BL Editorial: ‘…We all fall down’ - S. S. Tarapore

The global meltdown is deeply entrenched and no country is being spared the fall out. As Haberler said in Prosperity and Depression (1937), the seeds of a depression are laid in the preceding boom; thus, the present meltdown is the retribution for the sins of the past. Paul Krugman calls it a “nasty recession” which is perhaps a euphemism for “Depression”. The “D” word is still taboo, but it would be prudent to avoid facile solutions.

Heads of the G-20 countries have resolved that time-bound affirmative action would be taken and countries would co-operate and co-ordinate their efforts. Fifty years ago, Wilhelm Ropke, the Swiss economist, said that the more countries talk about international co-operation, the less there is effective co-ordination.
There is no reason to doubt the earnestness of the present initiatives but, ultimately, there is a need for country-specific action, particularly on external sector management. There are no clear-cut policies which can be followed and so it is best to go back to simple first principles.
If a country’s inflation rate is higher than that of the major industrial countries (as is the case in India), it is necessary to have a higher nominal rate of interest. As Moody’s have rightly warned, excessive interest rate easing would hurt. Some newspaper columnists too have recently expressed the fear that India could be building up the mother of all inflationary potentials.
Closely linked to interest rates is the need for an appropriate exchange rate policy and in this context there is reference to the Real Effective Exchange Rate, which is the trade-weighted nominal exchange rate, adjusted for inflation rate differentials.
‘Impossible Trinity’
The Reserve Bank of India (RBI) has been under attack from some analysts who draw reference to the Impossible Trinity, under which a country cannot simultaneously have an independent monetary policy, open capital account and a managed exchange rate, and that one of these objectives has to be given up.
During the recent cycle of large capital flows, the then RBI Governor, Dr Y.V. Reddy, was pilloried for intervening in the forex market. It was argued by highly respected High-level Committees that the appropriate exchange rate policy for India would have been to leave it to the market. Had the RBI followed this advice, during the period of heavy capital inflows, the nominal US dollar-rupee rate could possibly have appreciated to say $1=Rs 20.
Equally, as capital outflows gathered momentum, a hands-off policy by the RBI could conceivably have resulted in a depreciation of the rupee to say $1=Rs 80 (these figures are illustrative and not derived from any empirical analysis).
Advocates of a totally market-determined exchange rate argue that under their prescription, there would be no significant volatility in the exchange rate, but responsible policy-makers just cannot take such risks.
If the exchange rate were to experience savage risks, Indian industry would be devastated. Governors Rangarajan, Jalan and Reddy have tried to explain the soundness of the RBI’s exchange rate policy, but to no avail. The RBI attempts to come as close as possible to the tripod of the Impossible Trinity — reflecting the general theory of the second best.
What do first principles tell us about the balance of payments current account deficit (CAD) and the exchange rate? A country with a sizeable CAD cannot afford an appreciation of the currency. Countries with a large and sustained CAD could allow some appreciation.
The right approach
History shows that large capital inflows are invariably followed by large capital outflows. What would have happened had the RBI followed a hands-off policy on the exchange rate? The forex reserves would have been low and India would not have the wherewithal to meet the large outflows. Does not the nation owe a debt to selfless Governors of the past two decades, who have borne the barrage of criticism, yet done the right thing?
In the current international environment, India would find it hard to roll over the short-term liabilities which are reportedly $50-70 billion in the next few months. The authorities should ensure that these liabilities are paid off if the rollovers are available only at exorbitant interest rates.
To the extent there is a shortage of rupees to meet the forex liabilities we need to eschew brilliant financial engineering to hide the created money in the system. It is important not to contaminate the RBI balance sheet by dubious transactions to prevent the created money from showing up in the numbers.
A policy response to the domestic liquidity crunch has been to encourage all and sundry to go abroad and borrow, precisely at the time the major international markets are facing a crunch. This is a dangerous policy option. First, if the borrower does not have a good rating the cost would be high.
Secondly, there is the danger of an individual borrower defaulting. It is all very well to argue that this is not tantamount to a sovereign default, but a single Indian borrower default could affect the country’s rating. Thus, there is merit in allowing only the very best Indian borrowers to go abroad.
Using forex reserves
There is a lot of intemperate talk about resolving the rupee crunch by directly lending forex from the RBI’s reserves. Career central bankers, now in the top management of the RBI, would surely have visceral memories of RBI placing deposits with overseas branches of Indian banks and, when the RBI wanted to use these reserves, the banks were unable to repay.
Similarly, there are insensate proposals for the RBI to place its forex with institutions lending for infrastructure. This is nothing short of a fudge. We can delude ourselves but we cannot delude the international financial markets. The RBI must release forex only if the buyer, including the government, puts down the rupees. There are obvious dangers of the RBI opening up the monetary spigots. The forex reserves should only be used to meet forex liabilities — the reserves just cannot be a substitute for domestic resources.
Interest rates in a number of industrial countries are slowly moving to the zero level. While as part of international co-operation we have to make the right genuflections, we need to recognise the dangers of following the leader. As Vivek Moorthy, one of the few Indian economists dedicated to monetary economics, says, easy money leads to a meltdown.
There is considerable ecstasy that the centre of economic power is moving to India and China. What this implies is that these countries would have to bear the brunt of international adjustment. Are we ready to take on this additional burden?
The world is poised on a precipice and we need to remember the nursery rhyme Ring-a, ring-a roses, that ends: “…We all fall down”. And we need to ensure that in the process we do not break the spinal column of the Indian economy.