ECONOMIST Paul Krugman has recently written a column in The New York Times on the depreciating Indian rupee. He comes to the conclusion that India’s present currency crisis is fundamentally different from the East Asian currency crisis of 1997-8, since India’s debt, denominated in foreign currency, is small compared to what it was for the East Asian economies then. Hence he argues that there is no cause for India to panic; the rupee will depreciate for a while and then settle down, which would mean an upsurge in inflation for a while before prices too settle down. The real danger according to him is policy “over-reaction”, ie, raising interest rates to defend the exchange rate leading to an “unnecessary slump”. Krugman’s comments however are based on a misreading of the Indian situation. He is right that India’s current crisis is different from the East Asian crisis of 1997-8; but he is wrong that this difference means India does not have a crisis. Any net capital inflows into a country, in excess of its additions to foreign exchange reserves, necessarily finances an excess of domestic investment over domestic savings. In the case of East Asia, the net capital inflows had financed an increase in investment; in the case of India however the net capital inflows, when not adding to reserves, have financed a reduction in savings (via a liberalisation of imports at the expense of domestic production). This is the reason why industrial growth rate in India has been so abysmal of late despite a high rate of GDP growth (until recently): liberalised imports have simply eaten into the markets of domestic producers and hence restricted the output they produce. In the case of East Asia prior to the crisis, capital inflows took the form, to a significant extent, of a build-up of foreign currency liabilities of domestic banks, against which these banks gave loans for capital formation domestically. Corresponding to the increase in capital inflows therefore there was an increase in the domestic investment ratio. Now, the East Asian economies already had high savings and investment rates; what capital inflows did was to raise the investment rates even higher. Since a lot of these investments financed by capital inflows (via the banking system), were themselves not foreign exchange earning, consisting of construction projects, office blocks, and such like, these economies were in effect “borrowing short to invest long”, and “borrowing in foreign exchange to investment in non-foreign exchange assets”. This was the basic factor underlying the crisis. When the crisis came, every decline in the exchange rate made banks, who had borrowed in foreign exchange to lend in domestic currency, more insolvent (since the value of their liabilities went up relative to their assets); and every such increase in their insolvency made panicky depositors take out even more foreign exchange deposits which led to a further decline in the exchange rate. A cumulative spiral was thus set up which aggravated the crisis. But this crisis was not a structural crisis, in the sense that once the immediate shock was absorbed, these economies could easily withstand any subsequent reduction in the rate of capital inflows. Such reduction would merely entail a lower investment ratio than before the crisis, and nothing more. Since these economies already had high domestic savings and investment ratios anyway, this fact itself was no great tragedy for these economies. STRUCTURAL CRISIS In the case of India however matters are completely different. Capital inflows, when not adding to reserves, have not financed larger investment; they have financed larger imports at the expense of domestic production, and hence an industrial stagnation that has brought down the savings rate. Since the focus of attention in Krugman, as indeed in Indian official analyses of the current crisis, is on the post-2007-8 period, when low interest rates in the US are supposed to have led to burgeoning capital inflows into the “emerging market economies”, let us see how India absorbed these capital inflows in the post-2007-8 period. Year Gross Domestic Savings (% of GDP at Market Prices) Gross Domestic Capital Formation (% of GDP at Market Prices) 2007-8 36.8 38.1 2008-9 32.0 34.3 2009-10 33.9 36.7 2010-11 34.0 36.8 2011-12(R) 30.6 35.0 Source: Government of India, Economic Survey 2012-13. The widening of the current account deficit after 2007-8, which is the excess of gross domestic capital formation over the gross domestic savings and which is financed by net capital inflows (less additions to reserves), has been accompanied not by an increase in the investment rate but rather by a decline; the decline in the gross domestic savings ratio, however, has been even sharper. The economy has not been subject to excess aggregate demand pressures, as is obvious from the fact that unutilised industrial capacity and unsold food-grain stocks have been available in abundance. True, there may have been infrastructural bottlenecks, but nobody can argue that the level of activity in the economy has been restricted on account of such bottlenecks rather than of a deficiency of aggregate demand. The structural crisis of the Indian economy consists therefore of two components: first, a current account deficit of this order simply cannot be financed with the amount of net capital inflows that the economy is likely to receive in the foreseeable future (even if temporarily