Gandhiback Grievances

The interesting story of the day is definitely a rapidly “collapsing” Rupee haunted by abnormally high volatility over the past month. I scare quote “collapse” because it’s a term that reflects the Western bias of this conversation. If you’re an American who has invested in emerging market funds hoping for real gains intended for domestic consumption that beat an index well, then, you’ve been screwed. As far as India is concerned the depreciation is  of less concern. Still, Raghuram Rajan has his job cut for him, and I’ve discussed the Indian Rupee in this context before. However, since Paul Krugman blegs to learn what he is missing, I’ll offer a few things that worry me at the moment.

Primarily, like any other developing country with rentier bureaucrats, fuel subsidies are important to India twofold. First as a stimulant for middle class growth that demands transportation and electricity (generators are big); second as a key ingredient to important fertilizers without which the Indian farming model would fail.

Fuel subsidies pose an interesting problem for a country that will meet 90% of its oil needs through imports. (I mistakenly noted that 90% of oil is currently imported. That said, the greater the difference between the current figure and the future one, the worse one unit of depreciation will be). Basically all growth in India’s most important market will be financed from imports henceforth. On the one hand, the decisive role government plays in the energy market almost guarantees that deficits will face an upward pressure, in a time when yields are already rising. The sensible solution would unfortunately involve curtailing the provision of a good necessary for political success.

More importantly, as energy becomes the dominant theme in Indian trade – as it undoubtedly will – India looses the primary benefit of depreciation: exports. When trade structure is such that the cost effect (price of imports) of depreciation trumps the quantity effect (quantity of imports) the beneficial nature of depreciation is removed entirely. Known as the Marshall-Lerner condition, a country technically faces this dilemma when the summed price elasticity of imports and exports falls below one.

Usually, since goods tend to be price inelastic in the short-run, devaluations are not always immediately successful but work over time. Not so for dollar-priced oil. As the value of oil is already buoyed by demand from emerging markets, each point of depreciation for the Rupee is that much worse for its balance and budget. Using data from the International Financial Statistics and Direction of Trade Statistics from the IMF, Yu Hsing estimates that India may not significantly meet the Marshall-Lerner condition. Since the paper might be gated for some of you, I’ll copy the relevant result:

As the US real income declines due to the global financial crisis, the trade balance for Japan, Korea, Malaysia, Pakistan, Singapore, or Thailand will deteriorate whereas the trade balance for Hong Kong or India may or may not deteriorate depending upon whether the relative CPI or PPI is used in deriving the real exchange rate.