A major objective of international institutions such as the IMF-WB is to ensure advantages to other countries from India’s growth, in particular to their main financiers who are the large capital exporting countries. It follows that they want to ensure freer markets and fewer restrictions on all types of capital flows. Much of this is in India’s interest since we need more capital and better integration with world markets. But a democracy cannot ignore the concerns of its own citizens. The IMF-WB holy trinity of structural land, labour and other market-opening reforms harms many domestic citizens and, beyond a point, runs into severe resistance that imposes large political costs.
Liberalisation has reached a point of diminishing returns. Whatever was feasible in the above is surely in motion by now. Further organic reform will take place as states compete. Improving the supply-side has many other aspects. In choosing from the reform menu, the Centre must be guided by feasibility and pragmatism and ensure that benefits accrue to a majority.
The focus should be on leveraging the special circumstances that currently favour India. These include the impetus Covid-19 has given to digital aspects, where India has a comparative advantage, the possibility of supply chain diversification away from China, moving to a net zero economy and harnessing green initiatives as a source of investment and innovation. Attention should be given to developing skills and capabilities, improving employability, augmenting infrastructure, reducing logistics and other business costs through better Centre-state coordination, and enhancing the quality of governance and counter-cyclical regulation with good incentives. Much can be done to improve data use and privacy, functioning of courts and police. Instead of wasting political capital on reforms that encounter large resistance and shock the system, reforms should enhance favourable trends.
Yet, reform suggestions continue with the liberalisation agenda.
Privatisation of banks: There is a recommendation to privatise most public sector banks (PSBs), starting with those doing well. But the argument that PSBs are a drain on taxpayers’ money is based on the experience of the last decade. In the 2000s, they were doing better than private banks and withstood the global financial crisis better. NPAs rose because they were pushed into lending to infrastructure where there are inherent asset liability mismatches for commercial banks. Moreover, it was the first time that the lending was to private companies. Therefore, a full resolution had to await the setting up of the missing regulatory framework for bankruptcy. Improvements in PSB governance and risk-based lending profiles have resulted in falling NPA ratios and strong capital adequacy even under the pandemic shocks. Social schemes that were a drain on PSB resources are now largely financed through direct subsidies by the government.
Diversity in institutions and approaches makes for a more stable financial sector. PSBs are trusted by many savers. They have garnered Rs 1.7 trillion in their Jan Dhan accounts, while private banks have hardly any. PSBs can leverage their advantages in low-cost deposits through many co-lending opportunities and partnerships. The economy has suffered very low credit growth through the last decade and is ready for a turnaround. Private banks alone could not increase credit adequately — when lending from PSBs had slowed. This is not the time to disrupt the recovery in credit growth. PSBs should be allowed to compete and raise resources on their own. Only those who cannot do so, or have other serious weaknesses, should be allowed to exit through the privatisation or merger route. The strong will prosper. The Chinese way of growth, where the public sector shrinks as the private sector grows faster, would work better for India also.
Overshooting of the exchange rate: There are recommendations that the rupee should be completely market-determined. It should be allowed to sink under foreign outflows since this would benefit exporters. But pass-through of exchange rate depreciation is much faster in Indian imports, which are dominated by dollar-denominated commodities such as crude oil. Indian exporters largely have little market power and are forced to share the benefits of depreciation. Many studies show they do not gain from volatility. As imported inflation rises, monetary tightening follows and hurts the real sector. Real appreciation results in and requires more nominal depreciation. Any gain to exporters from overshooting is temporary. The fall in the exchange rate of the rupee from about Rs 8 in the 1990s to about Rs 80 currently has not brought about a sustained rise in exports.
Market panics and large deviations from competitive real exchange rates hurt the economy and most participants. Lower volatility in the real exchange rate helps both gainers and losers when there are changes in the rupee value. Both positive and negative deviations from equilibrium real rates are harmful. Only a fraction of the foreign portfolio flows (FPI) that look for trading benefits gain from volatility, not the majority that has a steady commitment and is here to benefit from India’s growth. Trading FPIs want to be the first to go out, take profits and then wait for a rupee crash before coming back in. If they know there will be no crash, there is less incentive to be the first out. The country’s risk premium falls. This may have contributed to a reversal of outflows.
Some rupee volatility is good and encourages firms to hedge currency risks. Central banks typically let the currency fall under outflows, so exiting FPIs get less. Then the bank comes in, buying low, stabilising the currency and reducing the overshooting. Trend depreciation has to compensate for inflation and productivity differentials. That US inflation exceeds that of India, and productivity tends to rise with growth, reduces the required depreciation. It helps exports if the rupee depreciates as much as major export competitors. Depreciation has been close to that of the Chinese currency. So intervention that prevents overshooting has only facilitated the working of markets and their discovery of equilibrium values.