Handling external shocks – on economic policy

Source– The post is based on the article “Handling external shocks” published in the Business Standard on 16th November 2022.

Syllabus: GS3- Economy

Relevance: Global economic scenario

News– The article explains impacts of rapid tightening of monetary policy by US and other Advanced Economies. It also explains its implications for India.

Why blindly following the federal reserve policy is not appropriate?

This is designed for the excess macro-stimulus and tight labour markets in the US. Moreover, interest parity holds tightly only for AEs that are fully open to capital flows.

following the Fed involves letting the exchange rate depreciate while tightening monetary and financial conditions. But this could aggravate external shocks, creating sharp price movements in thin markets.

A sharp currency depreciation hurts those who have borrowed abroad but a sharp interest rate rise hurts domestic debtors. It can push leveraged sectors into crisis.

Exporters who typically sell in contested markets gain little, while the cost of commodity imports that are invoiced in dollars rise immediately.

We are seeing the consequences of demand over-stimulus that ignored supply-chain bottlenecks in advanced economies’ response to pandemic.

The belief that Advanced Economies can borrow at low rates regardless of the size of borrowing ignores history. Even in the US, which has the advantage of being able to print dollars, inflation, interest rates and deficits were high in the 1970s. Fiscal rules were implemented later and debt was brought down.

What is the pragmatic policy that is needed by India?

To sustain growth while keeping inflation low, supply-side reforms must continue. It should be supported by counter-cyclical tax rates, a larger share of expenditure on capacity building, real repo rate that are based on expected inflation, competitive real exchange rate without excessive nominal depreciation and capital flow management policies.

A widening of the current account deficit due to a persistent rise in oil prices does require reduction in aggregate demand as well as depreciation, but within limits. Continuous depreciation is inflationary and results in real appreciation, which encourages more imports.

Therefore, to reduce deficits multiple policy levers are needed. More emphasis should be on longer-term sustainable measures such as encouraging exports, reducing oil intensity and energy imports.

Why is this type of policy feasible for India?

Growth and reform induced tax buoyancy gives fiscal space consistent with adequate consolidation.

India does not have full capital account convertibility. So, capital flow management policies can be fine-tuned to selectively encourage or discourage different types of flows.

Micro and macroprudential regulation can be relaxed to counter tightening of financial conditions due to outflows. Reserve loss further tightens liquidity but can be sterilised by increasing holdings of government securities. The surplus reserves are adequate for cyclical US tightening.

Policy cannot work against fundamentals. Rupee depreciation and stock market correction have been less than in most other advanced and emerging markets. This indicates that markets are factoring in India’s comparatively better prospects and lower inflation.