Thank you, Mr. Bernanke?

Op-ed in the Business Standard, New Delhi

June 25, 2013

The rupee rout was triggered when Helicopter-drop Ben (Bernanke) intimated that he might turn into Hoover Ben. The prospect that the chairman of the US Federal Reserve would suck back the liquidity he had been so generously providing to the United States and the rest of the world created uncertainty and panic. Indian economic policymakers have watched with frustration and helplessness. Two aspects of this crisis have received less attention: first, that one of the major costs of the rupee decline is entirely self-inflicted; and second, that there may well be a silver lining for India. Consider each in turn.

The 10 percent decline in the nominal value of the rupee over a short period of time entails three costs (rupee depreciation will have benefits too, but that is not the focus here): higher inflation as prices of imported goods and of domestic goods that are close substitutes rise; a larger fiscal deficit because the rupee cost of fuels rises without the increase being passed on to consumers; and a decline in the profitability of all those enterprises that have borrowed heavily in foreign currency and have not insured themselves against a rupee decline ("unhedged borrowing").

This third cost will manifest itself in reduced investment by these companies and hence lower aggregate growth; it will also manifest itself (eventually) in a worsened fiscal situation because the government will have to support these companies directly or the banks that have lent to them.

The important point, though, is that this latter cost is entirely self-inflicted. In the last three years, the government has allowed greater foreign currency-denominated borrowings by the private sector by progressively relaxing the so-called external commercial borrowing limits. Actual borrowings have increased from about $70 billion in 2010 to $115 billion today. Every episode of rupee pressure provokes a relaxation of these limits, which renders the economy vulnerable to the next rupee shock-which, in turn, provokes the next liberalization and so on.

And sure enough, in the wake of the recent crisis, too, the government has further relaxed external commercial borrowing limits-which will come back to haunt the economy down the road. This is folly. Until hedging becomes common practice, the Indian government cannot afford to allow risky foreign borrowing. That means reductions-even drastic ones-in the external commercial borrowing limits, which is exactly the opposite of current policy. One consequence might be a more depreciated exchange rate because of less foreign financing; but that will be less costly because there will be fewer dollar obligations to repay and roll over in the first place (in the long run, a policy of restricted external commercial borrowing limits could even improve the current account and reduce dependence on foreign financing).

Turn next to the silver lining in this latest episode. It is easy to forget that Indian macroeconomic policies have improved considerably with the return of P. Chidambaram as finance minister last summer. There has been liberalization of foreign direct investment, a concerted effort at tax reform, restraints on spending, and a steady-if stealthy-reduction of the diesel subsidy. It is also easy to forget that the finance minister's reforms last autumn were facilitated, even galvanized, by external events: the sharp deceleration of economic growth and, most important, the then-looming investment downgrade by credit rating agencies.

But if impending crisis was a necessary condition for helping the government pursue good policies, then it may prove absolutely essential to prevent the government from pursuing imprudent policies now. In the run-up to the general election, the temptation to open the fiscal spigots will be irresistible. The next elections will be closely contested and will involve more horse trading and more political maneuvering than ever-which will add to the populist pressures to spend and spend. As internal restraints on these pressures weaken, external ones will have to come to the rescue in strengthening the hands of the reformers within government. And that is where the rupee crisis can play an important role.

The fate of the food security bill is a possible illustration of this dynamic at work. Even if its incremental fiscal costs were small (estimates by Prachi Mishra of the ministry of finance suggest they could be substantial), its passage could provoke a further outflow of capital that in these testy times is just looking for an excuse to head for the exit doors. That logic might have enabled the government to convince the Congress party to postpone submitting the bill to Parliament. (Of course, there is an alternative interpretation in which the postponement is aimed at bringing the bill closer to the elections to maximize its vote-getting populist potential.)

The rupee crisis will also facilitate more prudent policymaking by the Reserve Bank of India (RBI). The monetary easing since April last year was always questionable, with the RBI appearing overly responsive to the populist demands to boost growth despite the elevated level of inflation and the large current account deficit. Skittish capital and a vulnerable currency will now help the RBI to focus on the more important objective of maintaining macro stability.

In the months ahead, with elections looming on the horizon, the government's ability to pursue an ambitious and proactive reform agenda is limited. Faster clearance of projects and improvements in coal supply remain within reach. But reforms-relating to land acquisition and the financial sector-that require parliamentary approval seem increasingly elusive. The most tragic casualty-despite the best efforts of this government-is the passage of the constitutional amendment bill, which would have initiated the implementation of the goods and services tax.

But a respectable outcome in these politically uncertain times would, in the spirit of the Hippocratic oath, involve doing no harm. Specifically, resisting what are likely to be mounting pressures to spend would be a significant achievement. The sword of Damocles of a run on the rupee hanging over the Indian economy would be no bad thing. Instead of being annoyed with Ben Bernanke for the mayhem inflicted on the Indian economy, the responsible elements within this government should perhaps send a thank-you note to him for helping them stave off the fiscal profligates. Hoover Ben, as opposed to Helicopter-drop Ben, may be just the right person to save this government from its political populist self.