Thursday, August 4, 2016

India's impossible trilemma

In an earlier post, I had argued that "the simultaneous pursuit of macroeconomic stability (or low inflation), high growth, and depreciating currency" may not be possible for any country in a closely integrated global economy. I'll call this the impossible trilemma that commentators in India advocate. A failure to appreciate this also leads them to be critical of the RBI's reluctance to lower interest rates.

Their argument is logically attractive. Lower rates will encourage investments, induce job creation, boost consumption, and therefore put in place a positive growth spiral. Lower rates will also trigger exchange rate depreciation, boost exports, and feed more growth forces. So what is wrong with this assessment?

The logic applies only if businesses are well positioned to respond to lower rates with investments. What if the businesses are stuck with excess capacity, indebtedness, and far less demand than expected? It is, therefore, no surprise that corporate credit off-take is contracting, especially to the small and medium enterprises, pointing to deeper factors that go beyond mere high-interest rates. And what if banks, with battered balance sheets, are unwilling, even unable, to assume more risks? And the global trade conditions lend little credence to the belief that India's external trade will take off with a lower rate and a depreciating currency.

More fundamentally, what if the conditions required to achieve the ambitious high growth rates are simply not there? What if the industrial base, corporate sector, human and financial capital formation, depth of financial intermediation, and state capacity are too limited and narrow to sustain high growth for long periods? Most importantly, what if the consumer base too is far smaller than expected?
I feel that the most important belief that should be dispelled is that we can grow fast and long with a combination of low rates, higher inflation, and macroeconomic stability. The belief comes from a failure (or difficulty) to realize (imagine) the limitations of our capital accumulation (primary products, credit, labor, capital goods, and state capacity) stock as well as flows. Push any of these buttons too hard and too long and excesses will become evident in just 2-3 years. Opinion makers are deceived by extrapolating the limited world that they see around us as representative of India and making growth assumptions based on them. Unfortunately, this is a tiny sliver of the vast and largely still very poor country. I wish there were some great interactive graphics that could explain this nuance to those advocating high growth strategies.

In the circumstances, the only way to realize such high growth is through episodes of over-heating that India had in the 2003-08 period. Corporates made reckless bets and aggressive bids, especially in the infrastructure sector, banks provided credit with limited due diligence, markets and government egged on. This was also complemented with a generous boost in public spending by way of welfare schemes, which cranked up rural demand. Once the party got over, everyone was left picking up the pieces and still haven't recovered from it. 

There is only one way out of this. Steady and gradual human and physical capital accumulation, as well as the development of strong state capacity. Building rapid and sustained growth in a balanced manner on our current foundations does not look a promising endeavour.  

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