For one evening--just a few hours really--the Indian rupee traded as if the appointment of Raghuram Rajan as the country’s chief central banker was some kind of Ramrajya. From an all time low of Rs 61.80 a dollar, it shot up to Rs 60.77. But next morning, the heady feeling had worn off, the hangover had begun and the rupee was back well above Rs 61. Among the media, analysts and the general talking head population, Rajan’s appointment was seen as evidence that the government was serious in solving our economic problems.
This kind of a thing is frightening. It shows that the elite of our country does not understand the nature of the problems we are facing and and the kind of actions that are needed to solve them.
Let’s do a quick survey of the problems and see what can be done. There are three major problems that we have:
1. Inflation is too high, especially the inflation that matters, which is consumer inflation
2. Growth is too low
3. The rupee is getting cheaper and cheaper. This is a by-product of the fact that far more money is flowing out of the country than is flowing in
What can be done to solve these problems? The answer is simple--growth. Improve infrastructure, remove bureaucratic hurdles, improve law and order, improve the education system etc. Also, as the great philosopher A.K. Antony would add, improve human nature. However, all this will take time to do and we haven’t even started doing most of it. The question is, what can be done NOW to stave off the immediate crisis.
Here’s a framework to understand the issue. The major lever that can be moved in the short-term is what is called monetary policy. This is the price of money, meaning interest rates. Here’s what is supposed to happen if you raise interest rates:
1. Inflation goes down
2. The rupee should stop falling, maybe even rise
3. Economic growth gets worse
Here’s what is supposed to happen if you lower interest rates:
1. Inflation increases
2. The rupee falls even more
3. Economic growth gets better
As usual there are some caveats. Here are the major ones:
• Some economists say that both inflation and poor growth in India are ‘structural’. What they mean by this is that there are other reasons like poor productivity and other economic hurdles that cause them. Therefore lower interest rates will not encourage growth and higher interest rates will not slow down inflation. This is probably partially (but only partially ) true.
• The rupee’s fall is supposed to be self-limiting. If the rupee keeps falling, then exports will become cheaper and therefore more competitive and imports will become too expensive. This will restore the balance and the rupee will eventually stabilise at a new level.
However, some economists say that because of poor productivity and infrastructure, Indian exports don’t rise when the rupee gets cheaper. This is borne out by the experience of recent months.
It is also likely that a falling rupee doesn’t really tamp down imports as much as it should. The main burdens on the import bill are gold and oil. In oil, the government shields consumers from high prices so we don’t consume less petro-products when prices rise. In gold, people’s hunger to buy seems disconnected with price. The government has taken some measures to control gold imports but the rising level of smuggling shows that it may have just driven imports underground.
One at a time
Anyhow, it’s clear that the three problems: falling rupee, low growth and high inflation, can’t all be tackled at the same time. Here are the options before Raghuram Rajan:
Option 1: Go for Growth, Let the Rupee Fall
Lower interest rates and let the rupee fall and inflation rise. Eventually, growth will take care of everything. The fear is that foreigners will pull out money if the rupee falls. This is not true. People pull out money based on future expectations. If the correct level for the rupee is Rs 75 (for example), then it’s better for it to get there quickly and then stabilise further future expectations.
Option 2: Go for Low Inflation, Protect the Rupee
Increase interest rates, and kill growth till inflation stabilises. This could also stabilise the rupee, maybe. However, the downside of poor growth will be terrible in the long run.
Now comes the politics. Option 1 is good for the country over long-term and bad in the short-term for the economy as well as the UPA’s election prospects. Option 2 is relatively good in the short-term and for the UPA’s election prospects but bad for the country over long-term.
The right choice now is a classic case of short-term pain and long-term gain. Prices are going to be high, fixed income returns low and the rupee is going to 70, maybe 75.
So that’s it. How has the PM and the FM defined Mr. Rajan’s job? If Raghuram Rajan is to save the country, then the UPA has to be sacrificed.
If the government of the Great Economist PM had not screwed up the economy so badly, then his party would not be in this hole today. But it is, and today good economics is bad politics. And vice versa.
Unfortunately, based on track record, one could also fear that the Great Economist will use his genius to invent a third option, one that combines the worst aspects of the above two. This could be something like the state that we are in now--high inflation, poor growth and weak rupee.
Any bets on what will actually happen?