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March 10, 2012

Self-inflicted wounds

Both the Rupee and India’s economy are victims of poor governance

Will the ides of March bring relief from India’s politically-driven, precipitate, yet in some ways inexplicable, departure from its senses last year? Hopefully that departure will be temporary. But, while it persists, there will continue to be a collapse of domestic and international confidence in India, its currency, and deepening doubts about its ability to manage its future. 2011 ended with the Rupee’s external value having tanked. Its internal value is still being eroded by inflation; which still rages despite months of monetary tightening. Prolonged fiscal laxity and effective devaluation are offsetting its effects. Continuous high inflation relative to the US and other OECD economies will imply continuous devaluation without necessarily improving competitiveness.

India’s economy is slowing at a rate that may soon approach stall speed. Meanwhile, India’s politics are played out in the theatre of the absurd. The political agenda in 2011 was hijacked by the anti-corruption movement, pressing parliamentarians to pass a bill to cut their own throats. They have avoided doing that for 48 years. The Lokpal Bill is not going to change much in our political landscape. Of course, it is now de rigeur to state that not all politicians are corrupt. But anyone who funds and fights an election almost certainly has to be. And, the investment made in fighting an election has to be recovered through corruption while in office. Insisting on a Lokpal Bill – justified and overdue though that may be – is rather like asking a turkey to vote for Thanksgiving or Christmas; believing blithely that the actual outcome will reflect holy intent.

Photo: Akshay Mahajan

At the risk of being considered cynical, one must ask whether a central Lokpal, with or without Lokayuktas, will eliminate, reduce, or even curb marginally, deep-rooted, endemic and, almost culturally embedded, corruption in India? Or will it be yet another public institution created in great hope; only for it to become ineffectual and dysfunctional, in the way that all public Indian institutions have become, for the domestic intelligentsia and world to ridicule?

We hold our Election Commission in high esteem. Yet, consider how much visible corruption it chooses to ignore in the electoral process by accepting submissions about personal wealth from potential electoral nominees that are palpably understated and misleading. Look at the way in which our laws relating to assets disproportionate to income have been enforced. Dealing with Indian corruption requires a fundamental sea change in India’s political culture and in daily political behaviour; with the re-introduction of a sense of ethics and morality in the political process. Is that likely to occur with the institution of a Lokpal? Anyone who thinks so lives more in hope that reality. The problem is not one of institutional lacunae. It is one of behaviour.

But, let’s not get diverted by the infection that has already driven our polity, populace, and political discourse, insane. Let’s look more closely at the economic mayhem that is being perpetrated unintentionally instead.

Viewed dispassionately, the main reason for the collapse of the Indian Rupee (INR) in 2011 was a collapse of confidence in India and GoI on the part of the global and domestic investor community. It is in that community that the relative supply-demand relationship for US Dollar versus INR is determined. There is no plausibly positive texture to the ‘India growth story’ anymore in the minds of foreign investors; and, increasingly, in the minds of the largest Indian corporates. Their loss of faith in India, and Indian governance, seems now to exceed that of their foreign counterparts. Relative to other emerging markets, India is now being seen by the investment community as a soufflé on steroids that is collapsing under the weight of internal political contradictions. Indian corporates are suddenly discovering that they are over-exposed to India and rupee risk.

There are, of course, other plausible reasons, such as the sudden strength of the US Dollar (USD) as a safe haven currency vis-a-vis most other currencies (except the Japanese Yen) in the aftermath of the self-inflicted Eurozone debt crisis; and the rapid shrinkage of EU bank balance sheets to meet new capital adequacy norms as well as provisioning norms, resulting in a sharp sudden outflow from India on the accounts of these banks. There is also the argument that, with the relative Indian inflation rate being 7-8 percent higher than the US inflation rate for 18 months, it is but natural that the INR should depreciate against the USD by 10 percent or so in nominal terms over that period; although the actual depreciation was closer to 22 percent before the INR recovered somewhat in early 2012.

There is some validity to these arguments. But they are not main reason for the INR’s sudden collapse. It is more the stripped-down perception of what India is now seen as (an emerging markets emperor without clothes), rather than the theoretical persuasions of what governs nominal exchange rates, that is determining the view of the foreign exchange market. India has been marked down sharply by the global investor community (domestic and foreign) in the last few months because of poor performance, poor policy, and governance paralysis. It was generally rated through 2000-10 as one of the three best emerging markets to invest in. At the end of 2011 it was ranked the worst of some 35 emerging markets to invest in; whether from the viewpoint of FII or FDI. The natural consequence was the markdown of the INR by even more. There has been some recovery in the INR and portfolio investment in India triggered by the ECB’s Long-Term Refinancing Operation (LTRO) but the underlying concerns remain.

That view, the most pessimistic since 1991, is in turn caused by a combination of factors: One, the obvious inability of Government to govern; Two, the inability of the Cabinet and of the UPA-2 coalition to coalesce on anything important politically, with the Congress and GoI being continually held to ransom by supposed ‘allies’; Three, the growing public perception, fuelled by the media that, within the Cabinet, key senior Ministers are deliberately injuring their colleagues for personal political gain; and Four, the National Advisory Council (NAC) encouraged by Sonia Gandhi now becoming a shadow-government that interferes with day-to-day policy-making by government.

