Policymakers must focus on simultaneously managing the exchange rate and domestic inflation while maintaining an open capital account for renewed economic growth
After a record slide of 23.9% in the June quarter, the year-on-year contraction in real GDP narrowed to 7.5% in the second quarter of this fiscal.
As India embarks on a new set of economic reforms, triggered by the pandemic and its economic fallout, it faces complexities that were not at the centre of the initial reform effort three decades ago. The crisis in 1991 was centred on the balance-of-payments. Allowing the Indian rupee to fall from an artificially high level with respect to other currencies was a key part of the solution. Another vital feature of the reforms was also focused on India’s relationship with the world economy: extraordinarily high tariff barriers began to be reduced, allowing for welfare gains from greater international trade, as well a better equilibrium in the balance of trade. Reforms of the domestic economy that increased market orientation was, in some sense, opportunistically combined with these externally-oriented measures.
Three decades later, India is in a very different position—its balance of payments is in good shape, and foreign exchange reserves are sufficient to weather even abnormal shocks to the economy. The headline reforms are focused on politically difficult attempts to reduce frictions in labour markets and agricultural markets, though these are running into problems because of inadequate attention to ameliorating the impacts of new risks that workers and farmers may face. Figuring out a new trade-off between efficiency and risk for the domestic economy is a clear conceptual issue, even if the details are challenging to work out.
In terms of connections to the rest of the world, however, it is less clear what the right policy mix should be. We can think of three types of international flows: labour, goods and services, and capital. India has benefited from being able to send workers with a variety of skills to different types of economies that could employ them more productively than at home: construction workers and nurses in the Persian Gulf, software engineers in the US, and so on. Direct benefits came from large remittances back to India. The pandemic, especially, but also some significant changes in US immigration policy, have had some major impacts on this international connectivity, but new vaccines and a change in the US president are likely to reverse these shocks. In any case, there is not much that Indian policymakers can do or need to do on this front.
The second category, goods and services, is one where Indian policymakers are still struggling to determine the right policy mix. Since the initial reforms, the Indian rupee has steadily depreciated, roughly according to a market-determined equilibrium. India has been able to grow its exports, both in a variety of agricultural and manufactured commodities and in services, from software services to tourism. It has been reasonably competitive in a range of goods and services, though nowhere near what China, or even smaller countries like Bangladesh in specific niches such as garments, have achieved.It was only in the last few years, even before the pandemic, have Indian exports struggled to register growth. Whereas the export powerhouses of East Asia consistently ran surpluses on the current account of the balance of payments, India has mostly run deficits, albeit manageable ones.
Current account deficits have to be covered somehow, though various forms of foreign capital—the third category of international flows. Whereas economic theory and economic policymakers mostly agree on the benefits of international trade in goods and services—subject to the political challenges of looking after the losers, such as workers who might see their jobs replaced by imports—there is less of a consensus on the benefits of international capital flows.
Obviously, having to borrow abroad in a forced situation is undesirable. But, even other kinds of capital flows can raise fears of instability if they are reversed, or make exports less competitive if they push up the value of the rupee. This latter issue is present even if capital flows are in the form of FDI, and therefore, more stable and sustainable.
Right now, India is trying to build its manufacturing capacity by raising tariffs, in an old-style push for import substitution. It is also providing direct incentives, such as the new scheme rewarding increases in production. Meanwhile, the country is a relatively attractive destination for foreign capital, both FDI and portfolio investment, and the government is encouraging the former, in particular. But, these flows can make Indian exports less competitive if the rupee appreciates too much, requiring domestic demand to do more of the work of absorbing increased output.
Arguably, this did work in Japan in the 1960s, but it is not clear if India is well-off enough to sustain that domestic strategy. In addition, the lack of competitive discipline that comes from successful exporting can hinder the achievement of acceptable quality levels. Some economists might argue for capital controls in this situation, while others might suggest that the Reserve Bank of India do more to keep the rupee at competitive levels, by accumulating foreign exchange reserves.
Lurking under the surface of these issues is the trilemma of being unable to simultaneously manage the exchange rate and domestic inflation while maintaining an open capital account, although foreign exchange reserves provide a way of softening the trade-offs. These are not new challenges, but they will need to be a focus for India’s policymakers as they seek renewed economic growth.
Professor of Economics, University of California, Santa Cruz. Views are personal