India Policy Watch #1: To Catch A Falling Rupee
Insights on burning policy issues in India
— RSJ
The Indian rupee this week declined to an all-time low as it went beyond 80 per dollar. For reasons that aren’t always clear to me, this kind of thing makes a lot of news in India. I mean, it was 79.9 the week before. There isn’t a yawning gap between that and 80. Yet opinion pieces are written, cartoons sketched, and old tweets of macroeconomic theorists like Akshay Kumar, Juhi Chawla and Sri Sri (Sri?) Ravishankar are dug out to contrast their current reactions to this phenomenon with their past asides. The WhatsApp factory also rolls out their new models that suggest how a strong dollar is bad for the US economy and how this is some kind of a switch and bait move that we are making on them. Somewhere in many of our heads, the strength of the Indian rupee is no longer subject to the dynamics of the currency market. Like many things these days, it too is anchored to our self-respect. And since our national clarion call is desh nahin jhukne doonga (won’t let the country down), we then start working on the narrative that shows all of this in a warm, positive glow.
All in a day in the life of India.
Anyway, I thought it would be useful to take this moment to appreciate the winds that are buffeting it, the long-term view of what will actually strengthen the rupee and then zoom out a bit to appreciate what’s happening to the US economy and what it could mean for India.
The Safety Of Dollar
We will start with why has the rupee gone to 80 a dollar? The simple answer is the US dollar has been more in demand since the start of the Ukraine war than before. This is true for all currencies, not just the rupee, as the chart below shows.
There are reasons for this. The 40-year high inflation print that the US is witnessing month over month has turned the Fed hawkish. It is likely to raise rates by another 75 bps in its meeting next week, and the consensus suggests the benchmark rates will be around 3.4 per cent by the end of the year. These rate hikes make storing money in dollars more attractive. This potent cocktail of uncertainty around the Ukraine war, the high oil and commodity prices that make emerging markets more vulnerable and the prospect of a global recession is starting to give global fund managers a massive hangover. Their most obvious response: flight to the safety of the US dollar.
The dollar demand has gone up as foreign portfolio investors have checked out of domestic equities across the world. In India, we have had over ₹2.3 trillion of outflow from the equity market so far this year. Things would have been worse had it not been for the domestic investors (mutual funds and insurers) who invested about ₹1.4 trillion during this period. The price of oil—averaging over US$ 120 or so during this year—has made things worse because we import over 90 per cent of our requirements. The across-the-board rise in commodity prices has further increased our import bill.
Almost simultaneously, the high rate of inflation, the rise in interest rates and a prospect of a recession have meant our exports are beginning to soften. The commentary from our software services giants suggests the demand pipeline isn’t what it used to be. This might also show up in other export-dominated sectors as the steep rise in interest rates starts to kill off growth in developed markets. This has meant the consensus forecast among analysts for the current account deficit has inched up to 3 per cent for the year-end. We will need more dollars to support that kind of deficit.
That apart, our own inflation numbers have remained high, and we are running a negative real interest rate (the difference between interest rate and rate of inflation). This will continue to support riskier assets and reward consumption that will feed back into inflation. So, expect further interest rate hikes, and that will impact growth. All of this indicates the dollar strengthening against the rupee is here to stay.
Propping Up The Rupee
What can be done to address this? This is market dynamics at play. There are too many interlinked factors here. Beyond a point, there are only tweaks that you can do in the short term to support the currency. The RBI has tried to ensure that the depreciation is orderly and gradual, which is the best it can do now. It has increased dollar inflows by loosening norms in multiple areas, helping curb volatility. The raft of measures taken here shows how many short term levers are available with a central bank to manage currency volatility. These included removing the interest rate restrictions on banks for foreign currency and non-resident deposits. Such deposits have also been exempted from the statutory liquidity requirements that Banks need to carry for their deposits. This has allowed banks to hike their savings rates for such deposits by almost 75 bps. This will attract dollar deposits from non-resident Indians. The RBI has also relaxed foreign investments in debt instruments and allowed the use of overseas foreign currency borrowing for lending domestically in foreign currency. Even the amount of external commercial borrowing businesses can do through the automatic route has been doubled to US$ 1.5 billion. These immediate measures will smoothen the flow and increase the supply of dollars. The idea here is to weather through the Fed interest rate hike storm for the next two quarters and then take stock.
