India’s economy in doldrums since 1991

• In May, America’s Federal Reserve hinted that it would soon start to reduce its vast purchases of Treasury bonds. As global investors adjusted to a world without ultra-cheap money, there has been a great sucking of funds from emerging markets. Currencies and shares have tumbled, from Brazil to Indonesia, but one country has been particularly badly hit.
• Not so long ago India was celebrated as an economic miracle. In 2008 Manmohan Singh, the prime minister, said growth of 8-9% was India’s new cruising speed. He even predicted the end of the “chronic poverty, ignorance and disease, which has been the fate of millions of our countrymen for centuries”. Today he admits the outlook is difficult. The rupee has tumbled by 13% in three months. The stock market is down by a quarter in dollar terms. Borrowing rates are at levels last seen after Lehman Brothers’ demise. Bank shares have sunk.
• On August 14th jumpy officials tightened capital controls in an attempt to stop locals taking money out of the country . That scared foreign investors, who worry that India may freeze their funds too. The risk now is of a credit crunch and a self-fulfilling panic that pushes the rupee down much further, fuelling inflation. Policymakers recognise that the country is in its tightest spot since the balance-of-payments crisis of 1991.
• India’s troubles are caused partly by global forces beyond its control. But they are also the consequence of a deadly complacency that has led the country to miss a great opportunity.
• During the 2003-08 boom, when reforms would have been relatively easy to introduce, the government failed to liberalise markets for labour, energy and land. Infrastructure was not improved enough. Graft and red tape got worse.
• Private companies have slashed investment. Growth has slowed to 4-5%, half the rate during the boom. Inflation, at 10%, is worse than in any other big economy. Tycoons who used to cheer India’s rise as a superpower now warn of civil unrest.
• As well as undermining 1.2 billion people’s hopes of prosperity, failure to reform dragged down the rupee. Restrictive labour laws and weak infrastructure make it hard for Indian firms to export. Inflation has led people to import gold to protect their savings. Both factors have swollen the current-account deficit, which must be financed by foreign capital. Add in the foreign debt that must be rolled over, and India needs to attract $250 billion in the next year, more than any other vulnerable emerging economy.
• A year ago the new finance minister, Palaniappan Chidambaram, tried to kick-start the economy. He has attempted to push key reforms, clear bottlenecks and help foreign investors. But he has lukewarm support within his own party and faces obstructionist opposition. Obstacles to growth, such as fuel shortages for power plants, remain. Foreign firms find nothing has changed. Meanwhile, bad debts have risen at state-run banks: 10-12% of their loans are dud. With an election due by May 2014, some fear that the Congress-led government will now take a more populist tack. A costly plan to subsidise food hints at this.
• To prevent a slide into crisis, the government needs first to stop making things worse. Those capital controls backfired, yet the urge to tinker runs deep: on August 19th officials slapped duties on televisions lugged in through airports. The authorities must accept that 2013 is not 1991. Then the state nearly bankrupted itself trying to defend a pegged exchange rate. Now the rupee floats, and the state has no foreign debt to speak of. A weaker currency will break some firms with foreign loans, but poses no direct threat to the government’s solvency.
• And so the Reserve Bank of India must let the rupee find its own level. The currency has not yet wildly overshot estimates of fundamental value. Raghuram Rajan, the central bank’s incoming head, should aim to control inflation, not micromanage one of the world’s most traded currencies.
• Second, the government must get its finances in order. The budget deficit has been as high as 10% of GDP in recent years. This year the government must hold down its deficit (including those of individual states) to 7% of GDP. It is already cutting fuel subsidies, and—notwithstanding the pressures in the run-up to an election—should do so faster.
• This is not enough to fix the government’s finances, though. Only 3% of Indians pay income tax, so the government’s tax take is puny. A proposed tax on goods and services, known as GST, would drag more of the economy into the net. It is stuck in endless cross-party talks. If the government can rally itself before the election to push for one long-term reform, this is the one it should go for.
• Last, the government, with the central bank, should force the zombie public-sector banks to recapitalise. In 2009 America did “stress tests” to repair its banks. India should follow. Injecting funds into banks would widen the deficit, but the surge in confidence would be worth it.
• There are glimmers of hope: exports picked up in July, narrowing the trade gap. But India faces a difficult year, with jittery global markets and an election to boot. Even if it scrapes past the election without a full-blown financial crisis, the next government must do much, much more to change India. Over the coming decade tens of millions of young people will have to find jobs where none currently exists. Generating the growth to create them will mean radical deregulation of protected sectors (of which retail is only the most obvious); breaking up state monopolies, from coal to railways; reforming restrictive labour laws; and overhauling India’s infrastructure of roads, ports and power.
• The calamity of 1991 led to liberalising reforms that ended decades of stagnation and allowed a spurt of fast growth. This latest brush with disaster could produce a positive legacy, too, but only if it persuades voters and the next government of the importance of a new round of reforms that deal with the economy’s flaws and unleash its mighty potential.

