India’s economy has grown rapidly over the last two decades, attracting foreign investors and evoking comparisons to China’s meteoric rise. But the emerging economy is now faltering, struggling with both internal and external challenges. Political scientist Milan Vaishnav spoke with Ila Patnaik, a leading Indian macroeconomist, about the country’s future and what officials need to do to get India back on the path to strong growth.

Vaishnav: The International Monetary Fund significantly revised downward its growth projection for India for fiscal year 2013–2014 to 4.3 percent. But the Indian government estimates that growth will be somewhere between 5 and 5.5 percent. Is the IMF is being too pessimistic?

Ila Patnaik
Patnaik, an expert on India’s economy, was a nonresident senior associate in Carnegie’s South Asia Program.
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Patnaik: The economic situation does look bad at the moment, but there are two things that might pull the growth rate up a little. If the monsoons are good and if exports pick up, then the IMF’s projection might prove too pessimistic.

The data over the last two or three months indicate that export figures have improved. Still, one can’t be too optimistic because export order figures are not very good for the time being.

All things considered, I don’t think growth will go above 4.5 percent this fiscal year.

Vaishnav: In the last several months the rupee has depreciated considerably, although it has recently rebounded. How much of this depreciation is due to domestic factors and how much to the global economic environment?

Patnaik: I think less than 25 percent of the depreciation was specific to India and the rest was due to global factors.

One significant external factor was a May 22 speech by U.S. Federal Reserve Chairman Ben Bernanke in which he indicated that the Fed would consider winding down its monetary stimulus program (known as quantitative easing, or QE3). After that speech, all emerging markets—especially the ones with large current account deficits—saw their currencies depreciate. India was one of those emerging markets.

Some of the Indian government’s policy responses were a bit overdone, which exacerbated the downturn. There was too much of a clamor to defend the rupee, and by tightening capital controls and hiking up interest rates too much, the government may have scared foreign investors away. The government’s move to rein in liquidity created the perception that the prospects for growth were lower than what had been previously expected. As a result, many equity investors got cold feet.

In some ways, the rupee did worse than other emerging-market currencies because of the government’s missteps. However, after Bernanke’s remarks on September 18, in which he reversed the U.S. position on the tapering of its monetary stimulus, the rupee regained a lot of ground, as did other emerging-market currencies. So I don’t buy the line that the Reserve Bank of India made the right move in mounting an interest rate defense; the capital controls and sudden sharp interest rate hikes that were implemented made things worse for the rupee in the short run.

Looking ahead, India’s economy is vulnerable because there continues to be significant volatility in global markets. The government should not overreact to this volatility; if it does, it will make a bad situation even worse. India’s policy on interest rates, for instance, should be driven by the domestic business cycle and economic factors, not by an attempt to defend an artificial value for the rupee.

Milan Vaishnav
Vaishnav’s primary research focus is the political economy of India, and he examines issues such as corruption and governance, state capacity, distributive politics, and electoral behavior.

Vaishnav: Everyone assumes that the U.S. economy will continue to recover and at some point the Fed’s stimulus initiatives will wind down. Are policymakers in India prepared for this eventuality?

Patnaik: Frankly, I don’t think anyone in the world has a plan in place to deal with the Fed’s eventual taper. Everybody is hoping that when somehow the rollback takes place at some point in the future, they will not be adversely affected. Some argue that the markets have already factored in all possible scenarios and so nothing drastic is going to happen.

But people are simply not ready for the very high volatility in the markets that lies ahead. The government of India needs to prepare for that volatility and not interfere in the markets. It should instead move forward with implementing sound macroeconomic policies that are pro-growth, anti-inflation, and deficit reducing. This will be far preferable to vowing to sell reserves to defend the rupee, which is not a winning strategy.

Vaishnav: Finance Minister P. Chidambaram has repeatedly said he has every intention of adhering to the very hard benchmarks that he’s laid out to roll back India’s large fiscal deficit. He has claimed that there will be austerity measures even though India is preparing for important state elections at the end of 2013 and for parliamentary elections next spring. Yet, historically, expenditures increase in the year before national elections. Will India meet its deficit targets?