The RBI also made an interesting move last week that was reported as the ‘internationalisation’ of the rupee. It allowed special accounts (rupee Vostro accounts) to pay and settle exports and imports in rupees. Further, the surplus in these accounts could be invested in government T-bills and securities. What does this mean? Simply put, if Indian firms can find counterparties who are willing to trade with them in rupees, they can do so more easily than before. On the face of it, this means very little. Because there aren’t many global firms who would want to settle their trade in a currency like the rupee that will depreciate in the long-term and which isn’t useful for trade with non-Indian partners. But it allows us to trade with Russia without getting the dollar involved.
In fact, it is both an economic move and a geopolitical one. We run a trade deficit with Russia. We can now pay for Russian oil in rupees. Russia can use those rupees to buy our exports. The surplus in these accounts can be used to buy government bonds. So we save on buying more dollars to settle this trade, and we create demand for government bonds because the surplus in this account will be invested there. Seems like a neat solution, and I guess the US and the west won’t mind because we have pointed out their hypocrisy on Russian gas and Saudi oil more than a few times now. Apart from this, the government has done its usual quota of excise duty tweaks to manage the situation. We have increased duties on the export of petroleum products and limited sugar and wheat exports. And we have cut import duties on key raw materials and on cooking oils to manage inflation. These won’t add to much, but it gives an impression that something’s been done to address inflation. When inflation stabilises, we will take ages to dismantle these duties. That is an old and different story.
That takes care of the short term. In the long run, the rupee's strength depends on the fundamentals of our economy. We must run a current account shortfall below 2 per cent, bring down the fiscal deficit and debt to GDP ratio that have gone up significantly in the past two years and keep inflation in the four per cent range, which was the RBI mandate. All of this is hard work and will need the government to translate its words into action. Structural reforms in labour and capital have been pending for ages, the infrastructure push promised in the last budget is still in the works, and fiscal discipline is a tad out of fashion. If we continue to insist on pegging our self-respect to the rupee, then we must know what to demand from the government.
Where Next?
Lastly, where does the global economy go from here? Well, it is clear that the Fed and other central banks were wrong in their assessment in 2021 that the inflation was transitory. They could have raised rates then, and we wouldn’t have seen the serious inflationary pressure we have now seen for the last six months. This isn’t hindsight. There were more than a handful of sceptics about the notion of transitory inflation. So, the question is, now that the Fed has gone into the territory of whatever it takes to control inflation, what kind of a landing will we have? Will it be a short and mildly painful recession, or are we going to be in for a hard landing? As some are saying, it is possible that we will see the peak of inflation in the next few months, and then the rate hike impact will start to bring it down quickly to more comfortable levels within a year. We could then have a rate reversion cycle begin as early as the end of 2023. That is what the optimists are seeing today.
However, it is possible that there’s a hard landing. That is not just inflation taking longer to tame, but the sustained high-interest environment kills growth and puts the financial system under enormous stress. There’s a possibility that a perfect storm of decline in investment, reduction in consumption and a recession could hurt incomes around the world. The pandemic saw a significant rise in debt levels for both firms and households. A scenario where interest rates stay high and incomes start coming under stress would spell bad news for the ability of these entities to service their debt. A cycle of default could then start and put the entire financial system under stress. We might not have a GFC (2008) like moment, but we could be in that vicinity in future. We have been so used to quantitative easing, low inflation and low-interest rate scenario in the last decade that it is difficult to envisage an alternative where things are radically different.
Yet, as history has shown, you ignore long-tail risks at your own peril.
