“The fiscal imbalance is the root cause of the twin problems of inflation and the difficult balance of payments position.” This is a statement made by the finance minister of India on the floor of Parliament. It was on March 19, 1990, and was part of the budget speech of Madhu Dandavate. The more things change the more they remain the same. In many respects, the economy might have regressed to a pre-1991 state, especially due to an eight-year persistent non-oil trade deficit, and an overvalued exchange rate. Dandavate’s statement is a reminder, if ever needed, that the external current account reflects the state of accounts of the government. The external strength of the rupee cannot be totally divergent with its internal strength. Since internally the rupee has lost at least 50% of its purchasing power in the past five years, it is but natural for it to move from 40 to 60 in parallel.
Hence trying to artificially suppress this pressure cooker of rupee depreciation is bound to fail. You need to let the steam off. But, of course, that does not mean you don’t intervene to curb volatility.
Since currency markets get carried away the herd mentality causes traders to behave as if there is no bottom. Hence it is important to calm the markets periodically. However, if you ignore fundamental and structural factors and reforms for too long, then you get into a tight corner. This is our current predicament. The widening trade deficit caused by imports of coal, fertiliser, edible oil and capital equipment, was flagged three years ago, by the commerce ministry itself. This needed a structural response, which was outlined in the ministry’s remarkable strategy paper. But inaction on structural dimensions combined with high fiscal deficits and inflation has led us to be cornered.
In this cornered situation, the Reserve Bank of India’s harsh measures came as a nasty shock, and caused disruption in the bond market. The rise in yields might entail a mark-to-market loss of R40,000 crore to bank treasuries. To curb volatility in currency, RBI has unwittingly caused huge volatility in yields. This outcome vindicated the RBI Governor’s own statement, where he had said that a failed intervention is worse than no intervention.
We are caught in a situation where every response now will have an unpleasant side-effect. In the lingo of economists, we are looking for second-best solutions, if not third-best. So, measures like