For a stronger economy: we need economic reforms beyond liberalization
India’s economy was expected to collapse due to the pandemic. But its recovery has been better than that of most countries. Appropriate countercyclical policy allowed this, but it worked because the reforms had reached a threshold of adequacy. In the recent past, growth has suffered from an excessive focus on structural reforms while neglecting the mitigation of shocks. Current policy has responded to the latter. But talk of the need for reform is once again in the air. So what are the necessary reforms?
A major objective of international institutions such as the IMF-WB is to ensure benefits to other countries from India’s growth, especially their major financiers who are major capital exporting countries. It follows that they want to ensure freer markets and fewer restrictions on all types of capital flows. Much of this is in India’s interest since we need more capital and better integration with global markets. But a democracy cannot ignore the concerns of its own citizens. The IMF-WB holy trinity of structural land, labor and other market-opening reforms harms many national citizens and, beyond a certain point, encounters severe resistance that imposes political costs important.
Liberalization has reached a point of diminishing returns. Everything that was doable in the above is surely in motion now. Further organic reforms will take place as states compete. Improving supply has many other aspects. In choosing from the reform menu, the Center should be guided by feasibility and pragmatism and ensure that the benefits accrue to the majority.
The focus should be on exploiting the special circumstances that currently favor India. These include the boost that Covid-19 has given to the digital aspects, where India has a comparative advantage, the opportunity for supply chain diversification outside of China, to shift to a net economy zero and exploit green initiatives as a source of investment and innovation. Particular attention should be given to developing skills and capacities, improving employability, increasing infrastructure, reducing logistics and other business costs through better coordination between the central state and improving the quality of governance and countercyclical regulation with the right incentives. Much can be done to improve the use and privacy of data, the functioning of courts and the police. Instead of wasting political capital on reforms that meet strong resistance and shock the system, reforms should reinforce favorable trends.
Yet suggestions for reform continue with the liberalization agenda.
Privatization of banks: It is recommended that most public sector banks (PSBs) be privatized, starting with those that are doing well. But the argument that PSOs are a drain on taxpayers’ money is based on the experience of the past decade. In the 2000s, they were doing better than private banks and resisting the global financial crisis better. NPAs have risen because they have been pushed to lend to infrastructure where there are inherent mismatches between assets and liabilities for commercial banks. Moreover, it was the first time that the loans were granted to private companies. Therefore, a full resolution had to wait for the missing regulatory framework for bankruptcy to be in place. Improvements in PSB governance and risk-based lending profiles have resulted in lower NPA ratios and strong capital adequacy, even under pandemic shocks. Social schemes that used to strain PSB resources are now largely funded by direct government grants.
The diversity of institutions and approaches makes the financial sector more stable. Many savers trust PSBs. They have raked in 1.7 trillion rupees from their Jan Dhan accounts, while private banks have virtually none. PSBs can leverage their advantages in low-cost deposits through numerous co-lending opportunities and partnerships. The economy has suffered very weak credit growth over the past decade and is poised for a turnaround. Private banks alone could not expand credit adequately – when PSO lending had slowed. Now is not the time to disrupt the recovery in credit growth. PSOs should be allowed to compete and raise resources on their own. Only those who cannot, or who have other serious weaknesses, should be allowed to exit through privatization or merger. The strong will prosper. China’s mode of growth, where the public sector shrinks as the private sector grows faster, would work better for India as well.
Exchange Rate Overshoot: There are recommendations that the Rupee should be completely market determined. It should be allowed to sink under foreign flows as this would benefit exporters. But the pass-through of exchange rate depreciation is much faster in Indian imports, which are dominated by dollar-denominated commodities like crude oil. Indian exporters generally have little market power and are forced to share the profits of depreciation. Numerous studies show that they do not profit from volatility. As imported inflation rises, monetary tightening follows and hurts the real sector. Real appreciation leads to and requires greater nominal depreciation. Any gain for exporters resulting from an overrun is temporary. The fall in the rupee’s exchange rate from around Rs 8 in the 1990s to around Rs 80 currently has not resulted in a sustained increase in exports.
Market panics and large deviations from competitive real exchange rates harm the economy and most participants. Lower real exchange rate volatility helps both winners and losers when the value of the rupee changes. Positive and negative deviations from equilibrium real rates are detrimental. Only a fraction of Foreign Portfolio Flows (REITs) that seek trading advantages profit from volatility, not the majority that have consistent engagement and are there to benefit from India’s growth. Commercial REITs want to be first out, take profits, and then wait for a rupee crash before coming back. If they know there won’t be a crash, they have less incentive to be the first out. The country’s risk premium is falling. This may have contributed to an inversion of the outputs.
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Some volatility in the rupee is good and encourages companies to hedge currency risks. Central banks typically let the currency fall below outflows, so outflow REITs receive less. Then the bank comes into play, buying low, stabilizing the currency and reducing the overshoot. The trend depreciation must offset inflation and productivity differentials. That US inflation exceeds that of India, and that productivity tends to increase with growth, reduces the necessary depreciation. This helps exports if the rupee depreciates as much as major export competitors. The depreciation was close to that of the Chinese currency. Thus, the intervention that prevents the overshoot has only facilitated the functioning of the markets and their discovery of equilibrium values.
The author is a member, Monetary Policy Committee and Professor Emeritus, IGIDR