From Financial Express, September 13, 2013

Getting India back on track

 In my last column (An Indian Spring? FE, August 22, http://goo.gl/hwW9cw), I raised the possibility of India descending into an Egypt-like situation. It probably will not get that bad, since India’s recent history and its societal makeup are sufficiently different. But there is one large commonality—a surplus of young people relative to decent jobs. That basic mismatch between demographics and economic opportunity can drive substantial waves of social unrest. One only has to think back to the early and mid-1970s to realise that India, for all its democratic resilience, is not immune to severe social and political instability. In an earlier column (Can India grow faster again? FE, August 19, http://goo.gl/8E9iwS) I listed some steps that India’s leaders need to take in the medium run: effective vocational training, removing constraints on electric power generation, and more devolution to the states and to cities. But before that, there is a short run crisis facing the country. Here are my thoughts on how to turn things around quickly and effectively. 

The immediate problem is a crisis of confidence. This is partly what has driven the plunge in the rupee, although the strength of the US and European economies has also contributed to the rupee depreciation. The erosion of confidence has been gradual, with multiple instances of government corruption and fiscal and monetary policy mistakes over the last couple of years. Fixing this will not be easy. The measures undertaken so far have smacked of panic: sudden promises of relaxing foreign direct investment caps, a grab bag of import controls, and derailing financial markets to curb “speculators”. All these measures, in my view, simply reaffirm the view that the government is adrift and that troubles will continue. The latter two types of measures also go against the basics of a coherent economic reform strategy, which should be built on promoting well-functioning markets in a global setting. 

With respect to the rupee, the Reserve Bank of India’s (RBI’s) initial response of trying to reduce speculation by making short-term borrowing harder simply sabotaged the working of short-term credit markets, and had no effect on offshore traders. Markets became thinner and more volatile. Instead, if RBI wants to prevent further overshooting downwards of the rupee’s value, it should follow an assertive and transparent (but feasible) intervention policy (something along the lines suggested by Kaushik Basu, announcing a schedule of intervention). Given what has happened, it may be mostly too late. One thing RBI should do is to raise its policy rate, as other emerging economies have been doing. Yes, this could further slow down growth, but the short run benefits of an interest rate hike, in terms of stabilising expectations about inflation and currency depreciation, seem to make this a worthwhile option. Reversing such rate hikes is easy and quick, and they do not have the deleterious impacts of unexpected changes in the rules governing the functioning of markets. 

With respect to the current account deficit, what the government needs to do is to use the opportunity of the rupee depreciation to push exports. The obvious areas are in information technology and related services, tourism, and possibly some kinds of consumer goods (including apparel, health and beauty items, and processed foods). Essentially, India’s products are suddenly a bargain, but some rapid and concerted marketing efforts are required to make sure that rich world consumers take advantage of these bargains. India’s embassies and missions abroad should be going into overtime, working with Indian businesses to seize the opportunity presented by the fallen rupee. Promoting exports, while more work and slower to take effect than restricting imports, will have a much larger medium term benefit. One of the easiest, most immediate opportunities is promoting foreign tourism, since the supply constraints are less problematic. 

On the domestic front, the politics of the looming national election make progress difficult, but if the government were to push harder to reach a grand bargain on the goods and services tax (GST), convincing the array of opposition parties that they will all benefit from a broader, more robust tax system, this would provide the prospect of a corrective on the fiscal front. My reading of some of the crisis of confidence is that it was driven by the government’s attempts to raise revenue through ad hoc, discretionary and retroactive measures, in turn driven by the need to reduce the fiscal deficit. But those policies hurt confidence, growth and government revenues, just the opposite of what was desired. 

The three examples I have suggested are policies that signal that the government is in charge, and is capable of providing leadership to the country. In contrast, most of the governmental responses to the crisis so far have seemed to signal desperation, weakness and lack of control. Much of the recent Indian policy debate has been reduced to finger pointing (evil speculators, heartless global capitalists, incompetent and venal politicians) and crying over spilt milk. It does not have to be so, and India’s leadership has to act as if it is worthy to lead in these challenging times.

