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Let the rupee slide, and fast - Outside View by S.S. TARAPORE

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Let the rupee slide, and fast
Jun 14, 2013

It is the duty of policy helmsmen to build confidence in the macroeconomic policy to say that there would soon be a return to the halcyon days of 8 per cent growth; inflation will be back to acceptable levels of less than 5 per cent; fiscal consolidation will be on track to around 3 per cent of GDP and that the balance of payments current account deficit (CAD) would be down to the safe level of 2.5 per cent of GDP. Furthermore, we would take comfort from green shoots in the global economy recovery which should raise all lifeboats. An article of faith appears to be that lower interest rates are a panacea for all the problems.

Global Situation

What would global economic policymakers do if it ultimately dawns on them that the world is in the midst of a long cycle of low growth? This view was brilliantly articulated in a path-breaking work by a Russian economist Nickolai Kondratieff entitled "Long Waves in Economic Life" (1926) with each cycle lasting 50-60 years. While I have, for many years, written on the possibility of the long cycle of low growth (Business Line, November 7), it is not very comforting to recall that poor Nickolai was shot for what was considered as a veiled attack on Stalin's policies!

Domestic impasse

When the financial crisis hit the world economy in 2008, India was enjoying a 8-9 per cent growth rate, but it was soon hurt by lower and lower growth rates till ultimately in 2012-13, the growth rate fell to 5 per cent and consumer price inflation was in double-digits.

With the Indian policy of lower and lower interest rates and a widening of the gap between savings and investments, the balance of payments current account deficit (CAD) rose to 5 per cent of GDP. Added to this, the rupee was kept relatively strong.

Historically, in India, effective revival of the economy has been through a step up in public sector investment which, then, triggered private sector investment and a revival of industrial growth. In the current context, with the constraints on fiscal expansion, the authorities lay great store by offering lower interest rates to stimulate private investment. A corollary of lower bank lending rates is lower interest rates on deposits and other forms of financial savings.

The exchange rate is clearly unsustainable, given the high CAD and relatively high inflation rate. It is an article of faith that capital inflows will continue uninterrupted, that inflation will come down and that the large CAD will shrink.

A gloomy possibility is low growth around 5 per cent, close to double-digit consumer price inflation, a 5 per cent fiscal deficit and a CAD of 5 per cent of GDP. Large capital outflows could put the economy into a tailspin.

The policymakers' focus on the Wholesale Price Index (WPI) is one of convenience as it shows a rate below 5 per cent; the more relevant index for the masses is the Consumer Price Index (CPI) which is slightly below double-digits. Essential to tackling the domestic side of the problem would be to provide for sufficiently attractive interest rates to encourage savings. The Government seems to erroneously believe that low interest rates and ample liquidity will step up investment.

Hopefully, the RBI would not be too enthusiastic about the early break of the monsoon and refrain from cutting policy interest rates on June 17. There is irrefutable evidence to show that bans on gold and raising import duties do not help reduce the CAD, as all that happens is that gold comes through the unofficial channel financed by lower invisible inflows such as remittances.

Again, the Government took comfort that the decline in international gold prices would reduce payments on account of gold; all that happened was that more quantities of gold were imported and there was no reduction in the amount spent on gold imports.

The effective solution for the CAD would be to allow a depreciation of the rupee. It is best to allow the rupee to depreciate quickly rather than periodically support the rupee by forex sales by the RBI.

The authorities should not be unnerved by the depreciation of the rupee during the past few days.

Tackling CAD

A premature intervention would halt the depreciation for a while, but still leave a disequilibrium. It is only when the rupee correction goes too far out of alignment, than warranted by inflation rate differentials, should the RBI intervene.

The present rate of Rs 58-59 is still heavily overvalued and intervention at this stage would be premature. A very slow depreciation encourages large capital outflows.

While most observers are arguing how soon the rate will move to $1 = Rs 60, the correct question is how soon it will move to Rs 70, which indeed is the appropriate rate given the inflation rate differentials.

To curb gold imports and correct the CAD, what is required is very attractive instruments which would be better than the return on gold.

A 3 per cent real rate plus the consumer price inflation of, say, 9 per cent would yield a nominal return of 12 per cent plus inflation adjustment for the capital - such an instrument would knock cold the demand for gold. As the CAD and inflation come down, the cost of such an instrument would also come down.

Disequilibrium trap

There is a strong possibility that if we persist with the present macroeconomic policy, we could end up with a disequilibrium trap of a 5 per cent growth, a 10 per cent consumer price inflation and a 5 per cent CAD - a situation which would sooner or later explode.

Early corrective action is imperative.

The rupee is overvalued. The RBI should allow it to fall rapidly to about 70 to the dollar, as an effective solution to the current account deficit.

Please Note: This article was published in the Business Line print edition dated June 14, 2013.

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.

Disclaimer:

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