Breakingviews - India in depth: A Japanese-style "big reset"
SINGAPORE (Reuters Breakingviews) - India needs a Japanese-style reset. For the country to decisively escape from its self-constructed trap of extreme economic pessimism, New Delhi needs to import the spirit of Abenomics.
The advice may appear counterintuitive, considering that new Japanese Prime Minister Shinzo Abe's strategy of aggressive fiscal and monetary easing is the opposite of the policies India should pursue. But at its core, Abenomics is about hitting an economic reset button so that corrosive forces, which have created a lousy equilibrium of their own, are defeated, and a more virtuous economic cycle can begin.
With economic growth at its weakest in a decade, India needs a reset as badly as Japan did when it elected Abe in December last year. Finance Minister Palaniappan Chidambaram has so far focussed on structural reforms. But pruning government expenditure and allowing greater foreign participation in aviation, insurance and retail does not produce results overnight. A bold reset - such as devaluing the rupee 16 percent against the US dollar - will have an immediate impact.
The Japanese yen has witnessed a 16 percent decline since Abe's election victory in December. The effect on Japanese companies is palpable. "Everything has suddenly changed," Hiroyuki Bessho, founder of Redfox, a 25-year-old enterprise software solutions company, told me in Tokyo recently. "Our customers are now more optimistic, and so are we."
Policy makers in India may dismiss the idea of devaluation on the grounds that the bug that has kept the Japanese economy from performing to its potential is entrenched deflation, while India's growth is stifled by double-digit inflation. But in both countries the opposite problems have had the same effect of choking off private enterprise.
There are other differences. Japan's deflation was the result of the bursting of a gigantic asset bubble in the early 1990s, and was compounded by a hollowing out of wages following an exodus from the workforce of the post-World War II baby boom generation. India's inflation has been a result of ultra-loose fiscal policies that, via generous state-set crop prices and a rural job guarantee, encouraged outsized wage growth in villages.
Those policies - combined with graft scandals that distracted the government from its task of creating capacity, especially in power and other infrastructure - have hobbled the economy. Not only are investments sputtering, urban consumption, too, is waning. Car sales fell for the first time in 12 years in the year ended March 31.
If this were a typical business-cycle downturn, a recovery would be around the corner. But India is in the throes of a multiyear credit-cycle downturn, which is being reinforced by structural rigidities in the economy. It is possible that India will exit the low-growth trap by attacking shortcomings like an inflexible labour market and a nonexistent bankruptcy regime. That, after all, is what Abe's detractors also recommend: "Don't play around with money, fix the supply side." But doing so takes years.
Devaluing the rupee would pose considerable risks. For a start, inflation will become worse than it already is. But by simultaneously tightening fiscal policy, the government could offset some of the inflationary effect of devaluation. Implementing a long-delayed goods and services tax, which will subsume many of the existing indirect taxes, would also help bring inflation under control.
A prolonged period of rupee undervaluation will create its own problems. More speculative capital will enter the economy looking to profit from an eventual revaluation. New Delhi may face international censure for manipulating its currency. But since India is by no means a dominant exporter, the criticism will be less harsh than China faced before it revalued the yuan in 2005.
The long-term gains from a cheaper currency will outweigh the short-term pain. Once it becomes clear that the central bank won't let the rupee rise from its post-devaluation level of about 65 to the dollar for a few years, a new economy centred on export-led manufacturing will have a chance to supplement software exports. The record high current-account deficit of 6.7 percent of GDP will quickly turn into a small surplus.
Besides bringing its spending under control, such a strategy would require the government to do two more things: Give abundant coal to power producers so that manufacturing has a real chance, and slowly free the banking system from its current mandate of channelling 23 percent of deposits to the financing of public debt.
The availability of cheaper electricity and credit will stimulate manufacturing and export of widgets that China can no longer make at competitive prices. India's young will get the job opportunities that an unnaturally strong currency is denying them. Besides, it's best to whack the wealthy with a tax they can't escape. The currency reset is effectively a tax on consumption and a subsidy to producers and workers.
Even if the government resists, it might face devaluation anyway. More than any other economy in Asia, India is addicted to the cheap money being printed by central banks in advanced nations. As this monetary stimulus recedes, India will find it hard to finance its ballooning trade deficit. With foreign-exchange reserves barely enough to pay for six months of goods imports, resisting the pressure for currency depreciation will be futile. Rather than accept a weak rupee via a currency crisis, India should consider embracing such an outcome as a strategic choice.
It's futile to expect such a bold step from the Manmohan Singh government, which has already entered the lame-duck phase. But serious contenders for the prime minister's job in 2014 - Rahul Gandhi of the ruling Congress Party, Narendra Modi of the opposition Bharatiya Janata Party and possible "third front" candidate Mulayam Singh Yadav - should start exploring the devaluation idea. Communicating the plan as a campaign pledge, which is how Abe marketed his anti-deflation programme, will give it legitimacy. The great reset will not obviate the need for fixing the Indian economy's many weaknesses; but it will make that task a lot easier.
(Editing by Peter Thal Larsen and Katrina Hamlin)
(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)
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