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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is senior fellow at the Peterson Institute for International Economics and co-author with Devesh Kapur of ‘A Sixth of Humanity: Independent India’s Development Odyssey’, an FT book of the year
When the rupee fell sharply in the wake of the Iran war-induced energy shock, India’s policymakers concluded that the economy’s fundamentals were sound, the problem was temporary and foreign-exchange related, and the best response was to attract financing rather than make policy changes.
Accordingly, in June the Reserve Bank of India announced a scheme to guarantee favourable dollar returns for foreign investors, especially the diaspora, with the aim of attracting $50bn-$70bn by September. But now, after some initial enthusiasm, the rupee is once again under pressure amid anxiety that the target may not be met. Why so?
The answer may be a misdiagnosis of the rupee’s problem. Rather than being shortlived and related to foreign exchange, it could reflect structural challenges for macroeconomic stability and growth.
First, despite the Modi government’s commendable push on renewables, India’s energy dependence is unusually high, which makes it vulnerable to shocks. The country’s net energy imports amount to about 35 per cent of overall needs compared to about 20 per cent for China.
Compounding this is a longstanding failure to price energy at market levels, encouraging overconsumption. The distortion extends beyond fuel. In the case of fertilisers, where production relies on natural gas, prices are fixed so the subsidy varies between 70 and 80 per cent depending on global prices.
For electricity, the subsidy bill of about 1-1.5 per cent of GDP is paid by state governments, with farmers and households receiving subsidies of 90 and 45 per cent of costs respectively.
The fact is that more than 60 per cent of energy subsidies benefit the middle class and the rich. India does have the capacity to pay subsidies directly to those who need them most, which would allow prices to be rationalised. But neither the central nor state governments have dared to make this change.
Recent rupee turmoil may also reflect structural challenges to growth. The promise of AI and rate rises in the US have reduced flows to emerging markets as global investors rebalance their portfolios towards America. But even in the year before the Iran war, the rupee was under pressure despite heavy intervention by the RBI and actual and projected growth of over 6.5 per cent.
Concerns about growth are reflected in weak corporate investment. This has steadily shrunk and is now at just over half its peak of the boom years in the 2000s.
This is a puzzle because the obvious drivers of investment appear strong: macroeconomic stability, a sound financial system, rapid growth in infrastructure and a government pursuing reforms. It rationalised tax and labour laws and corrected its protectionist instincts by concluding free trade agreements with the UK and EU while attempting to finalise one with America. But evidently, investors remain unpersuaded.
Two long-term technological shifts also cast a pall. One is robots substituting unskilled labour, the other is AI substituting skilled labour. India was hoping to be an alternative manufacturing base to China. The entry of Apple and other multinationals was encouraging but proved an exception: India’s global market share in labour-intensive manufacturing has been declining steadily since a peak of about 2.5 per cent in 2011.
AI is also a threat to India’s IT services growth engine. The big domestic companies that drove the early boom have either slowed hiring or are starting to cut jobs. The “global capability centres” — hubs that were key to the sector’s growth — specialise in activities like data analysis that can be done by AI. Share prices of Indian IT companies have dropped sharply.
More fundamentally, the government has been unable to reassure investors about the predictability of the business environment. It has at times acted in an apparently arbitrary way to tilt the playing field in favour of a few large companies. Several businesses have been forced to sell their operations to bigger rivals after tax and other raids by enforcement agencies.
Economists used to debate whether public investment crowded out private capital. India may instead be witnessing private investment by favoured players crowding out private investment by smaller and overseas rivals.
The broader question is whether the political impulses that have corroded checks and balances are undermining India’s investment climate by weakening confidence in the rule of law. If so, the rupee’s weakness may signal deeper problems that need fixing.