China vs. India: Who Will Win The Race To Be More Financially Open?

• Since the 2008 financial crisis, both China and India have taken steps to become more financially open. But while the Indian economy appears to be ahead at present, policy continues to segment onshore and offshore markets in both economies and policymakers face challenges in further financial integration.
• In a working paper from the Bank for International settlements, Guonan Ma and Robert McCauley consider the relative closure or openness of the world’s two largest emerging economies, China and India; and conclude that, contrary to the findings of most academic studies, India is actually more open than China right now, but that both countries are progressing towards being more financially open. This is a technical paper and will leave the casual reader scratching their heads, but the authors make a number of interesting observations through the course of their dissertation, and for those of us wondering exactly when, or perhaps if, these two economies will open up fully, it holds much of interest.
• India comes out ahead of China, in terms of financial openness, on six of the eight measures used by the authors to determine how financially open an economy is. One of the most obvious measures of a currency’s openness is to look at forward foreign exchange rates within the country versus offshore. Capital mobility, the authors point out, ensures that any differential between onshore and offshore rates in an open economy is arbitraged away pretty swiftly.
• China’s onshore forward currency market kicked off in 2003, but the rules state that traders inside China can only access the domestic forward currency market when they are actually fulfilling a “real” transaction in the real world. So you need a proper market transaction backed by documentation. Of course, in the open, offshore market, all comers can transact, which automatically creates a price differential. The authors found that while there were some quite sizeable gaps, after 2008 the average of the gaps for both the renminbi and the rupee fell noticeably, suggesting that both economies have become somewhat more open since 2008. India is ahead on this measure, but China appears to be catching up.
• Another measure compares short-term interest rates onshore and offshore, which some academics regard as a good test of capital mobility (i.e., no gap, or one that is swiftly arbitraged away, is characteristic of an open currency since capital flows to the better rate). Prior to 2010, when China allowed offshore renminbi banking, yields had to be inferred from non-deliverable forward contracts (NDFs). The NDF market originated in the 1990s. Instead of settling the whole contract the counter-parties simply settle the difference between the currency spot price and the forward price, on an agreed notional principal. The whole system was developed to cater for trading in emerging market currencies with capital controls, where it was simply not possible to deliver the forward contract offshore. NDFs are usually quoted with the US dollar as the reference currency and settlement is generally in dollars as well. Banks acting as market makers for NDF contracts typically quote forward rates from between one month to a year ahead, with the IMM dates (the four quarterly dates of each year that are used for most futures and options contracts) as the target points. Again, looking at the gap between onshore and offshore rates for India and China, the evidence points towards India being more open (i.e. a smaller positive gap between the relative cost of onshore and offshore rates), but with China catching up. At the same time, the fact that there is a gap shows that both currencies are still relatively closed by comparison with say, euro/dollar trades, where the rate in both Frankfurt (offshore) and New York (onshore) are identical.
• The authors point out that both China and India have run “natural experiments” by allowing firms to list their shares on both domestic markets (Shanghai and Mumbai respectively) and Hong Kong and New York. Although onshore and offshore trades take place in different currencies, a free flow of capital would tend to arbitrage away any price differentials between the two pretty quickly. In fact the authors found that Chinese shares tend to trade at a premium in Shanghai over their prices in Hong Kong or New York, i. e. Chinese investors would love to be able to buy these shares directly in New York were it not for currency controls. Before the crash, Chinese company shares listed in Hong Kong were on average 45 percent cheaper than the prices quoted in Shanghai. This has since narrowed to 15-25 percent.
• On measures of the internationalisation of the two currencies (the extent to which the currency is used for trade outside the home country) the rupee “has proceeded as far or even further than the much discussed renminbi internationalisation”. The authors point out, however, that their study is based on the three yearly survey by the BIS, and the most recent survey, not analysed in their report, is expected to show a major increase in renminbi internationalisation.
• What the study seems to show is that currency controls and restrictions in both China and India are being slowly eroded by multi-national firms inside both countries using intra-firm transactions to arbitrage onshore and offshore markets, though Indian firms are generally more advanced than Chinese firms, with the latter being at an earlier stage in their multi-national operations.
• The authors also take issue with various commonly accepted formula for measuring openness and stress that research henceforth needs to take account of pragmatic, de facto issues. All of this will be just so much academic speak to most business folk, but the takeaway is that both countries have moved quite a long way towards openness since the 2008 crash, but both still have some way to go. An openly traded currency with a free floating exchange rate is one of the hallmarks of a mature, advanced economy, and both countries are headed in that direction, but quite when they will get there is anyone’s guess.

