Fighting without fighting

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A film that I still remember from my teenage years is the Bruce Lee classic, Enter the Dragon. In the film, when the group of contestants is travelling to the island for the tournament, Lee is asked by a rather aggressive competitor, Parsons, about his martial arts style. He responds that his is the art of “fighting without fighting”. He then demonstrates this by persuading Parsons to get into a dinghy, believing that they are going to a nearby island to fight. But Lee simply lets the dinghy rope play out and Parsons can do nothing about it, except, presumably, cool down.

As the policy establishment attempts to find a solution to the problem of rapid rupee depreciation, the public debate is full of combat analogies and metaphors describing the process. The opinion is overwhelmingly, if not unanimously, that the “battle” has been lost. More and more commentators are suggesting that an approach to the International Monetary Fund (IMF) is fast becoming inevitable. But, clearly, whether correctly or not, the government is greatly concerned about the political consequences of this. In a situation in which economic logic and political calculations are so much at odds with each other, perhaps Bruce Lee’s self-characterisation provides a lesson. What the government needs to think about is “going to the IMF without going to the IMF”.

The measures taken by the Reserve Bank of India (RBI) over the past four weeks need to be viewed in the context of a basic demand-supply framework. A currency is a unique “commodity”, in that it simultaneously has two prices, an external one (the exchange rate) and a domestic one (the interest rate). Unless specific measures are taken to disconnect the two prices, they will move in tandem. Looking at the exchange rate from a demand-supply perspective, there are two alternative ways to influence it with a view to resisting depreciation. You can either increase the supply of the other currency (say, the dollar), thereby making it cheaper, or you can reduce the supply of your currency, thus making it more expensive.

Increasing the supply of dollars can only be done by tapping into a new pool of resources. An IMF arrangement is certainly one option here, but not the only one. The others that have been talked about are a sovereign debt issue and, what is essentially the same thing, an NRI bond. Recent comments from both the RBI and the ministry of finance suggest that none of these options is being considered. Of course, this may change in a rapidly evolving situation.

The other option, which the RBI exercised, was to reduce the supply of rupees, through various liquidity management measures. There are many channels through which this might work on the exchange rate; the one that has been emphasised in the communication is that it makes speculating on the rupee more expensive and will, therefore, contain the additional downward pressure on the currency, leaving it to be determined by “fundamental” demand and supply factors. But to go back to the “two price” story, making the rupee more expensive outside also makes it so domestically. Consequently, interest rates have risen, which translates into heightened growth risks in an already delicate growth scenario.

In these circumstances, it appears to me that increasing the supply of dollars is the more effective way to stabilise the rupee. Its collateral damage to growth will be relatively lower. As mentioned earlier, this can either be done through the IMF or through the market (either a sovereign issue or through the NRI channel). And if the former is perceived to be infeasible for political reasons, that leaves just the latter.

Importantly, however, in terms of what needs to be done to get the money and for it to have its full impact, the inflow of dollars meaningful, there is actually very little difference. Whether formally, through an explicit set of conditionalities, or voluntarily, as a means of sending a positive signal to potential investors in a sovereign bond (not to mention rating agencies), a strategy to sharply reduce the current account deficit is an absolutely critical part of the plan. Do this, and the inflow from either of these sources will be reinforced by private flows, based on renewed confidence that the macroeconomic stresses are being dealt with. Don’t, and risk putting the economy in a situation in which an entry into an IMF programme becomes virtually inevitable.

The components of such a strategy have been widely commented upon, including by myself, but bear repeating. First, a significant reduction in imported energy sources is a priority. This includes pricing petroleum fuels to fully reflect the price of imported crude oil. It requires a rapid transition to cash transfers of subsidies to eligible beneficiaries for kerosene subsidies. It needs to tackle the huge burden of the implicit diesel subsidy flowing to unintended beneficiaries, mostly through diesel-fuelled passenger cars. Finally, it needs to incentivise domestic sources of energy. There has been progress on gas, but coal has fallen behind and poses a threat to the current account for years to come.

Second, the strategy needs to address the physical import of gold. Increasing import duties and other barriers to trade are not sustainable. The only tenable approach is to introduce financial products that provide investors at least some of the attributes of gold without requiring physical imports to the full extent. The existing stock of gold with Indian households also needs to be tapped into as far as possible. Here, products that are based on fractional reserves – that is, only a fraction of the total investment needs to be held in physical form – need to be experimented with and aggressively marketed. Even if physical imports were to be reduced by, say, 25 per cent, it would have a huge impact on the current account.

Third, the strategy needs to address the massive impact of shrunken iron ore exports on the current account. A phased approach to reactivating mining while strictly monitoring environmental compliance needs to be agreed upon and quickly activated.

If these steps are committed to, enhancing dollar inflows as a way to address the immediate pressure is feasible. Most importantly, there are options available at this point in time, which will not be there a few months from now. Better to fight without fighting than to fight at all.

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