What should we do about the falling rupee?

So the more perceptive of you would have realized that the rupee is falling. And fast. At the beginning of the year, fifty four rupees bought a dollar. Now you need over sixty rupees. That’s a fall of over ten percent in half a year.

People argue based on differences in interest rates and interest levels between India and the United States, and India’s current account deficit, that the rupee deserves to depreciate. Some argue that the rupee should actually trade even lower. That is correct. What makes the fall of the rupee worrying, however, is that it has happened so quickly. No theories on trade imbalance or rates imbalance or inflation can account for the fall of ten per cent in half a year.

The issue, of course as everyone knows, is to do with capital flows. While India has run a persistent current account deficit, the continuous inflow of foreign investment into the Indian markets (either direct or indirect) had ensured that the rupee was relatively stable over the years. With India maintaining a high growth rate in the GDP over the noughties, the inflow was persistent. Things aren’t so good now, however.

India’s GDP is slated to increase at a paltry 5% this financial year. The growth story is seemingly over. And that is not all. Things aren’t looking great in other parts of the world also. Due to this concept of margin financing, sometimes when some of your holdings lose value, you are forced to liquidate other holdings in order to comply with “margin requirements” (we will not go into the technical details here). So with markets around the world not doing great, and India’s growth not as spectacular as it used to be, and with the country’s muddled policies (check out how difficult the government has actually made it to invest in India – irrespective of your nationality), investors started exiting. With some investors exiting, asset values dropped and the rupee dropped. Consequently other investors exited. And so forth. It did not help that there was nothing inherent in India’s government policies to hold them here.

So that’s the story so far. Question is what we should do going forward. As I mentioned earlier, there are two levers that can help shore up the rupee – the capital account and the current account. Within the current account there are two components – imports and exports. What normally happens when a currency depreciates is that exports become more competitive and go up further. Imports become costlier and thus reduce. On the current account front, thus, we have what is called as “negative feedback”.

Notice that in the past whenever an economy staged a recovery, it was generally preceded by a devaluation of the local currency. So since our currency is already devalued the stage is set for recovery, right? Unfortunately it’s not so simple. While it is true that our exports are now likely to be more competitive, fact is that Indian industry is not well placed to capitalize on that. Investment bottlenecks, labour laws and bureaucracy means our entrepreneurs haven’t been able to move fast enough to take advantage of the falling rupee and up exports. This can be borne in the fact that the Reserve Bank of India, which normally shies away from controlling exchange rates (as long as they are not too volatile), has issued several public statements on this matter in the recent past, and taken steps to prevent further fall in the currency levels. That the Central Bank has had to step in to protect the currency shows that we are in extraordinary times. The natural corrector to a falling exchange rate (increase in exports) is absent.

Matters are not helped, of course, by the fact that one of our largest imports is an asset – gold. Thing with asset prices is that unlike prices of “normal goods”, the demand for assets increases with price. When asset prices increase, people see “momentum” in the asset and want to get on to the bandwagon. So there goes part of another natural corrector to a falling exchange rate (less competitive imports).

So coming back to where we started off with – what should the Government do? While this is going to be a time-consuming process, what the government needs to do is to ensure that exporters can exploit the falling rupee. Reforms in this direction are not easy of course – since they require significant efforts in removing bureaucracy and making it easier to do business – which means we need significant administrative reform. There is also the small matter of possibly having to reform labour laws (while on the matter of labour laws, check out this paper by Takshashila Scholar Hemal Shah, who presents some easily implementable reforms in the labour law). While these are difficult things to implement, the fact that there is a crisis gives the government an alibi to push ahead with the reforms. PV Narasimha Rao had done that once in 1991. The problem now is that the government may not have political will given that elections are less than a year away. In this context, it would be advantageous to have early elections, for a new government with a fresh mandate might be more prone to taking tough short-term measures.

Currently, the government is trying its best to shore up on the other levers. Gold import is being curbed – except that it will be hard to implement since they will simply get diverted to the black market. The Finance Minister is traveling the world putting up a roadshow to get investments to India. That, however, is akin to putting lipstick on a pig since there is little in India’s fundamentals and current economic scenario to attract foreign investors. Even if some of these measures succeed, they will only lead to temporary respite to the currency. Fact is that for sustainable improvement in currency, tough reforms are mandatory.

Why The Congress Party is Pro Big Government

Back in 2009, just before the general elections, I had advisedĀ people to vote for the NDA. My argument there was that irrespective of the relative merits and demerits of the parties leading the two coalitions, the BJP was a more likely candidate to lead a reformist government for it was not the incumbent. Incumbent governments tend to get cozy with unelected people who are in power (for example, leaders of PSUs, unions, civil servants, etc.) because of which they are loathe to take up policies that cut the power of such people. In other words, they are loathe to take up reformist steps that decrease the size of government.

The same argument can be extended to argue why the Congress is inherently a pro-government party. The fact of the matter is that it is the party that has been in power at the Union government for most of our history. This means that a large part of the unelected government organization has its loyalties with the party. Consequently, the party too sees itself as being loyal to this cadre, and will not pursue policies that cut down their power.

This explains why the Congress-led UPA1 government decided to reverse the earlier NDA government’s decision to repeal the Essential Commodities Act. It explains why the Congress-led UPA1 government did not pursue the reforms in the APMC act that had been set in motion by the earlier NDA government. This also explains why the Congress-led UPA2 government is trying to push through the Food Security Bill, which seeks to increase the role of the government in the agricultural supply chain.

The reforms that the UPA governments have been trying to pursue are those that do not significantly impact its unelected-government-organization constituency. Foreign investment in retail, for example, will only affect the retail industry, and the government doesn’t have much skin in the game there. The Indo-US Civil Nuclear Agreement again doesn’t trample on government feet. Conversely, nuclear energy is a field where a compelling argument can be made in favour of a government monopoly, so that agreement will only increase government participation in the energy sector (note that I’m not against the deal. I’m only trying to explain why it is acceptable reform for the Congress). The MGNREGA again brings in several thousand more people into the government folds. The only exception in the list of UPA-led reforms that might challenge big government is the Right to Information, but that act was passed in the infancy of the UPA1 government when it was much more beholden to the National Advisory Council (NAC) than it is today.

So what explains 1991? Two things. Firstly, it was a whole bunch of low hanging fruit. Though government was reduced, the resulting incremental growth increased the size of the pie so much that the proportion of the enhanced pie that the unelected-government-organization had access to was enhanced. So from a rational tradeoff perspective, it was the right thing to do. Secondly, and more importantly, the reforms were inevitable. The Indian economy was in such bad shape that there was no way out but to do those reforms. So holding up 1991 as proof of the Congress Party’s reformist credentials is wrong.

But what is the guarantee that a non-Congress government will pursue reforms that could reduce the size of the government? They fully recognize the fact that large parts of the unelected-government-organization cadre are beholden to the Congress party, and they will want to cut this constituency down to size. Hence, they will work towards reforms that will reduce the size of government. Yes, there is no guarantee that they will not open up other fronts that will increase the government’s footprint, but they are unlikely to do worse than a government involving the Congress.