GOING BACK TO IMPORT SUBSTITUTION

[I wrote this in the Calcutta Telegraph on 2 December 2008, five weeks after the attack of Pakistani terrorists on the Taj Mahal Hotel in Bombay and days after P Chidambaram was transferred from the finance to the home ministry.] DEALING WITH DEPRESSION

I have suffered two blows in a week. The first was the terrorist attack on my favourite Indian city and on its iconic hotel, The Taj. In more affluent times, I have sometimes occupied one of its sea-facing rooms, sat in the bay window and watched yachts of its neighbouring yacht club sailing in a light breeze. In less affluent times, I have done the same thing from a window of its tea room. The Taj is a part of my nostalgia for Bombay, which I had to leave when I could no longer afford to live there. The other, though not of the same magnitude, was the departure of P. Chidambaram from the finance ministry. He has been the mainstay of my journalistic writings in the past four years. I found myself disagreeing with his policies and pronouncements every so often; he was an inexhaustible font of ideas for columns. He was so inventive in his errors that I was never bored. I do not know what I will do without him. I presume he was a victim of the global crisis: his innate optimism was increasingly, jarringly out of place in the middle of the worsening economic conditions, and his passive approach to countercyclical policy did not appeal to the Prime Minister. That the PM has taken the reins in his own hands perhaps indicates the seriousness with which he takes the slowdown. He is an improvement because he tends to consult more widely and listen more carefully. Not that the best policies would necessarily emerge from a collectivity of economists; for they are as susceptible to herd instinct as any other group. Montek Singh Ahluwalia will no doubt herd them and deliver their wisdom, suitably packed and processed, to the PM. The PM could even make Ahluwalia finance minister. There is the little matter of a minister having to be Member of Parliament; but since Parliament has less than six months of life left, maybe Ahluwalia can function without being elected for that long. This is a problem that the PM is well equipped to handle. Let me get away from the personalities and come to the issues. The government has already loosened monetary policy in response to the slowdown; banks are no longer constrained from lending by their cash holdings. That led to some increase in their lending; but they parked a good deal of their increase in assets in government securities. In the eight weeks to November 7, banks’ loans increased by Rs 195,000 crore. But they also put Rs 84,000 crore in government securities earning 8 per cent instead of lending it to businesses at 14 per cent and more; they trusted the government more than they did businessmen. And their deposits increased by only Rs 111,000 crore; Rs 84,000 crore of what they lent did not come back to them in deposits. Of that Rs 84,000 crore, Rs 29,000 crore went to replenish people’s cash hoards. Monetary policy is not working against deflation. What, then, can the government do? It could use fiscal policy — increase expenditure or reduce taxes. There may be some possibilities in this direction. But Chidambaram ran such large deficits in the past four years that he increased national debt enormously. He undid the reduction that BJP finance ministers achieved in the ratio of fiscal deficit to GDP, and took the fisc back to the worst days of Yashwant Sinha. This year he did some disingenuous financial engineering and seriously understated the fiscal deficit. Admittedly, one reason why he did so was the Prime Minister’s expensive scheme for fuelling corruption, namely the National Rural Employment Guarantee programme. While the PM is perfectly capable of such follies in good times, I am not sure he will be so reckless now. If we assume that he would be prepared to follow rational anti-deflationary policies, what can he do? The current deflation means that the demand for goods and services is growing less fast, leading to a slowdown in the growth of their production. What he needs to do is to increase national expenditure, which economists divide traditionally into four parts: consumption, investment, fiscal deficit and the surplus on the balance of payments. Of these, consumption depends on income and hence on total expenditure. It can be stimulated to some extent by giving people cheap loans to buy homes, cars and consumer durables. But at a time when incomes and employment are under threat, they are unlikely to be able to repay loans if they take them; so this course is best avoided. Investment will come down because growth of demand is slowing, profits are shrinking and businesses are running short of cash; it is difficult to stimulate it at this juncture. As we have already seen, Chidambaram increased fiscal deficit so much that it would be best if the government did not raise it further. That leaves the balance of payments, which is heavily negative. We have been importing far more than we export. We could do so because many foreigners have been investing in India; we have used their dollars to finance imports. In fact, so much foreign capital has been coming in that it exceeded our payments deficit and we accumulated over $300 billion in reserves till last May. Some $50 billion of them has since disappeared: capital has been going out, and the Reserve Bank has been selling dollars to raise the sinking dollar price of the Rupee. If the government keeps watching passively, the rest of the reserves will melt away in the next few months. This is where the possibilities of policy lie. If we export more, that increases demand for our goods and services. So does import substitution — that is, replacing imports by domestic produce. Import substitution has a stale, musty smell in India. The government was an assiduous practitioner of import substitution from 1939 till 1991. It replaced cheap imports with expensive domestic production. It thereby reduced people’s purchasing power and their real incomes; and it raised the costs of production and made our industry internationally competitive. I gleefully exposed the folly of those import substitution policies. That is why I was taken into the finance ministry by the present PM in 1991 when we needed an alternative to import substitution. I was eased out as soon as we got past the crisis. So I am the right person to say that the time has come for the government to revert to import substitution. But not in the way we did it till the 1980s. We should remove all import duties — including the outrageous duties we levy on agricultural and consumer goods — and let domestic production compete fairly with imports. But we should devalue the Rupee and give equal encouragement to import substitution and export promotion. The prime policy instrument should not be import duties, but the exchange rate. That may be accompanied by a rise or fall in reserves — it does not matter while the reserves are so high. What matters is the relative prices of domestic and foreign goods; we should use the exchange rate to manipulate them so as to increase domestic output and employment.