As a parting shot, the then finance minister Manmohan Singh’s response in the Rajya Sabha addressing the fears of devaluation of the rupee needs a revisit:
Let me say that in this country there seems to be a strange conspiracy between the extreme left and extreme right that there is something immoral or dishonourable about changing the exchange rate. But that is not the tradition. If you look at the whole history of India’s independence struggle before 1947 all our national leaders were fighting against the British against keeping the exchange rate of the Rupee unduly high. Why did the British keep the exchange rate of the Rupee unduly high? It was because they wanted this country to remain backward and they did not want this country to industrialise. They wanted the country to be an exporter of primary products against which all Indian economists protested. If you look at Indian history right from 1900 onwards to 1947, this was a recurrent plea of all Indian economists—not to have an exchange rate which is so high that Indian cannot export, that India cannot industrialise. But I am really surprised that something which is meant to increase the country’s exports and encourage its industrialisation is now considered as something anti-national.
India Policy Watch #2: Q.E.D.
Insights on burning policy issues in India
— Pranay Kotasthane
Nowadays, it seems like just one government agency is burning the midnight oil: the Enforcement Directorate (ED). It’s never out of the headlines.
There’s data to back this claim too. Responding to a Lok Sabha question earlier this year, the Minister of State (Finance) revealed that while during 2004-14, 112 searches were carried out by the ED, this number stands at 2974 in the eight years since 2014, a twenty-six-fold increase! Forget for a moment that the conviction rate of ED in raids conducted under the Foreign Exchange Management Act is merely 0.5 per cent.
Whether it is political parties in the opposition, Chinese companies, fugitive economic offenders, or non-profits, the ED has become the de-facto brahmastra.
Structurally, ED is a law enforcement body deriving powers from a wide range of laws. It was constituted as the “Enforcement Unit” way back in 1956. And since foreign exchange control was a big obsession back then, it primarily investigated cases arising from the Foreign Exchange Regulation Act (FERA), 1947. Then came the Foreign Exchange Management Act in 1999, the Prevention of Money Laundering Act (PMLA) in 2005, and the Fugitive Economic Offenders Act in 2018. A wide remit backed by labyrinthine economic laws made it easily weaponisable.
Now, it is well-known that many law enforcement agencies in India are politicised. Neither is ED the first one nor the last. In the naughties, the “CBI raids” served the same purpose. Exploring the pervasive politicisation of the ED, Pratap Bhanu Mehta writes:
The use of the ED has three purposes. The first is intimidation. The second is to keep the narrative of the old corrupt regime boiling. This is not a difficult proposition to sell to the public. But the third is to reveal the sheer self-absorption of the Opposition.
“For my friends, everything; for my enemies, the law.” said a former Peruvian Field Marshal Óscar Benavides. That is precisely what seems to be happening here.
Domestic politics aside, two Chinese mobile phone companies have recently come under ED investigation. In response, China’s foreign ministry spokesperson had this to say:
The frequent investigations by the Indian side into Chinese enterprises not only disrupt the enterprises’ normal business activities and damage the goodwill of the enterprises, but also impedes the improvement of business environment in India and chills the confidence and willingness of market entities from other countries, including Chinese enterprises to invest and operate in India.
Keeping aside the hypocrisy of China’s moralising, the spokesperson makes an important point. If the narrative goes out that economic crime investigations are being used for political purposes, India will pay a big price. Retrospective taxation was the poster child for India’s economic mismanagement last decade. We don’t need another deterrent puncturing investment dreams this decade.
What could bring law enforcement agencies under control? Are there structural checks and balances that prevent political misuse? I don’t know. But an essential component of strengthening India’s Republic has to be to make investigative agencies truly autonomous from executive control.
Not(PolicyWTF): The Question of Choice
This section looks at egregious public policies. Policies that make you go: WTF, Did that really happen?
- Pranay Kotasthane
"Life is like a box of chocolates. You never know what you're gonna get." This Forrest Gump quote is equally applicable to the Indian judiciary. On most days, it comes out with verdicts that just follow the prevailing social trend. But, there are also those rare moments when the judiciary stands up to defend the Republic from the Democracy.
Take what happened last week. In 2019, the Central Consumer Protection Authority (CCPA) —a new regulatory body—was formed to protect consumer rights. Earlier this month, the CCPA, in its infinite wisdom, issued guidelines that prevent hotels and restaurants from levying service charges. The guidelines thundered:
No collection of service charge shall be done by any other name. No hotel or restaurant shall force a consumer to pay service charge and shall clearly inform the consumer that service charge is voluntary, optional and at consumer’s discretion… No restriction on entry or provision of services based on collection of service charge shall be imposed on consumers. Service charge shall not be collected by adding it along with the food bill and levying GST on the total amount.
