Indian Economy in Catch 22

Spread it!

Email This

The developments in Indian Economy over the last couple of months presents interesting analysis. The currency fluctuation, sustained inflation and consequently higher interest rates have given rise to a jigsaw puzzle which the Finance Ministry and RBI are trying to tackle through various instruments available at their disposal.

The key factors namely currency valuation,inflation, liquidity,industrial  output and economic growth form tightly coupled aspects of the same puzzle.Let us start by looking at the basics.What constitutes
  the movement of a currency against dollar? The Balance of Payments will help us understand this better.BOP indicates the net flow of currency inside and outside a country. BOP has three components namely Current Account, Capital Account and Financial Account.

• Current Account =Net of Trade(Goods and Services)
• Capital Account=International Capital Transfers in the form of physical asset such as land and non-produced assets
• Financial Account=International monetary flows related to investment in business, bonds ,stocks etc.

Theoretically the BOP should be zero. Thus:
Current Account+Capital Account+Financial Account=0

Thus current account is theoretically supposed to balance out the capital and financial account.If the company exports more than import,then it would be a net credit on current account since money is coming into the economy leading to current account surplus.Similarly if there are more of capital investments or financial investments into the country it would result in capital surplus or financial surplus.In the event that there is more of capital investments into the country(meaning capital account surplus),then the country is supposed to give the return back to the investor and this is recorded as a current account debit thus negating the impact resulting in a zero sum game.

The flight of the dollars as a result of capital account,current account and financial account results in fluctuation of local currency.When there is a dollar in flight due to investments in stocks,bonds etc.(financial account surplus) OR due to investments in physical assets such as land and other real estate instruments (capital account surplus),the circulation of dollar in local market increases, resulting in weakening of dollar against the local currency(since dollar supply is more).Similarly a dollar out flight will result in strengthening of dollar(weakening of rupee) due to reduced availability of dollar in local markets.The in flight or out flight of the dollar is driven by slew of macroeconomic factors such as strength of other related economies, investor confidence, demand of goods and services within and outside the economy etc.

With this background,lets come to the case of India.The Euro zone crisis had been looming large for past couple of months now.This has resulted in reduced investor confidence leading to FII's pulling out their money from Indian Markets(Dollar out flight).The increasing price of crude oil in the international markets(from $75 by Sep 2011 end to $95 by mid-December) has made imports dearer resulting in more dollars leaving the economy. The resultant depreciation of rupee due to reduced dollar supply has increased the cost of goods in the local market which has resulted in inflation. In order to reduce the rupee circulation in the market which is leading to inflation,RBI has been increasing the interest rates on a continuous basis. The increased interest rates has resulted in reduced borrowing and consequently reduced funding available for the businesses resulting in a fall in Industrial Output. The fall in industrial output would lead to negative economic growth technically referred to as recession.Hence the aspects around dollar availability,inflation,interest rates,industrial output and growth are all very closely interrelated.

The way out of this deadlock is bring an in an appreciation of the Indian currency by increasing the inflow of dollar into the economy. The vigorous attempt by the govt to bring in the FDI in multi-brand retail could be seen as one of the desperate measure to boost the Capital account surplus by increasing the dollar inflow. The disinvestment policies of the public sector companies could provide another key impetus by virtue of increasing the FII's.

The monetary policies which would need to be adopted by RBI at this juncture is a more tricky one.RBI would not be in a position to reduce the interest rates unless it sees a significant reduction in the inflation.A cut in the basis points at this juncture might lead to burgeoning of an already high inflation figure, although the move could provide an impetus to the industrial growth.
Hence India is a unique situation of having to choose between taming inflation Vis a vis boosting growth.At this juncture only a bold fiscal policy such as increased FDI (FDI in Aviation,Disinvestment Strategy)could provide some way out. We would also need to wish hard for the crude oil prices to reduce so that the Current Account deficit is reduced.A concrete solution to the Euro Zone crisis would also help in boosting investor confidence resulting in in flight of dollars. India would need a miracle with a combination of factors working in it's favor to bring the rupee back in course. Its testing times ahead...