I have always welcomed the threat of a crisis. That seems to be the only real trigger for debate and discussion in India. For the first time in 15 months, the BJP/NDA government has been forced on the backfoot by external developments. Not everything, however, has changed: for example, ministers continue to mouth the convenient untruth that the economy was in the doldrums in May 2014. The Hindu (dated 25-8-2015) reported that Mr Amit Shah, president of the BJP, had said that the Modi government had, in 15 months, raised the average growth of GDP from 4.5 per cent in the 10 years under UPA to 8.2 per cent! I would ask students of economics to examine that statement and tell their class how many words in that sentence are true.
In the wake of the Monday massacre, the finance minister rushed to reassure the markets and the investors that all the key indicators have looked up smartly in the last 15 months. Very true. What he did not say was that we reached a fiscal deficit level of 4.1% at the end of March 2015 after crossing two crucial markers of 4.8% in March 2013 and 4.4% in March 2014.
So it is with every other indicator like the current account deficit, inflation, foreign exchange reserves etc. One performs a journey of a thousand miles by crossing the 800th milestone, the 900th milestone and so on.
Unanticipated events
Not all external developments will be benign. That is the lesson the government has learned in the last week. The crash in oil prices, the decline in commodity prices, and the lifting of sanctions on Iran, created a sense of “God is in heaven and all is well with the world”. The unanticipated event was the China crisis and the unusual (for the Chinese government) step of multiple devaluations of the yuan.
Such completely unanticipated events have happened before. In September 2008, Lehman Brothers, a leading financial institution, collapsed, triggering a crisis that reverberated throughout the world. At least four European countries touched the brink of insolvency.
India’s majestic march with an average growth rate of 8.8 per cent (old series) between 2004-05 and 2007-08 was interrupted; nevertheless, the five-year period of UPA I ended with an average of 8.4%.
Similarly, in May 2013, when the Indian economy was stabilising, Mr Ben Bernanke made a thoughtless and unnecessary remark about ‘taper’ — gradual withdrawal from the purchase of US Treasury bonds. He was rightly castigated for his ‘taper tantrum’.
When the Indian economy paid a price for these external developments—for instance, the rupee depreciated—the BJP was merciless in its criticism. That was understandable. What was not was the extravagant promises made—the rupee will rise to Rs 40 to the US dollar (!) and India’s GDP will grow at 10% under a BJP government.
On Monday, August 24, the Sensex shed 1625 points. In August, the rupee has depreciated by about 3.3% against the US dollar. Such volatility and decline in asset prices are stressful. The government will scramble to do something, and even if it succeeds, success will come at a cost. Contrary to popular belief or desire, in a global economy, the Government is no longer the lead player, it is more an umpire. We must therefore adjust our understanding and expectation of what the government can and should do.
The impossible trinity
Take the example of the exchange rate. It is closely linked to two other key issues: (1) an autonomous monetary policy and (2) free capital flows. No government can manage — or fix — all three. That is why it is called the “impossible trinity”. If theRBI keeps the policy interest rate high (to keep inflation down), foreign money will flow in, but the rupee will appreciate making imports cheaper and exports costlier.
If the government and the RBI agree to keep a fixed exchange rate, it would mean choosing between imposing capital controls and giving up autonomy on monetary policy, neither of which would be desirable.
Basically, there are three options:
1. Free capital flows and autonomous monetary policy, but a market-determined exchange rate;
2. A fixed exchange rate and autonomous monetary policy, but strict controls on capital flows;
3. A fixed exchange rate and free capital flows, but no autonomous monetary policy.
Which is the correct option? No one is certain. Even the so-called correct option may not work in all circumstances. For many years, China followed the second option, and fared well, but the rapid growth of China’s economy and its scale, size and spread of trade made option 2 obsolete.
The safer option appears to be option 1. The fear is flight of capital. It stems from the fact that governments are prone to adopt foolish policies that will frighten investors: run high deficits, make retrospective tax laws, create an un-level playing field, erect hurdles to doing business, not uphold sanctity of contracts or protect intellectual property, litigate endlessly or suspect and investigate every transaction. To shed the fear of flight of capital, we must abandon foolish policies and vow to never repeat mistakes.
I believe the government has learnt its lessons and is beginning to consult a wider spectrum of economists and investors. Let us hope we will now have a coherent economic agenda from the not-so-new government
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