Setting some conditions

What the government needs is an IMF programme - without the IMF

The possibility that India is one Ben Bernanke non-decision or one election freebie away from a serious external financing crisis cannot be ruled out. How is this government trying to head off such a crisis? How should it do so? A simple framework helps answer both questions.

This government has three objectives in descending order of priority: winning the next elections, averting a crisis, and preventing a sharp slowdown in growth. One could argue that, in the short run, it cares about the latter two only to the extent that they facilitate the attainment of the first objective. And, as a very illuminating JPMorgan document recently showed, averting the crisis requires India to attract about $25 billion in incremental portfolio inflows in the second half of this year to meet the country's external financing requirements. Failure to do so will push India close to the precipice.

To achieve these objectives, the government has three instruments: fiscal policy, monetary policy and deeper structural reforms. Increasingly, the government is deploying fiscal policy directly to the objective of winning elections. Handing out food, making direct cash transfers, and perhaps even reducing the debt burden of farmers are all policy possibilities. The underlying electoral strategy is to blanket rural India with money and handouts to counteract a possible Narendra Modi wave in urban India.

The government is then left with structural reforms and monetary policy to prevent a crisis and a growth slowdown. To be fair, it has implemented structural reforms by announcing liberalisation of foreign direct investment and trying to clear projects more expeditiously. But the deeper uncertainty about the regulatory framework for investment in India - especially in infrastructure, reflected in the yo-yo of actions that attract and repel investors - has effectively taken that policy instrument out of the equation.

That has left the government with monetary policy as the sole instrument in play. The Reserve Bank of India's (RBI's) clumsy recent surge-and-retreat illustrated the dilemma that monetary policy couldn't achieve two objectives: indeed, to the extent that it can help avert a financial crisis, it can do so only by squeezing growth, thereby reducing demand and hence imports.

 

The government believes it has an additional instrument up its sleeve to address the financing problem: the appeal to patriotism, which would wrench non-resident Indians to open their deep pockets to finance some of the $25 billion that is needed to fill the external funding gap.

Now, this strategy might well work: Mr Bernanke could continue the policy of quantitative easing; increased spending could lure rural voters into voting for the Congress without undermining investor confidence; the monsoons could be good enough to keep inflation on a leash while unleashing rural purchasing power; and non-resident Indians might well step up to finance the external deficit, as they have done previously.

But the government's strategy is a high-risk one. Tenuous fundamentals - slowing growth, high fiscal deficits, exasperated investors and entrepreneurs, and a looming external financing problem - will only require small triggers (often from the most unlikely source) to set off a conflagration.

So, what should the government do and not do? It must recognise that India is similar to all those countries that have been on the verge of an external financing crisis, and it must take the same sort of actions that they have taken. For obvious political reasons, the government cannot go to the International Monetary Fund (IMF) cap-in-hand. But what it needs is the ingredients of an IMF programme informed by co-ordinated, consistent and stable policies of adjustment and reform. In other words, India needs the following dose of self-conditionality.

• Fiscal policy is fundamental: with structural reforms of India's investment regulations ruled out as a helpful short-run measure, investor confidence will be overwhelmingly determined by the commitment to some semblance of control over the public finances. Investors are acutely aware, and make some allowance for the fact, that this is an election year. But even so, pre-election freebies must remain a trickle rather than turn into a flood.

Strenuous defences of the food security Bill on the grounds that its incremental cost is limited are unlikely to engender confidence, because the situation demands deficit reductions, not smaller-than-expected deficit increases. It is worth emphasising that the challenge is not one of preventing further outflows of capital, but to attract additional inflows of about $25 billion. The government, therefore, needs to reaffirm its commitment to achieving the deficit targets, this year and in the medium term - and underscore this commitment with actions, for example by raising prices to contain the emerging subsidy overruns.

• Monetary policy must be coherent: if fiscal policy remains uncontrolled, attempts to tighten liquidity through short-term squeezes and anti-market regulations will surely fail. Nor should the RBI target particular investors to squeeze or particular liquidity windows to tighten, such as by raising interest rates in the overnight bank funds market but not in the treasury bill market. Liquidity is fungible, so tightening must be broad-based. At its next meeting, and following up on Tuesday's measures, the RBI must raise its policy rates moderately, say by about 25-50 basis points, and allow the market rates to adjust commensurately. Above all, the RBI must stick to a steady policy of tightening to arrest the inflationary pressures that have been intensified by the decline of the rupee; any help that higher rates provide in retaining or attracting capital will be a bonus.
   
• The rupee must not be defended: at current levels, the rupee may well be slightly undervalued. Moreover, a declining rupee will stoke inflation and increase the fiscal deficit. But valid as all these arguments are, they cannot be a basis for defending the current level of the rupee. The reason is simply that the RBI and government cannot easily defend the rupee (interventions to smooth undue currency fluctuations must, of course, continue). Foreign exchange reserves are considered low, and the sharp liquidity squeeze that results from any significant intervention will not be politically sustainable, as the outcry over the RBI's moves last week showed. And the RBI that tries to defend a particular rate - without the underlying policy fundamentals in place - could be a sitting duck for speculative attacks.
   
• Foreign borrowing must not be further encouraged: the cardinal sin that this government has committed since the global financial crisis, ignoring all the lessons that have been learnt from recent and historical experience, has been to try to paper over its problems by encouraging foreign borrowing. This strategy has come back to haunt the country now and will continue to do so in the future. The desperation to attract capital in the short run is forcing the government into actions (facilitating increased debt inflows) that are at best debatable and at worst a burdensome legacy.

Some variant of this IMF-programme-without-the IMF will be critical for the government to implement in the weeks ahead. If not, at some point down the road, this government or its successor might well have to confront the unpalatable prospect of a real IMF programme. Will history then remember the Manmohan Singh of the IMF programme of 1991 - or that of 2014?

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The writer is senior fellow, Peterson Institute for International Economics and Centre for Global Development