India in the world of global uncertainties

It is important to signal that good economics rather than opportunistic politics will drive policy in the year ahead

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By Montek S. Ahluwalia, December 29, 2016 | Live Mint

Demonetization has so dominated the news that little attention has been paid to developments in the global economy and what they imply for India. Developing countries, which were growing rapidly even as industrialized countries slowed down after the crisis of 2008, are now slowing down. China is ready to accept growth going below 6.5%. What does this imply for us in the New Year?

Uncertainty is high

The US election, Brexit, a possible Frexit, and an isolationist mood in Europe all signal a possible retreat from global integration. No major reversal has occurred thus far, but if US president-elect Donald Trump does what he said in the campaign, the world could look very different.

The present situation is therefore one of great uncertainty, with few upsides. There is no likelihood of an advance in global integration, and some retreat seems certain, in areas such as immigration, and perhaps some tariff increases. It could be worse, but we don’t know.

Should we respond by turning our back on global integration? Both the left and the right may want to, but they would be wrong. The industrialized countries have turned against globalization because of their experience since the 2008 financial crisis: growth rates have fallen, jobs are not available, and inequality has increased sharply.

But this is not our experience of globalization. In our case, globalization combined with policy reforms—incomplete though they still are—has resulted in much faster growth in the period after 2003. Inequality has increased, but unlike the case in the US, where the median family income has stagnated in real terms for two decades, in India all sections have experienced rising real consumption and incomes. For the first time, between 2004 and 2011, the number of people below the poverty line fell by 140 million. If this is globalization, we should want more of it and work in all relevant fora to advance it.

Implications for trade policy

World trade is one of the areas of uncertainty. It grew twice as fast as world gross domestic product (GDP) before the crisis of 2008, but it has slowed since then, and in the last two years, it actually grew more slowly. This is not because of increased protectionism, but mainly because of other structural changes. One of these is the end of the unsustainable Chinese export-led boom. Another is the increase in the domestic value content of China’s exports, which reduces its dependence on imported components, and thereby reduces double counting of exports.

What does this imply for India? Slower growth in world trade will be a challenge, but there is also an opportunity. Rising wages and labour costs in China will force China to exit from exports of simpler labour-intensive consumer goods to industrialized countries, and move up the ladder to export more sophisticated products. We could replace China in the areas it vacates. How well we exploit this opportunity depends entirely upon our competitiveness.

We have the advantage of being located in Asia, which happens to be the fastest growing region in the world. We need to orient our trade policies to achieve greater integration with this region. Negotiations are under way for the establishment of a regional comprehensive economic partnership (RCEP) covering the 10 Association of Southeast Asian Nations (Asean) countries plus Japan, South Korea, China, India, Australia and New Zealand. We are part of these negotiations, but we are too often viewed as being obstructive rather than constructive. We need to review our position on RCEP to see if we can be more positive.

Trade negotiations are difficult exercises in which it is normal for each country’s negotiators to make maximal demands from others, while conceding as little as possible. In the end, no country gets a deal which it thinks is ideal. The question to ask is not whether the deal is ideal, but whether it is good enough. With the Trans-Pacific Partnership (TPP), which did not include us, effectively “Trumped” in the US, it may be a propitious moment to get the RCEP concluded.

One of the reasons we are negative in our negotiation strategy is that Indian business does not appreciate the gains from greater integration. A recent study by the National Council of Applied Economic Research concluded that joining the RCEP trade bloc could add about 1.3 percentage points to India’s growth rate. This should make Indian business strongly supportive, but it is not. It needs to be persuaded of the benefits of trade integration with Asian countries while being assured of policy support to improve its competitiveness.

One way the government could help is by reducing our import duties on inputs. Duties have come down greatly since the reforms began, but they are much higher than in Asean countries. If we join RCEP with import duties for non-RCEP members much higher than is the case for other RCEP partners, our producers will become uncompetitive vis-a-vis producers in other RCEP countries, for all items that require imports from outside the bloc. A reduction in duties to align them with those in other countries is essential.

Arvind Panagariya, vice-chairman, Niti Aayog, writing as an academic in 2004, had recommended reducing import duties to an average of 5% by 2009. The recommendation remains valid and should be implemented. We should not be deterred by revenue-loss arguments because customs duties are not the right instrument for raising revenue. That objective should be achieved through other taxes.

Capital flows in a world of uncertainty

The greatest uncertainty in the global economy today relates to short-term capital flows. Cross-border capital flows have declined sharply compared to pre-2008 levels and volatility is high. We are seeing this today as capital is flowing out of emerging markets and into the US, because of the rise in US interest rates. Developing countries need long-term capital flows but they are often not able to cope with volatility in short-term flows.

We have traditionally followed a policy of limiting exposure to foreign commercial bank lending, so a contraction of those flows may not affect us directly. However, foreign institutional investor (FII) flows can show volatility, which can cause problems. There are other uncertainties also. Oil prices are firming up internationally and some argue that they may go higher. With export performance likely to be weak in the near future, this could increase the current account deficit (CAD).

A higher deficit at a time of weak capital inflows will put pressure on the rupee. Some depreciation is desirable, especially in a situation where the pound, the renminbi and many other currencies have depreciated against the dollar, but a sudden large depreciation can be highly destabilizing. We should obviously do all we can to promote foreign direct investment.

Policy priorities

The Chinese have a saying that when everything is changing, it is best to remain still until things settle down. As the fastest-growing economy in the world, we were in a particularly good situation, described as “a beacon of hope” and “an island of calm”. The demonetization, and the disruption it has caused, has altered this perception and caused uncertainty about domestic policy and prospects.

It is important to signal that good economics rather than opportunistic politics will drive policy in the year ahead. The first priority must be to ensure that the ongoing disruption caused by demonetization is quickly overcome by reinjecting sufficient cash into the economy. The shortage of cash has accelerated digitalization which is good, but the notion that “sucking cash out of the economy” may be a good way of promoting digital payments should be rejected. Digitalization is desirable, but consciously prolonging the cash shortage is not the way to promote it.

There are also many “unconventional” ideas floating around which add to policy uncertainty. These include abolishing income tax and replacing it with a banking transactions tax. It is also being argued that government expenditure must be expanded irrespective of the impact on the fiscal deficit to counter the demand depression caused by demonetization.

The fact that the ratings agencies were unwilling to upgrade India despite a strong push from the government indicates that they have reservations about some aspects of our macro fundamentals. The agencies may be wrong—they have been wrong before—but in a world of global uncertainty, international investors are risk-averse and may give greater credence to the ratings agencies than we would like.

The most important objective for policy should be to end the prolonged stagnation in real investment in the economy. This is necessary for a resumption of growth and also job creation.

For this, markets and investors will look for early restoration of normalcy in cash availability, progress towards tax reforms, a fiscal deficit consistent with macroeconomic stability, progress in ease of doing business and expansion of investment in infrastructure. All this must be accompanied by fixing the stressed balance sheets of banks so that there is a healthy growth of bank lending to productive sectors. That is the least we need for a happy new year.

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