Why would the Indian State want to invest resources and time in changing these small matters is an always-relevant confounding question. But this time, the courts came to a partial rescue. The Delhi High Court stayed the guidelines. The judge even had a libertarian statement to go with the ruling. He said:
If you don't want to pay, don't enter the restaurant. It is ultimately a question of choice.
Music to my ears. Information asymmetry is not a problem as long as the service charges are known to the consumer beforehand. There is no market failure. The State can move on.
How I wish the courts applied this new-found virtue of choice to other areas such as:
If you don't want to get offended, don't read the book. It is ultimately a question of choice. No need to ban the book.
If you don't want to pay, don't enter the movie theatre. It is ultimately a question of choice. No need to cap movie tickets.
If you don’t like what others say about you, don’t talk to them. It is ultimately a question of choice. No need for defamation laws.
You get the drift. Don’t make the State a tool to address your pet grievance. It has bigger fish to fry. (And let it apply service charges for the fried fish.)
Global Policy Watch: The Three Internets
Insights on policy issues making news around the world
— Pranay Kotasthane
Many editions ago, I linked to one of Yiqin Fu’s articles on the Chinese internet. There’s so much about it that’s different beyond the fact that the State tightly controls the information flow there. For instance, Fu explains that the Chinese internet is different from the Western internet in these respects:
One, search engines (and not just Google) are hardly used. People read primarily through social media feeds.
And two, the complete dominance of super-apps:
Take WeChat as an example. It is home to the vast majority of China’s original writing, and yet: 1. It doesn’t allow any external links; 2. Its posts are not indexed by search engines such as Google or Baidu, and its own search engine is practically useless; 3. You can’t check the author’s other posts if you open the page outside of the WeChat app. In other words, each WeChat article is an orphan, not linked to anything else on the Internet, not even the author’s previous work.
The result of a lack of rediscovery means that knowledge creation, reflection, and historical context-setting are disincentivised. This resembles some parts of the Indian internet but is not quite the same. This architecture also means that people are pushed towards tracking the latest social media trend, with little or no incentive to create and read time-invariant content, such as blogs, articles, and papers without news pegs.
So, there are three broad internet prototypes:
The Western one: primary access is through desktop/laptop, not super-app based, search-engine driven, high discoverability of older articles, and email-based.
The Chinese one: primary access is through the mobile phone, super-app driven, low discoverability, and instant-messaging based.
The Indian one: The elites see an internet that’s a mix of the Western one and the Chinese one minus the censorship, while the non-elites are experiencing something much closer to the Chinese one.
Forget geopolitics for a moment. And consider the impact of these three internet prototypes on their respective users. Will their cognitive effects be different? If yes, in what way? This is a fascinating question to which I have no good answers yet. What do you think?
Another downside to skipping desktop is that weak ties built around emails are never formed. I don’t have data on Chinese employees’ modes of communication, but I wouldn’t be surprised if 90% of work communication is done over instant messaging. Multinational firms still use email, although when I asked on Chinese social media, my readers complained that emails often went unread. It seems like in the Chinese workplace, instant messaging still reigns supreme.
Fu argues that the result is that weak ties through cold emails are seldom formed. Again, not very different from the case in India where we need to have a phone number in order to form a weak link now. What is the social consequence of this phenomenon?
HomeWork
Reading and listening recommendations on public policy matters
[Podcast] MacroVoices #333: Erik Townsend and Patrick Ceresna in conversation with Harley Bassman on Inflation, Bond Yields, VIX vs MOVE, Demographics & More.
[Blog] Pakistan is in big trouble: Noah Smith covers the subcontinent for the second week in a row.
[Article] The functioning of the Enforcement Directorate, by Sonam Saigal.
[Paper] How to reform high-stakes exam systems? is an important question in the Indian context. A new NBER paper titled Pareto Improvements in the Contest for College Admissions has some clues.
#178 How Do I Raid Thee? Let Me Count The Ways