THE Indian economy is clearly afflicted by stagflation. According to the provisional estimates of GDP released recently by the Central Statistical Organisation, growth in 2013-14 was, at 4.7 per cent, not very much higher than the 4.5 per cent of 2012-13. That rate is disappointing because it includes a negative rate of growth of manufacturing. Point-on-point consumer price inflation, on the other hand, was at a higher 8.6 per cent in April relative to 8.3 per cent in March. This definitely adds up to a form of stagflation. Yet, if the media and the official establishment are to be believed, there are reasons to celebrate and the new government has given cause for optimism. This is because in recent times two, largely financial, trends have helped the establishment and the media divert attention from the stagflation that the economy is mired in. Since early February, the BSE Sensex has risen by more than 10 per cent, taking an already inflated index to record highs. The Bombay Stock Exchange that experienced one rally between August-end last year and January-end this year (which delivered a 19 per cent rise in the Sensex), has witnessed another bull run in the weeks prior to the elections. Given the nature of this market it does not take rocket science to establish that the surge in the index is because of a spike in investor demand for the limited amount of actively traded stocks. If financial investors are seen as even vaguely rational, this would be surprising. Rising equity values imply that investors are expecting the returns from the underlying assets to rise sharply. But all other indicators point to flagging demand, a deceleration in growth and a profit squeeze. Once again, with a vengeance, the stock market seems to be daring the real economy to go against its predictions and take a turn for the worse from its already sagging levels. As is normal, in search of explanations for these contrary trends in the “markets”, on the one hand, and the real economy, on the other, analysts have been grabbing at straws. The weakest of them is the argument that expectations that a stable government with a business friendly prime minister will be delivered by the elections, had driven investors to grab stocks of firms that would profit from the coming boom. BULL RUN DRIVEN BY SPECULATION Underlying even this explanation is the presumption that the bull run the market experienced was driven by speculation. Speculation about the outcome of the election. Speculation about the nature of the new government. And speculation that when that government does what it is expected to do, profits would rise enough to warrant the high valuations. Despite these extremely tenuous grounds, this explanation of why the ‘market’ is behaving as it is implicitly justifies its irrational exuberance. Who are these speculators? By all accounts they bring in money from abroad and carry the tag ‘foreign institutional investors’ or FIIs for short. Some of them are real asset management companies or other foreign financial firms looking for quick returns from a market boom they themselves engineer. Others, some analysts claim are “round trippers” or those who have illegally taken money out of India recently or in the past and find it convenient to bring it back through the stock market route to earn a profit. Either way this is money from abroad looking for speculative returns and perhaps a dose of legitimacy. And the evidence seems to be that much of it is actually ‘foreign’ money. Needless to say, once foreign investors shake up the market, domestic speculators too rush in. But it is foreign money that is generating a stock market boom that serves as a financial smokescreen for the poor state of the real economy. But that is not all. There is reason to believe that the financial boom makes things worse in the real sector. One reason, of course, is that if there is easy money to be made in the stock market, investors would think twice before taking on the risk of trying to earn returns from risky productive activity with long gestation lags. But there is a more immediate way in which the speculative binge is hurting the real economy. This is through the strengthening or appreciation of the rupee, which makes imports cheaper in rupee terms (because a good worth a dollar now costs less in rupees) and exports more expensive in dollar terms (because a good worth Rs 100 now costs less in dollars). If India’s exports become more expensive then India’s limited competitiveness in global markets, vis-à-vis a country like China say, is further undermined. More importantly, if imports are cheaper in an environment where restrictions on imports of goods into the country have been done away with by liberalisation, domestic producers would be outcompeted by (now cheaper) imports from abroad. As a result of both of these factors an appreciation of the rupee would impact adversely on domestic productive activity. This is what has happened, because of the surge in speculative capital flowing into the country. Measured against the dollar the rupee has been gaining ground, valued at 59.5 to the dollar (as per RBI’s reference rate) on May 15, as compared with 60.2 at the beginning of the month and 62.7 at the end of the January. This appreciation, however, needs to be put in perspective. What we are witnessing is not a long term appreciation of the rupee but a rise in its value as a result of volatility. Thus, while when compared to a year back the rupee on May 15, 2014 had appreciated by about 8.6 per cent vis-à-vis the dollar, on 28 August last year its value (at 68.4 to the dollar) was 13 per cent below its May 16, 2013 value. Second, even though the deficit on the current account of India’s balance of payments has come down quite significantly (largely as a result of a fall in gold imports), India remains a deficit country, expending more foreign exchange on its current account transactions than the foreign exchange it “earns”. So if currency movements are influenced by the net value of current transactions, which reflects a deficit, the rupee should be depreciating rather than appreciation. This is the long-term tendency in the external sector. So, third, this implies that the factors explaining the rupee’s fluctuations are largely related to the capital account, with periods of capital outflow or expectations of net capital outflow, resulting in a depreciation of the rupee and periods of net capital inflow or expectations of the same creating pressures for the currency to appreciate. Thus the recent (relative) appreciation is the result of a capital surge, whereas the July-August 2013 depreciation was because of fears that the US Federal Reserve’s decision to taper out its easy money policy would result in capital flight. A CASINO FOR SPECULATIVE GLOBAL CAPITAL As noted, the recent net inflow surge was largely the result of large speculative FII inflows into equity and debt markets. Net inflows over the year ending May 15, 2014 amounted to $5.98 billion, whereas inflows during the four and a half months since the beginning of this calendar year amounted to $11.73 billion and during the first 15 days of May as much as $2.24 billion. This has not merely generated a bubble in the stock market, with the Sensex soaring to record highs, but triggered a short-run appreciation of the rupee, because of excess supply of foreign exchange. Normally, under such circumstances, the Reserve Bank of India tends to intervene to buy up and generate demand for foreign exchange, to dampen the rupee’s appreciation, which is damaging to exporters and domestic producers. However, when the surge is as sudden and strong as it has been, the RBI cannot match the increase in foreign exchange supply with its increased demand. Concerned with the monetary policy implications of acquiring foreign currency assets, the Reserve Bank of India has chosen not to mop up all the excess foreign exchange liquidity through purchases. If it resorts to huge purchases that raise the foreign currency assets it holds, the corollary is an increase in the central bank’s liabilities or an increase in money supply. With its focus on reining in inflation the RBI is not keen on that. The problem is that when the rupee is appreciating, the dollar returns that short-run foreign investors earn in the equity market tend to rise. Each dollar invested not only earns a return because of the equity market boom, but also because when investors book profits and exit, the rupees needed to recoup the dollar investment they made when they entered the market is lower than earlier. This gives them an additional return, which only aggravates the speculative spiral. Thus the financial “boom” reflected in the rise of the Sensex, on the one hand, and the rupee’s value, on the other, is a result of India turning into a casino for speculative global capital. That not only directly affects productive activity by rendering productive investments unattractive relative to speculative investments, but also undermines the competitiveness of productive assets in the country in both global and domestic market. This only intensifies the stagflation afflicting the country. But the euphoria generated by the speculative boom serves to conceal this fact. But this gives the NDA government only temporary respite. Given the character of the forces driving the Sensex and the rupee’s appreciation, it is unlikely that the boom would persist and the possibility is that it may even be reversed, encouraging capital flight from the country. That would add another factor to the many damaging a flagging real economy.