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Suman Bery: Real choices

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Suman Bery New Delhi
The debate on exchange rates should really be about how best to stimulate investment.
 
Conversations over the recent Diwali holiday reveal two quite different perspectives on the recent management of the Indian economy.
 
Those with a dominantly domestic focus tend to be sharply critical. Some are disturbed by the rise in the rupee against the dollar; others oppose exchange market intervention even when sterilised through bond sales.
 
Opinions are equally divided on the issue of capital controls, particularly external commercial borrowing and participatory notes. Some feel that the existence (or reimposition) of such controls is of little consequence. Others argue that it is capital account freedom (just as much as trade liberalisation) which is responsible for the boom we are currently experiencing.
 
By contrast, those with a more cross-country perspective tend to view India as one among many large emerging markets, many of which are experiencing similar problems and issues. India's management of this phase of the global cycle is along the lines of many of its peers: to seize the opportunities currently offered by the global markets without taking unacceptable risks.
 
On these matters, the immediate resource is the invaluable back pages of Economist magazine. The November 3 edition reveals that, in local currency terms, India's stock-market performance in dollar terms (up 62 per cent over the year) is certainly at the upper end of the range, though not outlandish. Turkey and Brazil do better than us, South Korea and Thailand somewhat worse. The contribution made by appreciation against the dollar is also higher in Brazil and Turkey than in India, although India's appreciation is among the most rapid in developing Asia. Even with this degree of nominal appreciation, India's inflation rate, particularly the CPI, remains at the upper end of large emerging markets.* More surprisingly India is one of the few emerging markets running a current account deficit, although so far a relatively modest one of 1.1 per cent of GDP. (South Africa is running a much larger deficit, of 6.5 per cent of GDP.)
 
Where should we want (and expect) things to go from here? For me, the critical issue is how our policies help to expand efficient investment.
 
As I have often argued in the past, our desired (and desirable) investment rate exceeds our domestic savings rate, particularly as the latter is diminished by our fiscal weakness. This is unlike, say, China, which is a structural exporter of capital owing to the peculiar distortions in its state-owned corporate sector.
 
We should not draw artificial distinctions between foreign direct investment (FDI) and foreign portfolio investment. Both are foreign sources of financing for domestic investment, but they are both sterile if real resources are not made available to the economy. This can only happen with a widening of the current account deficit.
 
I had in the past accepted the rule of thumb that a prudent current account deficit was of the order of 2 per cent of GDP; I believe this was a principle first articulated by Dr Rangarajan a few years ago. Much has since happened both to growth expectations and the incentive framework. There is greater assurance today that foreign resources will be efficiently used so as to yield a positive return at world prices. So I would suggest that the level of the current account deficit considered "safe" be raised a notch or two, perhaps even doubled to around 4 per cent of GDP. One should remember that current account deficits of up to 6 per cent of GDP were common at the take-off stage in many Asian and Latin American economies.
 
How does one achieve this, what are the gains and what are the risks? It seems clear that a lower relative price of tradable goods (to nontradables) has to be part of this adjustment. This is just another way of describing an appreciation of the real exchange rate.
 
Such a real appreciation can occur in a number of ways: through reduction in customs duties on imports; through domestic inflation particularly focused on nontradables (chiefly labour, land and infrastructure services); or through some adjustment in the nominal exchange rate. If one actively wants to encourage a larger current account deficit, then appreciating the nominal exchange rate is a less inflationary route to pursue.
 
Put another way, the economy is looking to reallocate resources to the nontradables sector, which is where the returns are currently higher. In the short run these resources need to come from the tradable sector (including agriculture, as in the supply of agricultural land for higher valued urban uses).
 
Dynamically, the story could be very different as additional capacity gets created, and as labour force participation increases. Ideally one wants to use the resources available to expand the scale of the economy so that a smaller share of the tradables sector still represents an absolute expansion in its size.
 
Somewhat amazingly this realisation seems to have now hit the government, in that the Finance Minister (and the Commerce Minister) in recent encounters have counselled industry to prepare for a stronger rupee. Of course, a stronger fiscal adjustment than is under way at present would boost the domestic savings rate and allow a higher investment rate for a given current account deficit. Lower interest rates would achieve the same while damping hot money flows.
 
Critics will argue that this is exactly wrong: that investment growth should be maximised by boosting returns in the tradables sector as in the classic models of export-led growth, and that it is dangerous and imprudent to use foreign resources to increase the supply of non-tradables. This is of course the essence of the "Dutch disease" dilemma. These concerns will be heightened by the peculiar structure of our balance of payments, where a large trade deficit (7 per cent of GDP) is balanced by a services surplus of 6 per cent of GDP. The net capital account surplus of over 5 per cent of GDP is over and above that.
 
In sum, where capital flows are concerned the maxim "no pain, no gain" applies. The world has bought the India story and wants to be part of it. Equally corporate India wants to go abroad (and to be defended from external predators). All these point to an appreciated exchange rate. We cannot fight it; we should instead attempt to maximise the benefits and manage the collateral costs.
 
*Reserve Bank of India: Macroeconomic and Monetary Developments, Mid-Year Review 2007-08, October 30, Table 28
The author is Director-General, National Council of Applied Economic Research. Views expressed are personal

 
 

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First Published: Nov 13 2007 | 12:00 AM IST

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