Prime Minister Manmohan Singh is believed to have stymied the proposal to have a higher tax rate for the super-rich on the grounds that it wasn't an opportune time to do so. The recent caps on foreign exchange spending by companies and individuals, duties on imports of flatscreen TVs, etc, have led to a perception that we are regressing towards a pre-liberalisation era of controls. That may be overstating the situation but the fact is that across different socio-economic strata, there is a deep disenchantment with the state of the economy and the government's inability to deal with it.
In an election year, this can spell disaster. If all of the government's measures till now had little or no effect on stemming the rupee's slide or kickstarting investment or growth, is there a contrarian big-bang solution that could reverse the sentiment?
Recent empirical evidence suggests that there is a strong correlation between growth rates and electoral fortunes. Just look at what happened in 2009. The UPA swept back to power on the back of 8%-plus GDP growth rates in the three years leading up to the election. Then, consider this: according to CSO data, Bihar, Odisha and Chhattisgarh recorded 9%-plus growth in the years leading up to the last assembly elections. The CMs of all three states were voted back to power in the last elections. A study titled India: Election outcomes and economic performance by Arvind Panagariya and Poonam Gupta shows that states with high growth rates return 85% of incumbent ruling party legislators. This drops to 30% in states with low growth rates. So, the prime minister and UPA chairperson Sonia Gandhi may well want to gamble on growth.
Since July 15, the Reserve Bank of India (RBI) has tweaked policies four times in a bid to stem the depreciation in the rupee's value. What happened? The rupee declined 10% since then - from 59.39 to beyond 65 against the dollar. Over the past few months, the government, too, has undertaken reforms but investor sentiment has remained negative. Some experts believe that R70 to a dollar may be in sight and there is also a fear of India's sovereign rating being downgraded to junk status.
This situation calls for a change in script. What we need are big bang measures that take effect immediately - as opposed to steps that will begin to bear fruit six months later - to lift sentiment. Traditional monetary measures have failed and incremental steps to stop dollar outflows have proved counter-productive. It may be time for the RBI to think of cutting the repo rate by 100 bps, maybe in two tranches, to lower the cost of funds and incentivise consumption and growth.
I can almost hear the howls of protests from traditional monetarists. Such a move will fuel inflation and hurt the poor, they will cry. The government can't afford to be so reckless in an election year, politicians will plead. But what is the alternative? Will such a move be more inflationary than the 20% fall in the rupee's value since May 2? The RBI's steps, based on classical economic theory, haven't stabilised the rupee. Instead, they've spooked investors, made funds costlier, stifled growth and pushed back any prospects of an early economic recovery. They have also fanned the negative global sentiment about India. What's the worst that can happen if the RBI cuts rates? It can fuel inflation. But it can also spur growth, which can revive the economy and make it attractive for foreign capital. I strongly feel the balance of convenience lies in giving growth a chance.
I also recommend the following steps: first, ban gold and silver imports (for, say, six to nine months). This will tell the world that India is serious about addressing its current account deficit (CAD) problem; second, raise interest rates on NRI deposits to attract more inflows; stable inflows will bring the CAD down; third, raise petrol and diesel prices by Rs. 4-5 per litre to help the government pare its deficit. This will be inflationary in the short term but if the rupee strengthens, it will offset a part of the price increase; fourth, set aside $25-30 billion from India's foreign exchange reserves to defend the rupee against speculators; fifth, settle the Vodafone tax case to signal to the world that their investments here will not be subject to whimsical and politically-motivated policy changes; sixth, force real estate companies to cut prices to make housing affordable. This sector has linkages with more than 200 industries. If this sector revives, it will set off a virtuous cycle by generating demand in hundreds of feeder industries. Real estate companies will cry blue murder but higher sales volumes should compensate for lower margins; and finally, announce a time-bound plan to reverse the RBI measures that have contributed to the negative sentiment.
These measures will help turn sentiment that drives investments. This, in turn, can help kickstart growth and stop the outflow of dollars. It will be a bit of a political gamble for Singh and Gandhi but the potential electoral dividends may make the risk worth their while.