Raghuram Rajan to head India’s central bank

• Raghuram Rajan is often described as one of the few economists to predict the financial crisis. In a speech in 2005 to the world’s top central bankers he said innovation had made finance more dangerous. At the time his view was dismissed by Larry Summers, now a front-runner to become chairman of the Federal Reserve, as “slightly Luddite”.
• Mr Rajan has also been right about India. In 2010, as hubris in the country soared, he warned that “growth can never be taken for granted” and that “self-delusion is the first step towards disaster.” As he prepares to succeed Duvvuri Subbarao at the helm of the Reserve Bank of India (RBI) in September that caution seems prescient. India’s economy is in a funk and it faces a balance-of-payments scare. The rupee has fallen by 12% against the dollar in the past three months.
• Mr Rajan’s appointment, announced on August 6th, is welcome. As well as a stint as chief economist for the IMF and a star turn in academia, he has spent the past year advising the finance ministry and has been involved in efforts to get India’s reforms back on track (with mixed results). He believes in liberalisation, which India needs lots more of.
• Yet his is an unenviable task. To stabilise the currency the RBI recently introduced a package of measures to suck liquidity out of the banking system and in turn raise short-term market interest rates (the RBI’s benchmark rate was unchanged). This seems to be working but may cause a credit crunch among firms and banks, pushing GDP growth below the present 4-5% rate. India’s position is better than some critics allow: relative to its GDP it has a moderate amount of foreign debt to refinance. Still, for now the RBI must choose between a currency slump or strangling the economy.
• In the long run the solution is a big burst of government reforms that would restore confidence among foreign and domestic investors. But with an election due by May 2014, that looks unlikely. In the meantime, Mr Rajan will have to face other problems. India’s state banks are sitting on a pile of bad debts. The RBI’s recent decision, in principle, to allow India’s business houses to set up their own banks is also a headache. Mr Rajan is a critic of cronyism but he will have his work cut out to prevent licences going to well-connected tycoons.
• Mr Rajan is no administrator but will also have to reform the RBI. It is a fine institution, but a stretched one. In the 1990s it toyed with relinquishing some of its vast empire—it runs everything from monetary policy to public-debt issuance and bank regulation. Recently it has clung to its powers only to find that its multiple goals of stability, growth and low inflation conflict. Mr Rajan’s task is to resolve those contradictions. If he succeeds, Western central bankers, who have seen a proliferation in their responsibilities since the crisis, will have another reason to listen to his views.