Narendra Modi's external constraints

Against the odds that most people would have given, the BJP has secured an absolute majority in the new Lok Sabha. For its corporate supporters and even those who voted on an anti-incumbency instinct, this mandate marks a new beginning (for the former it involves “carrying the reform process forward”, as if we all know what this means). The economy, we are told, will rebound in no time. There are, as the business channels never tire of telling us, many "low hanging fruits".

All kinds of suggestions about what the government should do are proffered, some truly bizarre. For instance, I saw an economic analyst, precariously perched on a high stool, saying that giving a higher price for natural gas to the Ambanis was the first priority. It took me some time to recover my jaw from the floor! (Why insist only on a minimum education level for the HRD minister, what about the economists on TV?)

As someone who grew up before fruits started to hang low, I will argue that India’s economic revival faces many constraints. Since a number of these — e.g. infrastructure, the fiscal deficit etc – have been discussed threadbare in the media, I will focus on something that is rarely discussed, such as the external constraints facing the new government.

It is pointed out with glee by the supporters of the new government that the international markets' confidence in the incoming team is evidenced by the booming stock markets and the strengthening of the value of the rupee. There is some truth in this. The Indian economy, especially the industrial sector, has been in the doldrums for some time. Thus the booming stock market cannot be a story of the present state of the Indian economy; it must be about the future.

Financial capital inflows (as opposed to "real" FDI) into the Indian economy have been very strong in the recent months. Part of this can be attributed to very low interest rates internationally (because of "quantitative easing" in the US and Europe). The return to foreign investors investing in India consists of the rupee return less the expected depreciation of the rupee. Now, since Raghuram Rajan (the knight in shining armour?) took over as the Governor of the RBI, the rupee has been more or less stable (even appreciating) against the US dollar. This has given rise to what is called "carry trades"— an investor in the advanced capitalist countries takes advantage of the high interest rates in India (these are high mainly because inflation is high) and expects not to be subject to adverse exchange rate movements.

But carry trades are not the entire story. India has received more capital inflows over the last, say, six months than other emerging markets. So there is a Modi story to the international financial flows, the consequent stock market boom and the appreciation of the Indian rupee.

The prescriptions of the lady on the high stool revived memories of an idea that originated in natural gas discovery but has wider applications. This is the so-called Dutch disease. In brief, following the oil price increase in the mid-1970s, it was expected that the Netherlands would come through with flying colours compared to other European economies. This was because they had natural gas and oil in the North Sea.

In the event, it turned out that the Dutch had fared among the worst. This was due to foreign investors’ optimism about the economic prospects of the Netherlands. They started buying Dutch assets (houses, shares etc). This appreciated the Dutch guilder and made Dutch industry uncompetitive.

Is it possible that anticipations of success and the resultant euphoria manifesting itself in capital flows to India can kill off the very success on which the euphoria was predicated? Will the Modi government be a victim of an Indianised Dutch disease? It is certainly possible.

In India there is an excessive preoccupation with growth, which is one of the two targets that an economy should be grappling with in the short run. The two targets can be called internal balance (growth with low inflation) and external balance (manageable current account deficit). If a stock market (or property) boom fuelled by foreign capital inflows causes households to consume more, it raises growth but worsens the external balance. Similarly, any attempt to increase physical infrastructural spending (after all India’s roads and railways are crying out for investment and upgrading) will raise the current account deficit unless funded by increased domestic savings.

India starts from a high current account deficit — this has come down in recent months possibly because a part of gold imports are now smuggled and do not show up in official statistics. This means that its total expenditure on goods and services is more than its income from all sources. The current account is also the difference between current dollar receipts and current payments. I note, en passant, that Chidambaram used to get this definition wrong: the current account does not include financial flows (these are capital flows). An appreciation of the exchange rate would make Indian goods less competitive (as in the Dutch case) and would widen the current account deficit. As long as foreign lenders are happy to lend, India can live beyond its means. But this can never be taken for granted.

Therefore, the policy choices for the BJP government are limited, almost non-existent. On the macroeconomic front, high inflation constrains monetary policy (interest rates are not coming down anytime soon).

The high level of government debt constrains fiscal policy. Most of the Central government’s expenditure is on salaries and interest payments and cannot be reduced immediately. Only an export-led growth is compatible with improving both the internal and external balances. But exports depend on competitiveness on the part of Indian industry. With a surge in capital inflows, this is unlikely to happen. Thus the Modi government finds itself caught between the devil of the hand-me-down from UPA II and the deep sea of the overseas friends of the BJP. We have heard repeatedly that the new government will do out-of-the-box thinking. It has its job cut out.

The author is a retired professor of economics at the Delhi School of Economics