Friday, June 18, 2010

The Economics of Plenty - II

In my previous post, I argued for India discarding its existing economic policies formulated in times of shortages. India’s problems have changed and we now face a problem of plenty, especially when it comes to foreign exchange inflows.

Capital inflows, have outstripped our trade deficit over the last few years. However, India’s polices remain rooted in a time when capital inflows were miniscule and India was subject to a full blown balance of payments crisis. In continuing with these policies, India is ignoring its changed position in the world and its changed circumstances. It isn’t accounting for it’s strengths, overemphasizing its weaknesses, ignoring opportunities and losing sleep over threats.

India’s strength today is its population. After years of fearing India’s population problem, we are now in a beneficial demographic period. The rising middle class and its capacity to consume positions India firmly as one of the largest markets in the world. So why does this not show in our GDP? We need to look no further than our currency. India’s weak currency policy has many repercussions and an understatement of our GDP in terms of other currencies is just one of them.

A weak currency makes all products more expensive for the domestic population. Its futile to say that it affects only imported goods. In an economy which imports most of it’s fuel, currency related inflation is all pervasive. In addition, India’s domestic market for commodities is closely linked to international markets and a weak currency also causes domestic prices of locally produced commodities to rise. If it weren’t so, most of India’s domestic commodities would be exported. These increased prices reduce the ability of our domestic population to consume, reducing domestic growth.

A weak currency also makes it more expensive for Indian companies to buy foreign companies. While this is not an end in itself, it is a means to a very important goal; the ownership of Intellectual Property. When Tata bought Corus and Jaguar-Land Rover, it didn’t just but their capacity to produce steel and cars. It bought the technology which allowed production of superior quality steel and cars. Profits follow technology. Tata Steel and Tata Motors will show that to be true.  And there is no better example of this than Apple. The iPhone says its designed by Apple in California and assembled in China. Guess where the profits reside. India’s technological disadvantage can only be overcome by buying technology and then developing it further. If we start from scratch, by the time we reach where the world is today, the world would have moved on.

Looking at our conundrum from another angle, the capital needs of India’s infrastructure sector cannot be met domestically. We need global savings. Our policies should reflect our need to attract savings and the strength of our domestic market. Our current policy framework, in contrast, is making a case for capital controls which will stop global savings from reaching us, to allow us to continue exporting goods and services to other markets. Infrastructure is key to ensuring that our rural population benefits from growth. In most parts of the country rural connectivity is atrocious. Rather than taking our prosperity to our villages, we have succeeded in bringing our rural population to our cities. In a distorted understanding of urbanization in growing economies, we believe it is normal for our cities to grow and our villages to shrink. We seem to ignore the possibility of basic urban comforts reaching the villages instead. If we persist with our current policies, India will always remain an infrastructure starved nation which can only dream of inclusive growth, not achieve it.

And why are capital flows inferior to trade flows? Is it because the ones we focus on are those which can be reversed easily? FII flows can be reversed at the push of a button. So we design policies to allow only those flows which are subject to substantial market costs  if reversed. If we were to look beyond these, its easy to recognize the impact of our weak currency policy on long term stable flows. Who will want to invest in a currency, or in assets denominated in a currency which is intentionally weakened by policy. Our currency policy increases targeted returns and reduces targeted time span. So rather than incentivizing investors to start new companies in India, we are content with allowing them to own our existing companies. A perversity, if the stated intention is to achieve growth, isn’t it?

Times have clearly changed and our minds have to keep pace. Its not India’s growth which is at risk. As mentioned in my earlier post, India will continue to grow regardless. But whether it’ll grow enough to satisfy the needs of a young nation will depend on what drives our policies. Fear or self-belief.

A version of this post appeared on my Business Standard Blog on June 16, 2010

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