demand. Also, since Asia will still grow fastest, the effort should be to expand business with economies in the region. Diversification is the best way of hedging risks.

The correlation of Indian equity prices with external shocks is higher than that warranted by our degree of openness, because of overdependence on portfolio investment flows from western sources. Moreover, only a fraction of Indian household financial savings goes into equity.

On the other hand, our financial integration with Asian economies is much lower than trade integration. So, developing domestic markets and boosting trade and capital inflows from within the Asian region are useful diversification strategies in the current environment.


As in 2008, the slowdown in global demand is leading to a softening of commodity prices, which is also being enabled by expansion in supplies of a permanent nature. That allows some offsetting of the recent rupee depreciation, in terms of its overall inflationary impact.

The reduction in dollar prices for oil would also improve the CAD. The improvement can be more if the Government allows pass-through of rupee oil prices, which is essential to reduce domestic demand. Since oil and gold together account for 40 per cent of India's imports, the resultant CAD improvement can be significant.

For this, the Government must device a formula for cost-sharing and automatic pass-through of petro-product prices, which should be combined with more competition in domestic retailing of fuels. These would reduce political resistance by allowing prices to both rise and fall, while distributing costs fairly across consumers, Union and State governments (in the form of revenue losses), and oil companies.


We must export enough at least to pay for our imports. At the same time, the Chinese model of cheap currency to enable export-led growth is unlikely to work with slower global growth, more so as the West tries to increase net exports to Asia.

Populous Asian countries do have a natural source of demand, as their per capita incomes cross a critical threshold. Flexible manufacturing is the future wave, with industry relocating near demand sources and not simply where labour is cheap. Asian intra-regional trade would, then, create demand more for Asian consumer goods compared to western foreign direct investment-led vertical export chains.

Letting wages rise to support local consumption may actually help Indian manufacturing. With a more appreciated real exchange rate, wages can be higher as imports get cheaper. If wages are rising, nominal appreciation in the exchange rate may become necessary to prevent inflation. The large foreign inflows into India before the Lehman crisis may have strengthened its currency. This, with rising wages, partly also due to Government action, may have widened the CAD to unsustainable levels.

A good policy would be to limit rupee volatility to ensure a competitive real effective exchange rate (which adjusts for inflation differentials between India's major trade partners). A purely market-determined exchange rate — driven by capital flows responding to external shocks — can be excessively volatile.

Other policies can also support exports — diversification; special packages for industries where competition is strong and margins are small; reformed labour laws; and improvements in productivity and infrastructure.

Cheap labour and undervalued exchange rate strategies may be easier, but have longer term negatives. The alternative, however, requires supply-side improvements.


As growth and manufacturing inflation both fall, they creates room for reducing interest rates. But if the recent rise in food prices continues, a quick response is required, preferably through supply-side measures having short as well as long-term impact. The reason for this is that double-digit food inflation leads to second-round wage effects, which sustain inflation.

With appropriate supply-side support, policy rates at neutral levels would be sufficient to anchor inflation. High interest rates reduce loan quality. A sharp rise in the exchange rate is also a negative for firms with foreign borrowing. Although half of corporate borrowing still comes from domestic banks, the extent of foreign borrowings is not small either.

Since some European banks are in trouble again, domestic substitutes may have to be found. In case of any credit event, the monetary authority must be ready to quickly act as lender of last resort to markets more generally.

A change in the composition of government expenditure towards investment would revive growth, crowd-in private investment, and mitigate the perceived threat from the fiscal deficit.

The extreme switch in corporate perceptions about the Government — from being completely pro to anti-business — suggests neither is true. There is an overreaction to corruption issues on the Government's part, which may be part of a healthy cleansing. But rising risks require negativity to stop. E-tracking of pending decisions could enable rewards for quick decisions, and explanations for delays and harassment.

The Government has to scale up its services for an economy functioning at a much larger scale. Industry also needs Government to deliver, but it has many investment opportunities given the pervasive supply-constraints.

(The author is Professor of Economics. IGIDR, Mumbai. >

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Published on June 13, 2012
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