Falling Re: It’s the fisc, stupid

Himanshu Jain | Updated on March 12, 2018 Published on August 13, 2013




Current account deficit is not the only problem. Credit growth, led by the government, is also to blame.

The rupee is again staring at the precipice. The RBI did announce a slew of measures to curb domestic liquidity in the hope of arresting this fall. However, genesis of the problem is government spending. That’s the rhinoceros in the room no one wants to look at.

The major mistake is to view the current account deficit as the sole thorn in the falling rupee saga. The relative price of the currency, like any other commodity in the market place, is a function of supply and demand.

The demand for currency over a period of time arises because of the supply of goods and services i.e. GDP growth; the supply of currency/money comes from credit growth.

So, in essence, the increase in the amount of credit net of the actual growth (of real goods and services) is what determines the relative value of the currencies.

A brief glance at net credit growth (credit growth net of GDP growth) of India and US shows that the net credit growth in India has been consistently higher (by a wide margin) than that of US, except for a five year interlude between 2003-07.

This fact superimposes itself on the direction of the Indian rupee, that depreciates remarkably over this period except for that five year hiatus ( see graph ‘The fallout of credit’).

So it’s quite apparent from the chart that the reason for the continued depreciation of the Indian currency is the low level of credit productivity reflected by the poor GDP/credit ratio.

Thus, the only way to save the value of the currency is to ensure that every rupee of credit created by banks leads to higher production of goods and services --- less new money producing more goods.

Govt spending the culprit

While the lower productivity of Indian labour can be cited as one of the reasons for this phenomenon, the performance shown by the Indian economy during the 2003-07 period would negate this argument. How, then, does one explain the abysmal productivity of Indian credit?

A look at the comparison of government and private credit offtake provides an answer. It is when the government shelved its penchant for spending taxpayer’s money on wasteful projects that the Indian economy saw its most remarkable rise (the easy global credit conditions during that period did help, but that has been the case since the 90s when the Indian economy lagged behind its peers).

So, when credit offtake was mainly driven by genuine demand of the private sector in 2003-07, it ensured high growth rates and an appreciating rupee ( see graph ‘Government’s the problem’ ).

However, since the financial crisis of 2008, the government’s plunder of the taxpayer’s money was back with a vengeance. The ratio of government credit offtake to private sector credit offtake rose rapidly.

With wasteful credit not contributing to growth, these re-distributionist policies of the government have been the single biggest cause for the decline of our currency, lowering of growth and spiralling inflation.

The currency is also an asset class like stock, bonds. The poorer a citizen, the more the chances of his wealth being stored in the form of currency.

A depreciating rupee robs him of his hard-earned wealth and transfers it to people holding other assets or foreign currencies.

So the whole façade of “inclusive growth” comes apart, as the poorest are worst hit by the government’s profligacy -- trampling over the wealth of the productive forces for short-term electoral gains.

Vicious cycle

The measures announced by the RBI would certainly reduce money supply growth (credit growth) due to rising interest rates.

However, with interest rates already high and corporates reeling under heavy financing costs, these measures would impart a body blow to the productive private sector and the growth process.

This, as we have seen, is an important factor in determining the value of the rupee.

So, falling growth would further put pressure on exchange rate, forcing the RBI’s hand against loosening the monetary policy.

This could turn into a vicious cycle of low growth, depreciating currency and tight monetary policy.

Over the past 60 years, several nations have bypassed us, following the principles of free market and economic liberty.

The only way to bring people out of their poverty is by ensuring rule of law, reduced corruption, legal and financial reforms, and relaxed policies and procedures. Then, manufacturing can thrive in this country again.

The important thing is to cut down on wasteful central schemes and expenditures. No matter how well intentioned they are, they largely lead to leakages and waste. Instead, it is important to empower States to carry out their own programmes based on regional needs.

These are long term measures that don’t yield quick electoral dividends.

But the time for any short-term, easy solution has passed us by.

(The author is an independent financial consultant at Random Chalice Research Pvt. Ltd.)

Published on August 13, 2013
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