From UPSC perspective, the following things are important :
Prelims level : Current account and capital account
Mains level : Paper 3- Policy options to revive the Indian economy
The article weighs in the policy options with the Indian policymakers to revive the India economy. This leads to the trilemma of managing the exchange rate, controlling the inflation and maintaining the capital account open all at the same time.
A brief overview of 1991 economic reforms
- The crisis in 1991 was centred on the balance-of-payments.
- Allowing the Indian rupee to fall from an artificially high level was a key part of the solution.
- Since the reforms, the Indian rupee has steadily depreciated, roughly according to a market-determined equilibrium.
- Extraordinarily high tariff barriers were reduced, allowing for welfare gains from greater international trade.
- Reforms of the domestic economy that increased market orientation was, in some sense, opportunistically combined with these externally-oriented measures.
What should be India’s foreign economic policy
- In terms of connections to the rest of the world, however, it is less clear what the right policy mix should be.
- We can think of three types of international flows: labour, goods and services, and capital.
1) Internation flow of Indian labour
- India has benefited from being able to send workers with a variety of skills to different types of economies: construction workers and nurses in the Persian Gulf, software engineers in the US, and so on.
- Direct benefits came from large remittances back to India.
- The pandemic and US immigration policy, have had some major impacts on this international connectivity, but new vaccines and a change in the US president are likely to reverse these shocks.
- In any case, there is not much that Indian policymakers can do or need to do on this front.
2) Trade in Goods and Service
- India has been able to grow its exports, both in a variety of agricultural and manufactured commodities and in services, from software services to tourism.
- It has been reasonably competitive in a range of goods and services.
- It was only in the last few years, even before the pandemic, have Indian exports struggled to register growth.
- Whereas the export powerhouses of East Asia consistently ran surpluses on the current account of the balance of payments, India has mostly run deficits, albeit manageable ones.
3) Capital Flow: Area where policymakers have option
- Current account deficits have to be covered somehow, though various forms of foreign capital.
- Whereas economic theory and economic policymakers mostly agree on the benefits of international trade in goods and services there is less of a consensus on the benefits of international capital flows.
- Capital flows can raise fears of instability if they are reversed, or make exports less competitive if they push up the value of the rupee.
- The country is a relatively attractive destination for foreign capital, both FDI and portfolio investment.
- But, these flows can make Indian exports less competitive if the rupee appreciates too much, requiring domestic demand to do more of the work of absorbing increased output.
Lesson from Japan
- Right now, India is trying to build its manufacturing capacity by raising tariffs, in an old-style push for import substitution.
- It is also providing direct incentives, such as the new scheme rewarding increases in production.
- Arguably, this did work in Japan in the 1960s, but it is not clear if India is well-off enough to sustain that domestic strategy.
- In addition, the lack of competitive discipline exporting can hinder the achievement of acceptable quality levels.
- Capital controls to some extent can help mitigate the risk in this situation.
- The Reserve Bank of India do more to keep the rupee at competitive levels, by accumulating foreign exchange reserves.
Consider the question “In terms of links with the rest of the global economy, it is less clear what the right policy mix should be. Do you agree with the view that focus on simultaneously managing the exchange rate and domestic inflation while maintaining an open capital account would help in the revival of India’s economic growth
Lurking under the surface of these issues is the trilemma of being unable to simultaneously manage the exchange rate and domestic inflation while maintaining an open capital account, although foreign exchange reserves provide a way of softening the trade-offs. These are not new challenges, but they will need to be a focus for India’s policymakers as they seek renewed economic growth.