'Exporters have to accept the rupee will vary'

Q&A/ Arvind Virmani

Arvind Virmani, who joined the finance ministry earlier this year as the Chief Economic Advisor, recently met up with our correspondents Siddharth Zarabi and Asit Ranjan Mishra. Pointing out that India became the third largest economy in purchasing power parity (PPP) terms last year; Virmani said managing capital inflows was a new type of challenge for policymakers. The interview was conducted shortly after the mid-year 2007-08 review of the Indian economy was placed in Parliament last month. Excerpts:

What is the big picture on the economy?

The key thing that has gone somewhat unnoticed is that India, in 2006, became the third largest economy in purchasing power parity (PPP) terms. Interestingly, the contribution of India to world growth, weighted by PPP, was the second highest in the world after China. This is the first time that it has happened. The important thing to note here is that it is more than the United States'. But, for those who give less stress to PPP (days after the interview, the World Bank reduced its PPP estimate of India's 2005 GDP by 40 per cent), it is equally interesting to note that for the first time India's contribution to global GDP, even weighted by current exchange rates, was the fifth highest (after the US, EU, China and Japan) in the world. These two-three things, taken together, are a milestone, which has been crossed.

How has it changed from the past?

We did not even appear in these lists. So, performance counts. There is no point only talking about what we can do. Size by itself is not everything, although it does influence many other things "" for instance, attractiveness to FDI. What we are really interested in is the per capita income. We are still a low-income country. Maybe in the next two to three years, we will go from being a low-income country to a lower-middle-income one.

What do three years of sustained growth suggest?

The sustained growth of 9 per cent-plus for three years suggests that additional things seem to have happened and tentatively, the review points out that this could be because of the change in the perception about India. Perhaps, global companies are beginning to recognise that the growth step-up in India is a long-term thing. This has perhaps led to higher growth than anticipated two to three years ago. As a result, you are getting much larger inflows of capital, as people perceive opportunities.

However, all the money that comes in may not be invested in productive opportunities. In the lag period, there is accumulation of capital in terms of reserves and this has a monetary effect. It is a new type of challenge to manage such inflows and is different from earlier years, when we used to worry about lower inflows. We have to sustain higher growth and manage inflows in a more integrated manner. As long as the growth process remains, the perception of India will remain, and inflows will continue.

You said capital flows need to be managed better...

With capital inflows, one immediate impact is that it reduces the cost of capital. That means people are willing to look at more investment, which previously they thought was not productive. This has all kinds of effects in terms of what happens to imports and import policy, the current account deficit, and how the financial market intermediaries work in the process.

Normally, each government department does its own thing. But in the current situation, one has to have an integrated view on how to manage the structure. If you do not manage inflows properly, then you lose the benefits and witness a negative impact. Part of this is the possibility of currency appreciation affecting certain types of exports. So, export policy comes into the picture. Depending on how much you sterilise or not (the rupee), there is a possibility of inflation going up. So, all these things have to be looked at in an integrated way.

Is there a crisis of high inflows?

There is no question of a crisis. One simple analogy is that if somebody wins a lottery, he does not know what to do with the money. So, it is a challenge, not a crisis.

What additional policy options or instruments are available to control inflows?

It is not that we will invent something new. The point is different things have been happening, which have been helpful in this regard. For instance, tariff rates have been going down. It has improved the economy's efficiency and increased the import intensity. That has helped.

Is a Tobin-like tax a possibility?

The academic view is that taxes cannot be sustained for long as they get evaded. What is being compared is a situation between no tax and tax. But we have had controls for 15 years. It was a deliberate decision to control inflows and it has worked very well. One has to interpret theory very carefully. The situation in India is very different from other countries. There are many things and that is what innovation means: collecting all the possibilities and discussing them. I would certainly not say that it is not a possibility. The situation here is different and it is not like we do not have any controls here. It is an optional thing and is not imminent.

Will the sub-prime crisis impact capital flows and India's growth?

We have not explicitly addressed this issue in the review, but it is at the back of what we have said. If the uncertainly was not there, one could have more confidently spoken of 9 per cent growth. However, since it is a major source of uncertainty, one has to be cautious. We do not see it (the sub-prime crisis) having a big impact on India's growth. It will have some impact "" you cannot escape it altogether. However, I do not expect growth to be below 8.5 per cent this year (2007-08).

What is your view on inflation?

Globally, the Consumer Price Index (CPI) is the most commonly used measure of inflation. India does not have a single CPI, we have sectional indices. So, we have conventionally used the Wholesale Price Index (WPI), which has a weakness as it does not capture services. What I am going to look at will come out in the Economic Survey (to be presented next February).

I would have been worried if primary inflation was not coming down, but it is. I would go with the RBI's forecast of 4-5 per cent at the end of the year (March 31, 2008).

Has the review soft-peddled the impact of rupee appreciation?

Trade data for the April-October period shows a growth rate of 20 per cent in dollar terms. That is certainly not a bad growth rate. There are different views on this issue. In fact, Ajay Shah and others at the NIPFP did some research (which we financed), the results of which show that there is no effect. I do not agree with that. They say that a 10 per cent appreciation or depreciation, would have a 0.1 per cent impact or some very minuscule number. It depends on the pass through effect.

However, we do believe something that the finance minister has emphasised very often, that one of the things that it depends upon is the extent of domestic value addition. Everybody was shocked at the extent of the appreciation and there has been a short-term problem. The government has offered exporters help. They need to understand there will be fluctuations in the exchange rate.