by A Sunil Dharan
Stock markets across the world went into a tailspin in June this year after Ben Bernanke, the Chairman of the US Federal Reserve, hinted at a tapering off of quantitative easing. Quantitative easing refers to the pumping in of money by the central bank of a country when the interest rates are already too low and traditional instruments of monetary expansion are ineffective. Under the present strategy of Quantitative Easing, QE3, the US Federal Reserve has been buying bonds worth $85 billion every month. A large part of this money finds its way to other countries, thus pushing up stock prices in these markets. A reduction in the extent of quantitative easing would have increased interest rates in the United States. Therefore, with the slightest hint of a tapering off of quantitative easing, capital from many countries flowed to the US market, leading to falling stock prices in these countries and depreciation of these currencies against the dollar.
In India the sensex came down and the rupee was in a freefall as foreign institutional investors dumped our assets and took refuge in dollar denominated ones. As this source of foreign exchange dried up, the foreign exchange reserves plummeted, making it difficult to finance the current account deficit. The foreign exchange reserves had come down to a level below our external debt.
However, a Balance of Payments (BoP) crisis seems to have been averted for the time being. Bernanke's assurance in September that quantitative easing would be continued seems to have settled the issue for now. The sensex has risen again. It had crossed the 21,000-mark on November 1. The rupee also seems to have been stabilised, albeit at a lower level. After touching a low of Rs 67 against the dollar on September 4, 2013 it is around Rs 63 now. With the recovery in FII inflows, the foreign exchange reserves have also slightly recovered. From about $277 billion in the first week of August it has gone up to $281 billion in October-end. However, the economy continues to be vulnerable and this episode only helped to expose the structural weaknesses of our macroeconomic management.
The Indian economy is in a precarious position. A combination of low growth, high inflation, high current account deficit and a depreciated currency plagues our economy. The economy has been in a slowdown for quite some time now. The annual growth of GDP came down from 6.2 per cent in 2011-12 to 5 per cent in 2012-13 and, as some estimates suggest, it would grow even slower in 2013-14. The slowdown has been more pronounced in the secondary and the tertiary sectors, with the manufacturing sector registering negative growth in some quarters. Consumer spending has not been rising. Also, the Gross Domestic Capital Formation as percentage of GDP has come down from 38.1 in 2007-09 to 35 per cent in 2011-12. All these point to a lack of aggregate demand in the economy.
The low growth is combined with high inflation, which has been more serious in the case of primary articles, especially food items and petroleum products. The depreciation of the currency also contributed to the increase in prices.
On the external front, the current account deficit had widened from about $2.5 billion in 2004-05 to about $88 billion in 2012-13. In the first quarter of the fiscal year 2013-14 it was $21.8 billion as against $16.8 billion in the first quarter of the previous year. Financing this higher deficit required a drawdown of foreign exchange reserves worth $0.3 billion. Many commentators in the media have attributed this widening of the current account deficit to the high fiscal deficit. However, the high current account deficit was not a case of a high fiscal deficit spilling over into the current account. Thanks to import liberalisation, the volume of non-essential imports has gone up. Gold alone accounts for a significant share of the imports. The value of petroleum imports has also been going up due to rising prices in the international markets and the falling value of the rupee.
What is the Government's response to this crisis? The present situation calls for active intervention by the government. Instead the government has been trying to make the country an attractive destination for private investment, especially foreign investment. It has been wary of actively intervening, lest it should send a wrong signal to the international investors and credit rating agencies. But a slowing economy with shrinking market size is unlikely to attract much private investment.
The government should have responded by increasing the fiscal deficit. But that risks downgrading by credit rating agencies and reducing capital inflow. Therefore, the economy is in a peculiar situation. The government does not intervene to accelerate growth so as not to discourage private investment and private investment is low because growth is low.
Nor has the Reserve Bank of India (RBI) increased the money supply growth for fear of fuelling inflation. But inflation continues to be high despite the RBI's efforts. Here again the reluctance of the government to intervene in the markets has not helped things. Moreover, with the public distribution system no longer effective and the dismantling of the administered price mechanism for petroleum products, the government lacks adequate instruments to control prices.
The current account deficit has been widening in spite of the slow growth. The reduction in the value of imports of capital goods and other items related to production and exports was more than offset by the increase in the imports of gold and other non-essential items. Increase in the oil import bill also contributed to the widening of the current account deficit. But the real worry was the low foreign exchange reserves which were insufficient to finance the current account deficit. The foreign exchange reserves with the RBI had come down significantly due to the capital outflow following Bernanke's statement.
In fact, the claim about our BoP position being 'comfortable' does not carry weight as the major part of we built up foreign exchange reserves thanks to FII inflows. Unlike China, India had not earned its foreign exchange reserves through exports. Such a strategy of financing the current account deficit using short term capital flows is not sustainable.
The Indian economy escaped a serious crisis for the time being but remains vulnerable until these structural problems are addressed. But that requires an activist State, not one that abdicates its responsibility to send the right signals to foreign investors and credit rating agencies.
Author is at Motilal Nehru College, University of Delhi.