Patnaik: Chidambaram demonstrated last year that he is able to stick to his deficit targets. If he doesn’t do so, India might have its credit rating downgraded and foreigners might move capital out of India.

Chidambaram has been able to create a fear among his colleagues that it’s bad for India to miss fiscal targets, and today they believe him because of the volatility they have seen. The general thinking in the past was that economists like to talk about fiscal deficits a lot, but those deficits really don’t matter; governments can spend as much as they like. This mentality has changed.

Having said that, this time it will be harder for Chidambaram to meet his targets for a different reason. Due to the sharp decline in GDP growth in India, growth in tax revenues will be lower. To adjust, the government could consider selling its shares in public sector undertakings, which would come along with other positive externalities as well, such as a more efficient allocation of labor and capital by reducing resources being devoted to inefficient firms. But this is politically costly.

Vaishnav: Do you expect there to be any significant movement on the economic reform agenda between now and parliamentary elections in spring 2014?

Patnaik: I hope that even though the elections are approaching, parliament will pass some bills during the winter session. The government will push, and there could be compromises even if all of the necessary reforms are not passed. I would like to see the proposed Indian Financial Code passed. The code would reform the financial sector regulatory system in India by replacing a multitude of existing, outdated laws with one modern, unified financial law. But maybe that’s asking for too much too soon.

I won’t be surprised if parliament does conduct some important business now because it’s the last chance before elections. Some of the pessimism about parliament being unable to get anything done in an election year is wrong, particularly in the light of the body’s very productive monsoon session.

Vaishnav: No matter what happens in the elections next year, there will be a new government. Are there likely to be any substantial changes to India’s broad macroeconomic policy framework after the election?

Patnaik: I don’t think so. Take a look at the financial sector changes India has enacted over the last twenty years. There has been a huge shift in the sector. There has been a lot of development on equity markets, setting up new regulators and delicensing. On the trade front, tariff reductions may have started in 1991 with the Congress, the current ruling party, but they went through many different regimes. When Yashwant Sinha was the Bharatiya Janata Party’s finance minister in 2001, he reduced tariffs as well and removed quantitative restrictions.

All in all, there has been continuity in reforms, though the pace of change has gone up and down. Even when a Third Front made up of smaller parties has come to power, reforms have not stopped. Of course, each government will fight over how individual shares of the pie are distributed based on whose interests they represent. That distribution might change a little, but politicians generally share an interest in restarting growth.

Vaishnav: Over the past year, India has welcomed greater foreign direct investment (FDI) in certain key sectors, namely pensions, civil aviation, broadcasting, and multibrand retail, and the United States has watched the moves with interest. Should raising FDI limits even further be a priority for the Indian government?

Patnaik: Raising FDI caps, while important, is not as important to India as it is to companies in the United States. But these are political issues. My sense is that the government won’t spend too much political capital now on lifting FDI caps because parties need to keep their political capital in reserve ahead of the elections. They would have to twist many arms to raise the caps since it is a minority government.

Vaishnav: In the past, you’ve advocated that India should remove some of its capital controls and become more integrated with the global economy. Yet, many government officials say India has survived the global economic crisis because it is not fully opened up to the world and has capital controls in place. With the world economy still fragile and the U.S. recovery nascent, is it the wrong time for India to roll back some of these controls?

Patnaik: I believe India has de facto opened up a lot more than the government is willing to admit. Indian officials need to wake up and see that India is far more integrated into the world than they acknowledge and that they need to make their country more resilient.

There are many things that can be done to make India more resilient. The country has a large number of capital controls that are completely irrational.

For instance, if companies are borrowing abroad, why doesn’t the government let them hedge? Foreign institutional investment flows in and out of India, and those investors can hedge in offshore markets. But they aren’t allowed to hedge in onshore markets. They can buy currency forwards but not currency futures in India.

In another example, when India opened up to debt investment, dollar-denominated debt was allowed to be more open than rupee-denominated debt. Thus, Indian companies and Indian banks rather than foreigners face currency exposure. That’s bad policy.

I think the debate about whether India should open up is pretty sterile. It has opened up, but because Indian officials keep pretending that the country is not open, they don’t focus on reforming those aspects of the market that would make India more resilient. In fact, they do the opposite.