the slide in the value of the rupee is halted because capital inflows do pick up and come in adequate magnitudes); and secondly, a reduction in this current account deficit cannot be achieved merely by lopping off excess demand, since the economy is not facing a situation of excess demand, but is, on the contrary, saddled with substantial slack, in the form of unutilised capacity and unsold food-grain stocks. East Asian economies when they experienced the crisis of 1997-8 were not saddled with such substantial slack. Hence even though their crisis was acute in an immediate sense, it was not a serious structural crisis. It could be overcome, once the immediate shock was over, through a mere reduction in domestic absorption of foreign goods, effected through the usual macroeconomic policy instruments without causing a protracted slump. But this is not the case for India. Let us see why. There can be three basic ways of reducing the current account deficit. One is through a fall in the external value of the rupee, as is happening at present. Such a fall is supposed to boost our exports and reduce our imports. But this is possible only with a reduction in the real effective exchange rate, ie, only to the extent that the nominal depreciation in the value of the rupee is not counterbalanced by a rise in the domestic price level. With oil being an important item of import and the rupee cost of imported oil being “passed on”, the main element that can prevent such counterbalancing is the rigidity of the money wage rates, ie, the fact that the bulk of the Indian work-force does not have its wage rates indexed to inflation. SANGUINE REMARK The only way that a fall in the value of the rupee can at all reduce our current account deficit therefore is necessarily through hurting the poor, which is why Krugman’s sanguine remark, that the spike in the inflation rate owing to the fall in the value of the rupee will only be temporary, cannot provide much comfort. Even this temporary spike in inflation will mean a permanent fall in the living standards of vast numbers of extremely poor people. But even if these poor people are squeezed, even if there is a depreciation of the real effective exchange rate, its impact on exports in the midst of a world recession is likely to be small. Even its impact on imports is not likely to be very significant. This is because almost half of the imports now consist of gold and oil. Gold imports are partly a reflection of the fact that, with the rupee depreciating, gold has become an attractive asset to hold; since this state of affairs will not easily disappear, gold imports are unlikely to come down much (unless there are strict import controls, on which more later). Likewise in the absence of petro-product rationing, oil imports are unlikely to come down much. As regards other imports, where the possibility of dumping in the Indian market cannot be ignored, mere price changes via exchange rate depreciation will not be effective. Besides, even if the exchange rate depreciation reduces the current account deficit, if it also brings down capital inflows, in the expectation that the exchange rate will depreciate still further, then this depreciation (and with it the attack on the people’s living standards) may well go on for a long time, with severe social consequences. The second way of cutting down the current account deficit is by pursuing policies of “austerity”. But these will necessarily have a contractionary effect on the economy which already is saddled with unutilised capacity, unemployment and unsold stocks of food-grains in the midst of acute hunger and malnutrition. This way, which is fraught with serious consequences for the people (since it will also entail above all cuts in welfare expenditures), will be adopted not because of “policy over-reaction” as Krugman fears, but as a consequence of IMF conditionalities, should the government go to the IMF (which is by no means unlikely in a few months’ time). The third way of bringing down the current deficit is by imposing import controls, and, should finance capital resist these, capital controls. These will not entail cost-push inflation via oil price increases; at the same time they will increase and not decrease the level of domestic activity, since in the absence of imports the demand for, and hence the output of, domestic goods will increase. In other words, import controls will be beneficial for the people both by keeping down the inflation rate and by increasing the level of domestic activity. There will of course be opposition from international agencies and from other countries to India’s adopting a protectionist policy stance. But since India’s tariff rates are well below the tariff bounds allowed under the WTO, tariff protection up to the “bound-rates” is well within the country’s rights, even under existing international obligations. Above all however “international obligations” entered into by a government committed to neo-liberalism, without the approval of parliament, cannot be allowed to stand in the way of the people’s welfare. A basic difference between East Asia in 1997 and India in 2013 which actually highlights the specificity and acuteness of the Indian crisis is that it cannot be overcome while pursuing neo-liberalism. In 1997 too capital controls were tried in Malaysia and were efficacious, but others did not adopt them. In 2013 India there may not be a choice. Prabhat Patnaik