The economy needs shock therapy

The balance of payments current account deficit (CAD) for April-December 2012 was $72 billion and the figure for 2012-13 could top $100 billion. Top policy honchos now concede that the CAD for 2012-13 could be 5 per cent of GDP.

As government functionaries have to make morale-building statements, the eventual CAD in 2012-13 could be 5.5 per cent of GDP. If it is of any comfort to the present policy top guns, a full-blown crisis will be reached by the middle of 2014.

Lessons of 1990-91

The erroneous popular perception is that in 1990-91, effective measures to tackle the CAD crisis came only after the new government took charge in June 1991.

Towards the end of 1990, India had difficulty in raising short-term money and an international default appeared imminent. In late 1990, there was a quiet appointment of an Economic Czar in the Prime Minister’s office —none other than Manmohan Singh.

Under his command, the Reserve Bank of India (RBI) went to town with monetary tightening; the fisc was reined in and gold was pledged to stave off an external default. Together with the rapid measures from June 1991 onwards, by the last quarter of 1991, international confidence was restored.

The year 2013-14 is, admittedly, not exactly like 1990-91. The economy is much stronger but we are a lot more of an open economy.

Hence, when international confidence evaporates, the outflow of capital will be that much more rapid. The underlying economic rationale of present policies needs overhauling.

Persons with impeccable credentials advise that investment should be stepped up without worrying about where the savings will come from. As the savings-investment identity requires a large CAD, capital inflows should be made more attractive.

Appreciating the rupee would provide a handsome risk-free return to foreign investors. It should not matter that volatile portfolio flows — topped by large Participatory Notes (PNs) — and recourse to short-term credit fill the CAD gap.

To please large industry, the RBI should reduce policy interest rates and increase domestic liquidity. Savers have no voice, so reduce bank deposit and small savings interest rates, while lowering lending rates.

If inflation increases — the Industrial Workers Consumer Price index (CPI) has crossed 12 per cent — we should talk about a new normal for inflation. Such policies would eventually result in political and social chaos.

There is, therefore, an instant need for major policy reversals if the economy is to be on an even keel.

Tighten Monetary Policy

First, the Government needs to give the RBI an unequivocal go-ahead to take measures to attain a significant and enduring reduction in the CPI inflation rate and bring down the CAD.

This will require the RBI to sharply raise policy interest rates and reserve requirements and reduce RBI accommodation. Interest rates on deposits, credit and government securities will rise. Second, to prevent forex reserves from being dissipated, the RBI should buy when there are capital inflows, to prevent an appreciation of the rupee, and refrain from selling when there are outflows.

The upshot is that the rupee would depreciate, as it indeed should. At the margin, it is preferable to have an undervalued rupee rather than an overvalued rupee.

The RBI would come under severe public criticism but it has the resilience to face up to such pressures, provided the Ministry of Finance and the Planning Commission stop their sabre-rattling, foisting inappropriate, soft policies on the RBI.

Third, the Government must immediately float inflation-indexed bonds, with full CPI inflation cover for both capital and interest, with attractive real rates of interest.

Also, a battery of schemes should be introduced to monetise domestic hoards of gold by offering gold-linked financial assets with attractive rates of interest.

Furthermore, the Government should no longer vacillate on setting up a Gold Bank. These measures would result in a significant reduction in the demand for gold imports.

Fiscal Tightening

There would need to be a Supplementary Budget in 2013-14 to reduce the gross fiscal deficit substantially below the 4.8 per cent of GDP projected in the February 28, 2013 Budget.

Non-merit subsidies — diesel and cooking gas — should be drastically reduced. More importantly, there should be an across-the-board cut in expenditures by, say, 5 per cent and select increases in taxes.

If, by July 2013, all these steps are taken, by March 2014, inflation would be substantially under control, the CAD would be out of the danger zone and it would be possible to ease monetary-fiscal policies. Such policies would no doubt create immediate political economy problems, but they would be short-lived.

The Exim policy cannot be a substitute for prudent monetary, fiscal and exchange rate policies. In the absence of shock therapy for dealing with inflation and the CAD, there would be a major upheaval, as India would eventually face the ignominy of international censure.

The question we all have to ask ourselves is who dies, so India lives, or who lives if India dies.

(The author is an economist. blfeedback@thehindu.co.in)

COMMENT NOW