In India, the value of the rupee has fallen dramatically, and the once heralded future economic powerhouse looks more fragile.
The U.S. Federal Reserve decided at this week’s FOMC meeting to continue the pace of asset purchases, to the surprise of markets. Since May this year, when Bernanke indicated that the Fed might slow its monetary stimulus, focus has shifted to the state of the emerging economies. Following the financial crisis and the subsequent bottoming out of interest rates in advanced countries, there was an inflow of funds into economies with higher potential returns.
Now, as the U.S. economy strengthens and yields on U.S. treasuries rise, there is concern that outflows from emerging economies will be destabilizing to the world economy.
In this context, Raghuram Rajan has taken office as the new governor of the Reserve Bank of India. Known for his work in economics at the University of Chicago, Rajan has also consulted closely with the Indian government in the past (he worked as the chief economic advisor to the finance ministry since 2012).
There are high hopes that he might be able to successfully steer India’s economy away from the pitfalls of investors and finance moving away from India. One of the reasons why India has seen its stock fall sharply over the past couple of months is due to its high current account deficit.
A nation’s current account encapsulates two elements. It can indicate the difference between a nation’s exports versus imports of goods and services (also including transfers). Or, the current account can be understood as the difference between a nation’s savings and investment. If a country has low national savings, it has to borrow from abroad to fund investment.
Similarly, a country might import goods and services to export other goods at a later date. The balance in the current account basically sums up a nation’s position as either a debtor or a creditor on the world stage. India’s high current account deficit means a sharp reversal in financing (lending) could constrain future economic activity, which cannot be funded from lower savings.
However, if Rajan moves strongly to curtail the rupee’s drop in value by raising interest rates and limiting lending, that could poison India’s growth as well. The RBI has taken some steps to constrain lending, but there are worries about adverse effects if they stay in place for longer than several months.
In a piece on written before his appointment to RBI, Rajan argued that India suffers from “bipolar behavior” among investors. That is to say, investors fluctuate between upbeat and gloomy assessments of the Indian economy that fail to recognize that the deficiencies currently criticized existed during periods of higher growth. According to his piece, inflation caused by stimulus spending after the recession led to slower investment and consumption.
Coupled with an inefficient bureaucracy that has failed adequately to allocate capital to projects with higher returns, this has led to higher deficits. However, he believes that “India’s current growth slowdown and its fiscal and current account deficits are not structural problems.” Running a more effective bureaucracy that does not hold back market investment would go far in his estimation. While the RBI can take steps to assist the economy and support the rupee, a truly effective response needs to come from government policy. Whether India’s government is up to the task remains to be seen.