Govt should increase inflation target; let RBI balance external accounts

Nobel Laureate Robert Mundell had coined the expression “impossible trinity” in the 1960s (when cross-border capital flows were far smaller compared with today’s) while arguing that a liberal capital account, an independent monetary policy and managed exchange rates cannot co-exist. One wonders whether we are in the process of trying to work an “impossible quartet” of macro-economic objectives and policies: Fiscal austerity; high real interest and exchange rates; solving the problem of bad debts of the banking system; and pursuing rapid economic growth and job creation.  

As for exchange rate and growth, last week the Swiss central bank blamed the strong Swiss franc for economic growth lagging that of even the Euro Zone. It has promised to continue its ultra-loose monetary policy to push up growth and, hopefully, pull down the currency. Clearly, even advanced economies manufacturing “differentiated” products are not immune to the exchange rate disease — economies like India’s are even more dependent on a competitive exchange rate for rapid growth and job creation. As Dr Shankar Acharya, the former Chief Economic Advisor of the Government of India, argued in this paper (“Beware a Strong Rupee”, May 19), “the history of global economic development since 1950 does not support the view that long periods of a ‘strong’ currency have been good for growth and development of nations. On the contrary, East Asian economies such as Japan, South Korea, Taiwan, China and Thailand… generally eschewed currency ‘strength’ and opted to maintain competitive exchange rates…” The result of our exchange rate policy is that, net of secondary income (mainly remittances which are not our “earnings”), the current account deficit in 2016/17 was $70 billion, or 3 per cent of GDP. As conventionally headlined, the deficit was $15 billion, or 0.7 per cent of GDP as per data released last week. Our exports were $280 billion, an eighth of China’s, less than Taiwan’s, and only a little more than Thailand or Vietnam’s (both $200 billion plus).  

Coming back to the non-performing assets (NPAs) of the banking system, last week the Reserve Bank of India (RBI) asked lender banks to initiate bankruptcy proceedings under the new Code against 12 companies, which are some of the largest borrowers from the banking system — their outstandings total about Rs 2.5 trillion or a third of the system’s NPAs. Interestingly, almost half the 12 are from the steel industry, a part of the tradeables sector whose fortunes are dependent on the exchange rate. This apart, these 12 cases, and their resolution, would be the first test of the efficacy of the Insolvency and Bankruptcy Code. The resolution would also give a better estimate of the likely write-offs to convert bad debts into performing assets, or their liquidation as the case may be — and of the funding needed to recapitalise public sector banks to meet Basel-III standards. Whatever the mechanism – a “bad bank”, asset reconstruction companies, proceedings under the Code, or management changes – one cannot get away from the need of public funding to the extent of a few trillion rupees. This apart, public debt will also go up with state after state taking on the burden of farmers’ debts.

Infrastructure is another major segment in the first 12 cases identified by the RBI referred to above. It is, almost by definition, capital intensive, and real interest rates are very important to its economics. It is worth recalling that, after the debt crisis of 2008, the central banks in the UK and the US reduced interest rates sharply, and gave fiscal support to banks — remember the Troubled Asset Reconstruction Program (TARP) in US, which was about 5 per cent of GDP? (To be sure, our debt problem is much less severe than the mortgage loans crisis of 2008.)

Coming back to the current account, the deficit is much less than the assumption of 2.3 per cent by the FRBM review panel, even as public debt is likely to go up. Meanwhile, investment as a percentage of GDP has been falling for the last few years in both public and private sectors: The former because of self-imposed fiscal constraints; the latter because of banks’ increasing reluctance to fund such projects, having burnt their fingers. This will surely affect future growth and job creation. Clearly, the quartet cannot sing in tune. There is a way out — give up or relax the first two. In other words, increase the inflation target; give a target to the RBI of balancing the external account, net of secondary income; and ignore the rating companies’ (and the panel’s) views on public debt and deficits.
The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com