Add to those: Five, opportunism on the part of the Opposition in making it clear to India and the world that its only agenda is to prevent Parliament from functioning, or letting the government govern, between now and 2014; Six, the long running soap opera of the 2G scandal, and the way in which its aftermath is being managed by the CAG, CBI, the Indian courts, and the Indian government, which is multiplying several times the harm done by the scandal itself; Seven, as noted earlier, the emergence of a populist anti-corruption movement, which may be complicating rather than improving prospects of improved governance; Eight, the serial emergence of other corruption scandals involving central and state governments in the real estate sector, in illegal mining, etc. and finally, a collapse of foreign investor confidence in the probity, integrity and capability of corporate governance in India where even saints have become sinners.

The combination of these negative perceptions has led to the view emerging, and taking hold abroad, that India is now an ethics/morals free zone. In that perception, all economic activity in India is undertaken with the driver of making as much as money as you can, as quickly as you can. That is done in any way you can (the less legitimate the better), without any regard for the consequences. The only concern is ‘not to get caught’. But that last risk has just materialised.

In the face of the INR’s sudden collapse, the Reserve Bank of India has generally done the right thing by interfering minimally in volatile markets. Besides, it does not have the firepower by way of sufficient free reserves to intervene effectively to defend the value of the rupee at any level for any length of time when such negative perceptions about India and the INR have taken such firm hold in global investment and forex markets.

When anything untoward happens in financial, currency or commodity markets in India, the immediate knee-jerk reaction of our ignorant authorities is to blame and ban speculators for causing these problems. The authorities never blame themselves. But that is where the blame lies. The greatest blame lies with the prolonged mismanagement of fiscal policy, which has been excessively loose for far too long. The current Finance Minister’s remarkable personal capabilities seem to lie in being UPA-2’s political fixer at large. He seems to have neither the time to run the Finance Ministry, nor any serious understanding of anything economic or financial. That seems to have resulted in leaving the running of his ministry to fate. Arbitrary decisions are made on policy as well as key appointments. At a time when India needs a full-time Finance Minister, doing nothing but being Finance Minister, we have a Finance Minister who does not have time to be the Finance Minister. This replicates the situation with Agriculture where the Minister prefers to focus on cricket and the development of hillside resorts in the Western Ghats.

Worse still, there appears to be a rift emerging on economic policy between one faction that comprises the PM, the former RBI Governor C. Rangarajan (Chairman of the PM’s Council of Economic Advisors) and Deputy Chairman of the Planning Commission, Montek Singh Ahluwalia; and another less visible faction that pushes for the more socialist, less fiscally responsible, inclinations of the Congress Party and its President. The rift between the two factions is impelling the loss of fiscal control, while bedeviling the pursuit of sensible long-term macroeconomic policy and day-to-day management of the economy.

To a lesser extent, some blame lies with the RBI which perhaps did not act swiftly enough, early enough, to slay the dragon of galloping inflation. Then it perhaps overreacted, thus damaging growth. But it would be grossly unfair to lay too much blame at RBI’s door. Monetary policy cannot do all the heavy lifting in managing the burden of adjustment when fiscal policy is excessively loose for populist reasons. India now has the twin problems of managing income subsidies that are running out of control with unwanted side-effects, as well as managing the unbearable burden of price subsidies. In addition it now has a serious problem of its current account deficit (CAD) running out of control as an unexpectedly large devaluation of the INR increases the oil import bill and indeed the total import bill generally. Remember that India is a massive net importer. Fiscal deficits running out of control, alongside CADs also out of control, are a deadly combination – a definite harbinger of a financial crisis to follow.

Loose fiscal policy, aimed at populist vote-buying in the guise of helping the poor, has artificially pumped up aggregate demand since 2004; with unintended consequences, such as the disruption of rural labour markets that have created an artificial labour shortage in the sowing and harvesting seasons. Poor supply side policy and Public Distribution System management has artificially constrained aggregate supply, especially of food grains. The chickens have now come home to roost with inflation being fuelled not just by the ‘excess demand versus constrained supply’ problem (especially with food) but also by a weakening currency that will have an impact in fuelling even more inflation across-the-board down the line. The underlying trends suggest that India will soon encounter another serious financial crisis if it continues along its present path.

To prevent that, the following measures are indispensable: First, rapid and massive improvements in public and corporate governance to rebuild confidence in GoI and the Indian economy; Second, the Opposition relenting from its present path of obdurate opposition for opposition’s sake, even when that is against the long-term national interest; Third, moving ahead rapidly with a series of third-generation reforms including more ambitious privatisation, to further liberate the economy and financial system from excessive state control; Fourth, relaxing immediately current absurd policies restricting FDI in all domains, not just retailing or insurance, with Indian policy-makers surrendering their compulsive obsessions with 26, 49 and 74 percent limits and letting markets make those decisions; and last, swifter action being taken on bringing to closure the never ending soap operas on a variety of corruption scandals that keep playing out in the media; diminishing the country’s self-respect and its international image abroad.

Unfortunately, endemic economic ignorance on the part of four-fifths of the political class—a deficiency that so many prominent, economically illiterate, politicians seem inordinately proud of—will probably contrive to prevent all this from happening. That makes a crisis inevitable. But, since India has a record of reforming only when it is in crisis, there are many who must be thinking—“bring it on” – regardless of the enormous costs that such a crisis would entail, especially for the poorest!


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