India's welcome new economic broom

Reuters

India's chief economic adviser Raghuram Rajan walks inside the finance ministry in New Delhi August 6, 2013. India named Rajan, a prominent former International Monetary Fund chief economist who in 2005 predicted the global financial crisis, to lead the Reserve Bank of India (RBI) as the country struggles to defend a rupee that hit a record low on Tuesday.

Article Highlights

  • By any reasonable metric, the Indian economy is in deep trouble.

    Tweet This

  • Economic growth in India had averaged around 8% in the decade prior to 2010 has now slumped to barely 5%.

    Tweet This

  • True to form, the Indian government has responded to the foreign exchange crisis with a piecemeal approach.

    Tweet This

Raghuram Rajan, the highly respected Chicago academic and former IMF chief economist, could not be assuming the helm of the Reserve Bank of India early next month at a more opportune moment for India. For his stellar international reputation and his many years of experience abroad should allow him to make the world of difference as to how India handles its worst foreign exchange crisis since 1991.

However, if Mr. Rajan is to succeed in a manner that is conducive to returning India to the rapid economic growth path on which the country had been until recently, he will need to remain true to the free market principles that he espoused whilst in Chicago. This carries with it the most important of implications not only for India but also for the global economy, since over the past few years India, along with China, has been a major source of global economic growth.

An economy on the brink

By any reasonable metric, the Indian economy is in deep trouble. Both domestic and foreign investors have lost confidence in the general direction of the economy in an environment of excessive government involvement and the poor handling of the country’s public finances. As a result, economic growth which had averaged around 8 percent in the decade prior to 2010 has now slumped to barely 5 percent. Equally disturbing has been the rise in consumer price inflation to almost 10 percent, which has to carry with it the deepest of social and political implications.

A further and more immediate indication of India’s present economic malaise is its current experience of a full blown exchange rate crisis. Over the past six weeks alone the Indian rupee has plunged by over 15 percent bringing its total decline over the past two years to almost 30 percent. Part of this decline is to be explained by a widening in India’s external current account deficit to almost 5 percent of GDP. However, the more important source of foreign exchange pressure is coming from outward capital flows by both domestic residents and foreigners, who are becoming increasingly reluctant to finance India’s external account imbalances.

True to form, the Indian government has responded to the foreign exchange crisis with a piecemeal approach that has been addressing the symptoms rather than the underlying causes of the crisis. Among the measures adopted have been increased tariffs and tighter restrictions on gold imports as well very much tighter restrictions on corporate and household capital outflows. Little wonder then that despite these measures, the Indian rupee keeps depreciating in the market to record low levels for want of a coherent plan to stabilize the currency.

The time is now

By now it should be clear to Indian policymakers that the foreign exchange crisis needs to be addressed by a basic shift in the overall macroeconomic policy approach aimed at restoring domestic and foreign investor confidence in the Indian economic growth model. It should also be clear by now that India does not have the luxury of waiting till after the scheduled May 2014 parliamentary elections to implement such a shift. This would seem to be particularly the case in the context of the tighter global liquidity conditions that might be expected once the US Federal Reserve starts to taper its quantitative easing program. For in the absence of an early restoration of investor confidence, India’s currency could go into a real tailspin. Such an eventuality would leave Mr. Rajan with little alternative but to hike interest rates to levels that could have untoward consequences for India’s highly indebted corporate sector.

At the heart of any strategy to demonstrate to investors that India was serious about getting the country back on a rapid economic growth path would be a redoubled effort to restore momentum to the country’s stalled structural reform program and to reduce the general government’s budget deficit from its present level of around 10 percent of GDP. In particular, bold steps should be taken to move the pricing and allocation of energy and food resources to a market basis that would improve both transparency and efficiency. In addition, every effort should be made to minimize the many structural roadblocks to investment as well as to improve the functioning of the labor market.

At the end of 1999, when Brazil was in the midst of a foreign exchange crisis similar to that now being experienced by India, the Brazilian government recruited Arminio Fraga, a highly respected former Princeton academic and Wall Street trader, to head its central bank. The Brazilian government also used Mr. Fraga to great effect to convince both domestic and foreign investors about the seriousness of the Brazilian government’s intention to reform its policy ways.

One has to wonder whether the Indian government would not be well advised to emulate the Brazilian success story of 1999 and use Mr. Rajan now not simply as the man in charge at the Reserve Bank of India but rather as the principal architect and point person for a revamped economic policy approach. However, for such a strategy to work, the Indian government would have to rise to the occasion by putting politics aside and by coming up with a coherent policy plan both to revitalize the structural reform process and to address the country’s saving and investment imbalance that might be credibly sold to a skeptical investor community.

Desmond Lachman is a resident fellow at the American Enterprise institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Desmond
Lachman

What's new on AEI

Retirement crisis is hyped
image Why the Foley beheading will force Obama to continue US airstrikes
image How the New York Times misguides their readers on Internet regulation
image US still has time to stake out a position of strength on Ukraine
AEI on Facebook
Events Calendar
  • 18
    MON
  • 19
    TUE
  • 20
    WED
  • 21
    THU
  • 22
    FRI
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled today.
No events scheduled this day.
No events scheduled this day.