Is India trapped in a macro trilemma?

By: |
October 1, 2020 7:45 AM

Increased protectionism Could be a contributing factor, besides monetary fiscal imbalances, pushing the stabilisation burden on to the Exchange rates

"Any shortfall in the maintenance of the 50 per cent LTV occurring on account of movement in the share prices shall be made good within seven working days," the RBI said."Any shortfall in the maintenance of the 50 per cent LTV occurring on account of movement in the share prices shall be made good within seven working days," the RBI said.

RBI’s recent recourse to rupee appreciation brought to fore the challenge of retaining domestic monetary control amidst sustained foreign currency inflow pressures. With headline and core inflation rising for many months, at the same time as growth slowed to 4.2% before Covid and descended to -24% thereafter, the difficult configuration impelled exchange rate adjustment for reconciliation. In the current, exceptional circumstances, a major source of foreign currency surplus is the sharp current account compression. Going forward, it is anticipated that current account pressures may ease due to progressive restoration of domestic production and import supplies, allowing the central bank more freedom to balance monetary and exchange rate policy objectives with an open capital account. However, the possibility of this trilemma persisting cannot be ruled out. The pronounced or reinforced protectionist turn initiated by Atmanirbhar Bharat measures could be a contributor.

There is little doubt the Covid shock is outstanding. It is in this context that RBI’s $56 billion addition of foreign currency assets in April-August needs to be viewed. 55% of this or $25 billion was bought in one month, July. Coarse calculations based upon April-June balance of payment outturn and assumptions for July-August indicate current account surplus could have been as much as $35-40 billion in April-August; the -37% fall in non-oil, non-gold imports was an important factor. The math from the capital account side buttresses the severe current account compression is the larger surplus source: net capital and financial account was -19.3 billion in April-June; net foreign investment flows (FDI and portfolio), non-resident deposits and overseas borrowings aggregate around $13 billion possibly. More than half the reserves’ accumulation in the five months to August arose from the current account side, therefore.

In a once-in-a-century event such as this pandemic, the current account compression is not surprising. There is also reason to expect its normalisation as production recovers from its abysmal decline last quarter and import disruptions ease. Would such restoration relieve excess foreign currency pressures, allowing unconstrained devotion of monetary-exchange rate policies to domestic objectives?

There are fundamental reasons why current account inflow pressures could endure. Although difficult to predict the trajectory of macroeconomic variables, where dynamics are characterised by simultaneous interactions in several dimensions, there are nonetheless fundamental drivers of direction and course. This is where Atmanirbhar Bharat—to make in India and make the country self-reliant—could be a contributor. Post-Covid, this takes a pronounced turn in the protectionist reorientation that began in 2018. In forthcoming times, it could potentially alter India’s usual current account dynamics. Combined with slower demand, the pre-covid monetary-fiscal hangover accentuated by the pandemic, the evolving configuration could trap the economy in macro trilemma. The outcomes could be self-defeating.

Specifically, the protectionist turn has now acquired a sharper edge. As from 2018, the objective is to replace cheap and select imports, encourage domestic production for home consumption and export. From April this year, the Atmanirbhar Bharat series of measures fast propel or promote ‘Make in India’ and self-reliance. These include modification of public procurement rules for maximum preference to firms with local content of 50% or more, excluding the below-20% domestic content ones from participation in most public tenders, reserving supply contracts valued below `2 billion for local-sourcing by the exclusion of global tenders, import bans of listed weapons/platforms, indigenisation of spares, and so on. Local content requirement scope has expanded since. Trade retaliation against China has also stopped some imports (e.g. power equipment), restricted others (e.g. colour TVs), discouraged through ‘country of origin’ declarations by sellers at procurement and e-commerce platforms, extended import duties (e.g. solar cells), imposed fresh anti-dumping duties for periods ranging from three months to five years ones (e.g. steel & fibreglass, digital printing plates, etc), amongst others.

The other side of Atmanirbhar Bharat focuses on manufacturing and export side with refurbished, reinforced measures and impetus. For example, active courting of foreign firms to relocate or manufacture in India, production-linked fiscal incentives of 4-6% to eligible domestic and foreign manufacturers in targeted sectors, detailed plans to boost manufacturing in select or key sectors, efforts and aim to integrate MSMEs in newly formed or global supply chains, etc.

The direction and trends of trade and industrial policy are thus clearly accelerated. Whether structural shifts will be triggered over time is an open question. It is difficult to predict the current account response as the effects will be observed over time. Then too, it is subject to many other factors, including exchange rate movements. For example, the impact of raised import duties upon non-oil, non-gold imports is hard to disentangle from slowing demand and exchange rate movements since 2018. Illustratively, retail headline inflation rose to average 4.8% last year (2019-20), above target and 3.4% in 2018-19.

The rupee depreciated 1.4% against the dollar in 2019-20 in nominal terms, over 8.9% depreciation in 2018-19 or cumulative 10% in these two years. However, in real effective terms (36-currency trade based weights), the rupee appreciated 2.4% in 2019-20, indicating exchange rate adjusted as the policy rate was lowered 90 basis points in April 2019-March 26 this year (before Covid). This easing was reinforced by durable liquidity injections through special and open market operations, forex purchases as ECBs were encouraged to bolster the net capital account to 1.55% of GDP (1.11% in 2018-19), while the current account shrank to -0.86% of GDP (from -2.11% year before) as GDP growth dropped to 4.2% from 6.1% in 2018-19.

The external and domestic contexts are pointers. The global shift towards deglobalisation much before Covid has accelerated. The domestic growth context and outlook are well known. On the monetary-fiscal front, the pre-Covid macro inconsistencies I flagged as inflationary risks this February (, have aggravated. They are poised to persist, necessitated by exigencies of the pandemic shock or its negative output-employment effects. The likelihood of fiscal improvements or that enlarged fiscal deficit and debt levels could cease to be a risk in the next two-three years is low, critically dependent upon growth outcomes. Neither looks set to normalise in the foreseeable future.

The directional forces are thus inclined towards smaller current account deficits if not surpluses. Enhanced current account side pressures, in addition to those from the capital account, cannot be ruled out. Then, decreased competition and import restrictions embody cost-push risks; sustained supply pressures in prolonging virus infection spread and growth could keep disinflationary forces from contracting demand suppressed; while other sources, e.g. diminished potential output, remain an unknown risk. Monetary factors constitute a potential vehicle; large fiscal deficits and debt-GDP ratios are historical inflation precursors.

With such macroeconomic alignments, unsterilised foreign currency purchases are increasingly unsustainable for a prolonged period. The burden of stabilisation has to fall upon the exchange rate.

The present trilemma may or may not have blown over. But, the above coincident configurations could trap the economy in it, leave the central bank no choice but to stealth tighten through appreciation to preserve domestic interest rate settings, avert further fiscal damage and so live with the trilemma. The perverse outcome of an appreciation to resolve inconsistent policies will, of course, be the erosion of the government’s fiscal payout to bridge the competitive disadvantage gap faced by domestic producers!

The author is Author is a New Delhi based macroeconomist
Views are personal

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