Financial Express, February 14, 2013

India’s inflation puzzle

India has been struggling with high inflation for over two years. The Reserve Bank of India (RBI) gradually raised its policy interest rate and has held it relatively firm, with only two small cuts coming recently. Meanwhile, economic growth has slowed dramatically. It has been asserted that RBI’s policy has contributed significantly to the growth slowdown. It has also been argued that monetary policy is ineffective in India, given structural rigidities and incomplete markets in the country’s economy. Fiscal policy and commodity prices have also been under the spotlight. What do we really know? 

A couple of weeks ago, Deepak Mohanty, an executive director of RBI, gave a speech in which he tackled India’s inflation puzzle. I will outline what he said, and then assess the arguments. Mr Mohanty first pointed out that India’s recent inflation surge and its persistence did not line up well with either its own history or what has been happening contemporaneously in the rest of the world. World inflation rose somewhat with the recovery from the Great Recession, but then moderated, while India’s inflation climbed to double digits. In India, moreover, a sharp growth slowdown seemed to do nothing to bring inflation down.

Mr Mohanty traces the start of India’s inflation spike to rises in the global prices of food, crude oil and other commodities. He refers to an unidentified analysis that pass-through of global price shocks to domestic prices increased in this recent period, and notes that corporate finance data are consistent with this increased pass-through. The depreciation of the rupee made the pass-through of external inflation that much worse. Mr Mohanty goes on to note the substantial increase in demand for higher-protein foods. He further documents the rise in real wages in rural India. He highlights the fiscal stimulus that coincided with the recession, and asserts that “higher fiscal expansion also impedes efficacy of monetary policy transmission.” Finally, Mr Mohanty emphasises that long-term inflation expectations rose in this period.

In examining the conduct of monetary policy as inflation spiked, Mr Mohanty emphasises that rises in interest rates trailed inflation, so that, starting from historically low interest rates, the real policy rate remained negative: “Thus, monetary policy was still accommodative though the extent of accommodation was gradually closing.” While all the other points made by Mr Mohanty have been widely recognised and detailed, it seems to me that this feature of recent monetary policy conduct has not received enough attention. Another important point that he highlights is that RBI’s estimate of India’s potential output growth rate has been reduced from 8.5% to 7%.

The story above is plausible, and draws on many analysts’ judgements. I have not been able to identify a publicly available structural model of the Indian economy that would allow one to say that the explanations above are the right ones, or to quantify their different contributions to India’s recent inflation experience. Formal, comprehensive empirical modelling is always a nice check on judgements that are necessarily fragmented and somewhat subjective. In the absence of a model, let me offer some additional thoughts, which may undercut the notion that India’s recent inflation experience should have been puzzling.

First, the monetary policy tightening was actually slow and even hesitant. There may have been good political and economic reasons for this, including fears about derailing an uncertain recovery, but RBI was neither choking off inflation nor growth in an assertive manner. Furthermore, RBI was not doing a good job of managing inflation expectations—interest rate hikes sometimes came with statements doubting if they would be effective. Sharper, faster interest rate hikes and confident statements would have worked. There is no puzzle in the experience.

Second, focusing on rising individual prices or on accommodative fiscal policy are both misleading. Yes, there can be short-term cost-push effects, and government deficits add to aggregate demand. But economic theory tells us that inflation is fundamentally a monetary phenomenon, having to do with the aggregate price level. The so-called fiscal theory of the price level, according to the best theoretical economic research that I have found, can tell us something about transmission channels, but not about long-run inflation.

Third, the growth slowdown has more to do with domestic political events that started to destroy India’s growth potential, more than RBI has estimated. The level of uncertainty for the private sector jumped. It is also true, I think, that government deficits have crowded out private investment directly. So fiscal policy has hurt potential growth. Global uncertainties and anaemic recoveries, especially in Europe, but also in the United States, have also worked to reduce potential output growth in India.

In sum, monetary policy was too timid, and failed to use the power of the word to complement actions; domestic economic management was dysfunctional in ways that reduced potential growth, while failing to account for structural changes in the economy; and global economic conditions exacerbated domestic policy shortcomings. This is a story with clear lessons and no puzzle.