I am sure that my readers would
have read a host of articles blaming the current crash in INR on global
circumstance or RBI. But, according to me, complete blame for the present
condition of INR lies at the door step of current government.
Should we blame the RBI?
RBI did its best given the
political compulsion it had to managed. There was intense pressure on Mr.
Subbarao to reduce interest rates but he managed to stave off the pressure by
opting for CRR cuts and decreased interest rates only thrice. RBI cannot be
blamed for the blotched up defence of INR. The classic defence for a currency
under attack is raising interest rates. This was employed successfully by the
then Governor of RBI, Dr. Bimal Jalan during Asian crisis. Since RBI do not have permission for hiking
interest rates to defend INR, it took whatever measures it can to prevent a
currency collapse.
The RBI can also be blamed for
staying behind the curve while hiking interest rates. Wholesale price Inflation
in India peaked somewhere in September 2010 while interest rate peaked in
September 2011. But again RBI cannot be blamed for it as we all know the global
macroeconomic circumstances during 2010 were very fragile and RBI was rightly
conservative in hiking rates.
According to me the only mistake
RBI did was not raising interest rates quickly once it realized that inflation
is going to be severe and easing interest rates due to political pressure.
The current government wants RBI to cut
interest rates thinking it will give boost to economic activity. According to
me it will only worsen the macroeconomic problems faced by the country. The
current lack of economic growth has little to do with high interest rates but
is the result of messed of government policy, rent seeking behaviour,
corruption, uncertainty, subsidies, retrospective taxation, complete lack of
reforms by current government. There
isn’t a single sector in economy which has not been destroyed by the current
government policy.
Reducing interest rates in this environment
will only increase consumption demand and will not stimulate new investment. It
is also worth considering that people’s faith in this government and economic
confidence has both reached nadir and will take time to recover. In
absence of any further investment in new production facilities falling interest
rates will fuel consumption and will result into further worsening the CAD.
If the government continues with
its current policy of doling out unwanted subsidies, reducing capital
investment in economy to control fiscal deficit instead of cutting down
subsidies etc, INR will continue it’s downwards spiral.
Should we blame Inflation?
Inflation in India is very high
compared to inflation in developed world. I think the INR deprecation is
logical consequence of high consumer price inflation in India compared to US
consumer price inflation.
I wrote this
article on 1st June 2012 whereby I stressed that
the real value of INR should be 70 - 72 per USD adjusted for inflation
differential assuming that productivity gains are equal.
If you look at the given chart you will see that since 1991 - 2003 INR
depreciated as per inflation differential but since 2004 - 2010 the value USD
was suppressed with respect to INR due to massive FII and FDI inflows into
India.
In absence of foreign inflows INR
should have depreciated gradually from 2003 -2010 and we would not have faced a
sudden deprecation in INR.
Although Inflation seems to be the culprit we will later see that current inflation itself is the result of high fiscal deficit and wasteful subsidies given by the government.
PS: - I have often heard the
argument that since current inflation in India is supply side inflation
reducing interest rates will add to new productive capacity. But, I have
already demonstrated that in current macroeconomic setting no entrepreneur
would like to take the risk of creating new assets due to economic uncertainty.
It is also worth nothing that most of the Indian corporate are saddled with debts
and debt ratios are reaching alarming levels. Even if interest rates goes down
most of the corporate will try to repair their balance sheets instead of
creating new capacity.
Should we blame foreign
outflows?
The most ludicrous
argument I have heard is that some analysts blame foreign outflows for INR woes. If Indian government
is indulged in heavy corruption, they do policy goof up, fail to pass a single
reforms in 9 years, dole out massive useless subsidies, and implement policy of
entitlement even when we don’t have resources what should FII’s do. Shall we
expect them to keep punching money in India even when our growth rates falls to
4%. It is most logical that foreign money will flow to the most productive
economy. If US is growing at 2.5% why should they invest in India and take
political risk and currency risk when India is growing at 4%
This leaves us with only one
culprit to blame for current INR woes, The Indian government.
I think real culprit for current
INR woes is high subsidy payments which are resulting into high fiscal
deficit. Even when government says that
it wont allow fiscal deficit to cross 4.8% of GDP they will do this by
suppressing the productive expenditure and capital investment instead of
cutting down on wasteful subsidy. Such short term vision is destroying the long
term productive capacity of the economy.
High fiscal deficit results into high aggregate demand. Since productive
capacity of the economy has not kept pace with high demand CAD has expanded to
4.8% of GDP. Now when the inflows have abated and CAD is at all time high INR
is depreciating.
Secondly, government has been
implicitly monetizing debt. RBI creates money to purchase bonds from banks
under OMO, this creates excess liquidity with bank which is then invested into
new treasury bills which fund fiscal deficit. If RBI stops purchasing bonds
from banks, interest rates will shoot up and government will be forced to
curtail its fiscal deficit. It will also increase interest rates in the economy
and solve the problem of negative real interest rates. But RBI continued with
currency printing to the tune of 2 lack crs per year to finance government
fiscal deficit and thus stroke inflation by keeping interest rates artificially
low. Since RBI is not independent of the government I will lay the blame for
this on Government instead of RBI.
Present Indian government is the
most corrupt and most incompetent government we have seen since independence.
The present government which is headed by a distinguished economist and full of
technocrats is completely to be blamed for current mess.
The Cure
The right medicine for
depreciating INR is raising interest rates and removing government policy
uncertainty.
Real interest rates in India have
been negative since last few years. This has pushed people into investing in
unproductive assets. Increasing interest
rates will channelize saving form unproductive investments like gold and real
estate to financial savings. This will reduce CAD as demand for gold will fall
and kick start the investment cycle and increase productive capacity of the
economy. Government can also make interest on all fixed deposits below 1 Cr and
having tenure of 3 years and above tax free
Secondly government should remove
policy uncertainty and proceed with an iron hand with reforms. This will boost
up economic confidence and will renew the flow of money in India and increase
productive capacity of the economy.
Since the problem is high fiscal
deficit (which is increasing the aggregate demand) and high CAD which is result
of government policy (government policies have made it difficult to produce at
home and easier to import) the solution has to be a reducing fiscal deficit by
eliminating subsidies, increasing government investment into infrastructure, reforms and
stable government policy framework.
This was exactly what Vajpayee
govt did successfully in 1999 -2003. The growth rate was low but Indian
macroeconomics was the best it had been since independence.
This medicine will be painful in
short term but will reduce inflation and interest rates in long term and help
INR regain its stature.
