Editorial Analysis || India’s Dutch disease?

• “Dutch disease” refers to foreign currency inflows that keep the currency stronger than it should be, reducing the competitiveness of domestic enterprises, thereby boosting imports and hurting exports.

• The phrase dates back to the 1960s when new discoveries of crude oil had boosted Dutch exports for a while, making their currency appreciate sharply.

• This appreciation made other industries uncompetitive and they atrophied or disappeared; so when oil reserves ran out, it took a while for the Dutch economy to normalise.

CURRENT INDIAN SCENARIO

• For all but three years in the last three decades, India has consumed more goods and services than it produced — that is, it had a current account deficit (CAD).

• Foreign capital funded this excess consumption: In the form of foreign direct investment (FDI), foreign portfolio investment (FPI), or external commercial borrowings (ECB).

• Often foreign investors bring in technology and expertise, and also provide risk capital (which India is short of) and cheaper funding for long-term investments.

• But the persistence of the CAD and the consequent dependence on external flows to keep the currency stable raise questions on sustainability.

• A point of serious concern is that the annual “rent” on foreign capital we have received thus far is already in excess of 1 per cent of GDP: Royalties and dividends paid by Indian firms to their foreign shareholders, and interest payments to foreign lenders, rose to 29 billion dollars last year.

CORRECT VALUE OF INDIAN RUPEE

• Volatility in the global currency markets is up again, and the rupee already one of the weakest currencies in the world this year.

• There are expectations of a 20 billion dollar deficit this financial year after several years of strong surpluses: Capital inflows of 55 billion dollars could be well short of the CAD estimated to be in the range of 75 billion dollars.

• To keep the rupee from depreciating further, the clamour for another large dollar loan from non-resident Indians (like the one that stemmed the crisis in 2013) has already started.

• This may see strong demand again underscoring the point that India has a liquidity problem (that is, a near-term shortage), and not a solvency problem (people do not doubt India’s ability to repay the dollars in the future).

WEAKER CURRENCY THE SOLUTION?

• India’s CAD is not very sensitive to changes in value of the currency.

• Half of our goods imports are things that we do not have, like crude oil, natural gas, gold, metallurgical coal, precious stones, uranium and copper.

• Another fourth are things that we cannot make, like cellphones, aircraft, defence equipment and capital goods (these include solar panels, robots, blast furnaces and hot rolling mills for steel).

• A weaker currency will only push local prices of these goods higher — while this may bring down demand for them, this would also mean a broad-based slowdown in the economy.

• Goods imported due to lack of cost competitiveness (like Ganesh idols, edible oil and small appliances), where a weaker rupee may help domestic manufacturers displace imports, are less than a sixth of total.

• Similarly, on the side of exports, nearly a third of the export value add comes from agriculture, and another third from textile, leather and two-wheelers.

• A minor decline in the value of the rupee thus is unlikely to drive export acceleration that will narrow the CAD meaningfully. And a big depreciation could disrupt the economy for a few years.

HOW TO PROTECT THE CURRENCY?

• Raising interest rates — this signals to the currency markets that the economy is willing to bear the pain of a domestic demand slowdown to protect the currency’s value. But pushing down growth for the whole economy is perhaps too high a cost.

• Controlling Capital Flight – A large part of the recent deterioration in India’s balance of payments could be because of capital flight.

• Sustained high imports of precious stones and pearls (where given the subjectivity in valuation, prices can be over-stated to send money out of India), and the surprising pick-up in FDI repatriation (that is, firms pulling back funds they had invested earlier) have together added more than 15 billion dollars to the balance of payments deficit over the past year.

• While both can have benign explanations too, one cannot help but suspect money escaping India fearing a crackdown on black money, helped along by the impact of unwinding of the Mauritius and Singapore tax treaties.

• Targeted mechanisms – Politically unattractive as they may be, higher retail prices of petrol and diesel may also help.

• India is now a large part of the incremental demand for crude oil globally: If higher prices slow down demand growth, as they have done to some extent in the last two months, it may even cool oil prices.

• Over the medium-term, measures like a change in our energy mix, greater indigenisation of electronics and defence manufacturing, and higher agricultural exports can help the economy get over the worryingly frequent bouts of currency volatility.

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