Rupee still looks vulnerable, India has three options, none
very palatable. One is to let the currency fall further. In most
countries a cheaper currency would boost exports and help close the
current-account deficit. But India’s manufacturing industry is too small
and too bound in red tape to ramp up quickly. So a turn-around in the
balance of payments may take time during which investors could panic.
Meanwhile the weaker currency may destabilise the domestic economy by
adding to inflation and increasing the government’s subsidies on fuel
and thus its borrowing.
The second option is to do the opposite and increase interest rates to attract more foreign money in, following the path of Indonesia and Brazil. But this would further hammer Indian industry, which is already in poor shape, and probably increase bad debts at banks too. If the economy slowed further as a result, equity investors might begin to worry about corporate earnings declining and pull out their roughly $200 billion of investments in listed shares. Inducing a credit crunch in India might make things even worse.
The last option is to lower government borrowing. It is running at 7% of GDP (including India’s states) and has stoked excess demand in the last few years, widening the current-account deficit. The populist political mood doesn’t make big spending cuts easy, though, and while it is often accused of epic profligacy, India’s central government has pretty low expenditure relative to GDP—about 15%. There is simply no way it can cut its way to a balanced budget. What India really needs is more tax revenues. But with a narrow tax base—only 3% of Indians pay income tax—this might mean concentrating tax rises on the formal economy, which is already reeling.
For now my sense is that the authorities’ plan is to let the rupee trade freely but hold out the threat of an interest rate rise or direct intervention in the currency market to try to scare off speculators. At the same time they will squeeze borrowing as much as is possible during an election and use administrative measures, such as higher duties, to try to cap imports. It is a bet that the economy will pick up soon and that growth will make India’s problems fade away. The trouble is that the economy is still decelerating.
The second option is to do the opposite and increase interest rates to attract more foreign money in, following the path of Indonesia and Brazil. But this would further hammer Indian industry, which is already in poor shape, and probably increase bad debts at banks too. If the economy slowed further as a result, equity investors might begin to worry about corporate earnings declining and pull out their roughly $200 billion of investments in listed shares. Inducing a credit crunch in India might make things even worse.
The last option is to lower government borrowing. It is running at 7% of GDP (including India’s states) and has stoked excess demand in the last few years, widening the current-account deficit. The populist political mood doesn’t make big spending cuts easy, though, and while it is often accused of epic profligacy, India’s central government has pretty low expenditure relative to GDP—about 15%. There is simply no way it can cut its way to a balanced budget. What India really needs is more tax revenues. But with a narrow tax base—only 3% of Indians pay income tax—this might mean concentrating tax rises on the formal economy, which is already reeling.
For now my sense is that the authorities’ plan is to let the rupee trade freely but hold out the threat of an interest rate rise or direct intervention in the currency market to try to scare off speculators. At the same time they will squeeze borrowing as much as is possible during an election and use administrative measures, such as higher duties, to try to cap imports. It is a bet that the economy will pick up soon and that growth will make India’s problems fade away. The trouble is that the economy is still decelerating.
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