FROM BUSINESS WORLD OF 26 JUNE 2006
The trade cycle – what next?
There is considerable demand in Europe for India’s success
story; I have given talks on it in Paris, Berlin and Ljubljana in the past
week. After one of them, a listener said that he understood India was experiencing
a sustained boom like the one Germany enjoyed for three decades after World War
II, which transformed it from a shattered economy to one of the richest in the
world; where, he asked, will the boom take India?
I did not have the heart to tell
him, but India’s boom differs from those experienced by Germany and Japan after
the War in a crucial respect. Throughout their booms, these two defeated
countries enjoyed a current account surplus. There was, therefore, no external
economic threat to their growth. India’s current account was briefly in surplus
between 1999 and 2004, but turned deficit soon after. Hence India’s boom faced
external vulnerability. In fact, I predicted a number of times last year that
the Indian economy would reach a turning point by 2007 at the latest. That
turning point came earlier than I had thought, namely in the form of the stock
market meltdown in May.
Those in power did not share my
diagnosis; they believed that because they were sitting on $150 billion of
foreign exchange reserves, they could cope with any external crisis. For them,
the break in Sensex is a trivial event. Indian politicians invest their
ill-gotten gains in property, while bureaucrats invest them in real estate and
government bonds. So for them, shares are a plaything of shady stockbrokers. If
a Ketan Parekh loses his fortune, a Harshad Mehta his life, that is rough
justice.
But because of something those in
power did 15 years ago, the stock market has become a plaything of foreign
investors, and their reading of where it is headed has an impact on the balance
of payments. A good deal of their money has flown out in the past two months,
and more may.
They brought in foreign exchange,
and they are now taking it away. But shares are bought and sold in Rupees.
Hence the inflows and outflows of foreign exchange must be reflected in money
supply. If they sell off shares, domestic money supply must shrink.
That would cause immediate
discomfort to the banks, whose cash reserves must contract; with it declines
their capacity to lend, and their revenue growth. That would worry their
mother, Reserve Bank.
Reserve Bank could easily restore
their cash balances by buying off some government securities from them. But
money supply also affects market rates of interest; the more liberal Reserve
Bank is with it, the lower the interest rates – and the more attractive
investing abroad becomes. If domestic interest rates are low enough, not only
foreign investors but also Indian companies, traders and speculators would take
money out and invest it abroad. That would contract money supply, and Reserve
Bank would have to buy even more securities to replenish it.
And at a time when their capacity
to lend is threatened, banks do not like low interest rates, for interest for
them is income. And if they do not like low interest rates, Their mother,
Reserve Bank, cannot like them either.
Hence once the stock market boom
broke, it was inevitable that interest rates must go up. Another reason is just
appearing on the horizon, namely inflation. India has had a relatively benign
inflation climate for ten years. But now, the supply-demand balance in
foodgrains is turning adverse, and so is it internationally in oil. And as
inflation rises, so must nominal interest rates.
As they rise, investment in
sectors that depend on borrowing must come down. Property is the most obvious
one, but not the only one. The downturn in investment takes time to show, for
investment plans cannot be revised or abandoned overnight. First come sleepless
nights for builders, lenders and investors; then, only after much biting of
nails, when they can no longer find any more money, do they start cutting down
investment.
But that too will come. The
Indian economy is not the Chinese; the Indian boom is not an export-led boom. So
it must turn down, if not this year, then next. Which is a pity, because with
slightly better, somewhat more export-friendly economic policy, we could have
gone on growing for many a year.
