The Government is clearly unwilling to do much about the rapid decline in the value of the rupee. Despite the rupee losing around a quarter of its value against the dollar over the last year, the RBI has not been pushed into making any dramatic interventions in the realm of exchange rates.
Instead, the Government has focused on coming to terms with a devalued rupee, even accepting the political dynamite of a sharp increase in petrol prices. The official thinking is clearly on the side of devaluation as an essential step in macroeconomic correction.
The case for such a correction is obvious. The current account deficit is large enough to cause concern. And, as India looks towards Asia to immunise itself from the economic crises in Europe and the US, it is difficult to ignore some of the country-specific trade patterns that are emerging. The massive trade imbalance in favour of China brings out the very real threat of that country taking over the Indian market in a way that it has done in other countries. A substantial devaluation of the rupee will provide some protection against marauding imports.
The real danger however lies in seeing the problem as merely one of an overvalued currency.
On the contrary, it is the result of a longer term trend that has emerged over the two decades of liberalisation. At the heart of the liberalisation process was the belief that if markets were opened, Indian manufacturers would be forced to deal with international competition. Once they gained that ability, they would be able to export to the rest of the world. And over time increased imports would be more than made up for by a more rapid growth in exports.
In reality, this process has been somewhat skewed. Liberalisation did result in the share of exports in Indian GDP growing from 6.3 per cent in 1990-91 to 16 per cent in 2010-11.
But the growth in imports was far more rapid. While imports were the equivalent of 8.4 per cent of GDP in 1990-91, it grew to the equivalent of 23.5 per cent of GDP in 2010-11. The gap of 2.1 per cent of GDP which prompted the entire liberalisation exercise has now grown to 7.5 per cent.
This widening trade gap is nowhere near causing a foreign exchange crisis because foreign exchange is flowing into the country in other forms, particularly foreign institutional investment.
FII investment may have slowed down in the wake of the current instability in the rupee, but it could very well pick up once the rupee settles down at a lower level.
The problem is that as imports take a greater share of domestic demand, it sharply constrains what is left for local products. As local production takes a hit and the growth rate slows down, so does domestic demand. This, in turn, further slows down the growth rate and can quite rapidly push the economy into a downward spiral.
The current crisis may not create the panic on foreign exchange reserves that we saw in 1991, but untreated it could soon have a similar impact on growth. What could make matters much worse is that the remedies that are being suggested are worse than the disease. The instinctive reaction to any sign of economic pressure is to ask for a more dramatic reduction in subsidies and further liberalisation. But both these measures will only make the crisis worse.
At a time when domestic demand is under pressure, a cut in subsidies will reduce demand further. Slashing agricultural subsidies will take the industrial slowdown into the agricultural sector as well. While there is a long-term need for a rationalisation of subsidies, this is not the time to do it.
Again, liberalisation will open up markets and increase imports, making conditions even more difficult for domestic producers. The demand for opening up retail to foreign direct investment could, in fact, be the worst option in the current scenario.
Retail stores set up with FDI would be naturally inclined to stock more foreign products than Indian ones. And given the tendency of the Indian consumer to prefer the foreign, there is no reason for FDI in retail to curb this inclination.
It is important then to come to terms with the fact that reforms so far have been largely confined to the opening up of markets. The constraints on production have not been adequately addressed. The implicit idea that reforms would reduce the role of the government has not quite happened.
The outlays of the Centre, the States and the Union Territories together accounted for 32 per cent of GDP in 2010-11, barely distinguishable from the 33.2 per cent in 1990-91. And the method used in this spending does not appear to have been reformed enough. While the growing scams are an indication of the extent to which rules are being broken, it is not even clear that the rules themselves are crony-proof.
Added to inefficient government expenditure are other production-related challenges. The difficulty of land acquisition for industry as poor farmers cling on to all that they have, is only one of the many major problems constraining the growth of production.
In this production-unfriendly environment, the problem is not just one of not attracting foreign capital, but that of Indian capital itself moving out. Indeed, we now have the phenomenon of Indian capital setting up firms abroad and then exporting to the Indian market.
As long as we see reforms as no more than the opening up of markets, we should be prepared for a rapid decline in the growth rate.
(The author is Professor, School of Social Science, National Institute of Advanced Studies Bangalore.)