The Budget, the Survey and the trilemma

The Economic Survey correctly argues for investment-led growth. The Budget understandably wants to tap a cheap pool of global savings. But can these co-exist?

Two big themes emerged from this year’s Economic Survey and Budget — one explicit and the other more implicit. The Survey explicitly batted for re-stoking investment-led growth. This is foundational. As the contrasting experiences of Latin America and East Asia — as well as India’s own experience in the mid-2000s — have revealed, strong growth can only be sustained when underpinned by private investment. Bursts of consumption-driven growth are unsustainable because they inevitably spawn imbalances, either domestic (higher inflation) or external (wider current account deficits). An investment-led strategy therefore has to be the lynchpin for sustained 8 per cent growth. 

Meanwhile, a key theme emerging from the Budget was a conscious strategy to rely on greater foreign savings. Hence the Budget enumerated a series of measures to attract more FDI, foreign portfolio investment, and issue a sovereign dollar bond. The motivation is unsurprising. With household savings declining in recent years (as households have dipped into savings to support consumption growth) and the public sector using up virtually all household financial savings, concerns about private sector crowding-out have progressively risen. On the flip side, the global interest-rate cycle has turned again in 2019 with G3 central banks expected to ease further. Why not tap cheap foreign savings to fill the gap?

While this may alleviate short-term domestic pressures, a medium-term strategy to harness foreign savings is incompatible with an investment-led strategy to drive domestic growth. Why is that? Because an investment-led strategy is necessarily an export-led strategy. Here’s why.

Investment & exports

If the investment rate has to rise, the domestic savings rate must rise in tandem. If not, the current account deficit (which is just the investment-savings gap in an economy) will balloon, increasing macroeconomic uncertainty and choking off the very investment that is needed. However, if the savings rate has to go up, by construction, consumption to GDP will have to come down. 

But if consumption to GDP is coming down why would the investment rate be presumed to go up? Why would entrepreneurs accelerate investment if consumption growth is slowing? Only if exports — the other driver of demand — are growing rapidly to make up the difference. And therein lies the key: That for any investment-led model to sustain, it must necessarily be driven by strong exports growth. Otherwise the model is internally inconsistent and unsustainable. Therefore no country has experienced close to double digit-growth without investment and exports acting in concert.

This combination is exactly what drove India in the mid-2000s. Between 2001 and 2006, GDP growth averaged almost 8 per cent, and investment growth averaged 16 per cent a year. Guess what drove investment? Exports — which grew 20 per cent a year in those years. In contrast, private consumption grew at 7.2 per cent — less than GDP growth — such that consumption-GDP fell and the savings rate went up to help finance investment. India became China-like in the mid-2000s, till the global financial crisis hit. 

We need an encore. For strong growth to sustain, India will need sustained investment. But for investment to be sustained (and financed at home) India will need exports to fire.

Exports & the exchange rate 

And herein lies the tension. If growth is to be driven by exports, it’s incompatible with an excessive reliance on foreign savings (and the associated capital inflows) that will put upward pressure on the exchange rate. There is a casual belief in India that exchange rates don’t matter for exports. However, as we have previously shown in an empirical analysis at the India Policy Form, exchange rates — along with global growth — are a crucial determinant of India’s exports.

Export growth surged between 2005 and 2011, growing at 14 per cent a year. Since then, they have slumped to 4 per cent average growth. Some of this is, undoubtedly, because of both slowing global growth and deglobalisation. But, as we have shown in our IPF paper, some of the export slowdown is also attributable to the 20 per cent appreciation of the real effective exchange rate (REER) between 2014 and 2017. To be fair, there was little policymakers could have done to prevent the appreciation because it was the upshot of a large, positive terms of trade shock to the economy from lower crude prices along with strong capital inflows which — as theory suggests — should cause both actual and equilibrium real exchange rates to appreciate. 

As crude prices climbed back up, the REER depreciated almost 10 per cent in 2018, but more than half of that depreciation has reversed in recent months. All told, therefore, the REER is still almost 15 per cent stronger than it was five years ago. Some could argue this is not worrying because it simply reflects higher productivity growth in India. But that hypothesis does not gel with the fact that India’s underlying current account balance (ex oil and gold) has consistently worsened over the last five years — suggesting external competitiveness is increasingly under pressure. If the REER was reflecting productivity gains, competitiveness wouldn’t be getting progressive threatened. 

The exchange rate & the trilemma

It will be hard enough to boost exports in a world of slowing growth and rising protectionism and nativism. What India doesn’t need is for the exchange rate to compound the challenge. It’s therefore important for policy not to inadvertently induce further appreciation pressures. The real exchange rate is impacted by several factors: productivity differentials, terms of trade, government spending, and capital inflows/net foreign assets. Therefore, any policy that aggressively attempts to attract capital inflows risks inducing more appreciation. In 2017-18, for example, capital flows surged to 3.5 per cent of GDP pushing up the broad REER by almost 5 per cent that year alone. 

But couldn’t the RBI intervene to prevent appreciation? For starters, because the real exchange rate is driven by fundamentals, the central bank cannot meaningfully influence it over any length of time. Second, even when attempting to influence the nominal exchange rate, the central bank comes up against the trilemma. With India’s need for independent monetary policy, the more the capital account is open, the less control policymakers will have over the exchange rate. To be sure, sterilised intervention does give the RBI some degrees of freedom, but this is not without distortions. Over the last two months, for example, India has received strong capital inflows after the decisive May election result. On its part, the RBI has intervened aggressively to prevent a rupee appreciation. Much of this has been sterilised by paying forwards in the foreign exchange market. But this has also contributed to pushing up the forward premium, which will disincentivise corporates and importers from hedging, risking financial instability. Similarly, had the RBI intervened only through buying dollars in the spot market and then soaked out the liquidity through OMO sales, it would have pushed up domestic bond yields, and potentially attracted more “carry inflows”. In other words, there’s no free lunch.

All told, therefore, a strategy that relies on foreign savings risks putting more upward pressure on the real exchange rate and impeding export growth, at a time when exports will have to catalyse investment. 

So what should authorities do? First, don’t resist rupee depreciation, particularly if the Chinese yuan is also depreciating, because India’s greatest competitiveness concerns are vis-à-vis China. Second, avoid excessive reliance on foreign savings. Instead reduce total public sector borrowing so that more domestic savings are available to finance domestic investment. Once investment gets a fillip, savings will rise in tandem given their pro-cyclicality. Third, double down on factor market reform, infrastructure and transportation logistics to improve external competitiveness, and expand India’s global export share, thereby creating the impetus for an investment revival. 

All this won’t be easy, but is unavoidable if we aspire for sustained 8 per cent growth.

The author is chief India economist, JP Morgan