Correcting a Disequilibrium

Fiscal measures

1. Reducing public expenditure and raising taxes, which reduce aggregate demand and therefore imports. This is the classical austerity package, and it is what an International Monetary Fund programme ordinarily requires.

2. Taxes aimed at imports specifically, such as higher duties on gold or on consumer goods.

3. Export promotion through the tax system, by refunding the domestic taxes borne by exported goods. The principle here is the one point of international tax that a student of trade must know: a country may relieve exports of its own indirect taxes, because a good should be taxed where it is consumed, but it may not subsidise them beyond that. The line between the two is the subject of the countervailing duty in [Commercial Trade Policy].

4. Incentives for foreign investment, which finances a deficit with capital that is stable and brings technology.

Exchange rate measures

Devaluation and depreciation are not the same thing, and the difference is examined.

Revaluation and appreciation are the corresponding terms for a rise in the currency's value.

How a devaluation is supposed to work. It makes exports cheaper in foreign currency and imports dearer in domestic currency, so foreigners buy more of the country's goods and its residents buy fewer foreign ones. Spending switches, and the trade balance improves.

But only if quantities respond, and that is a real condition with a name.

The Marshall Lerner condition. A devaluation improves the trade balance only if the sum of the price elasticity of demand for exports and the price elasticity of demand for imports is greater than one. The reason is that a devaluation has two opposite effects: it raises the quantity of exports sold, which helps, and it lowers the price in foreign currency at which each unit is sold, which hurts. If demand is inelastic, the price effect wins and the balance gets worse. A country exporting a commodity for which world demand hardly varies with price, and importing oil which it must have at any price, can devalue and end up paying more.

The J curve. Even where the condition holds, the balance worsens before it improves. Contracts already signed are priced in the old terms, so the import bill rises at once in domestic currency while export volumes take months to grow. Plotted against time, the trade balance falls and then rises, tracing a letter J.

Does the condition hold for India? The Economic Survey has estimated it. Its own regression finds that a one per cent appreciation of the rupee reduces net total trade by 1.26 per cent, with the merchandise trade elasticity at minus 1.45, so that merchandise trade is highly responsive to the exchange rate, and concludes that on a net basis a weaker currency is good for India's merchandise trade balance. But services trade is relatively inelastic, at minus 0.38, which the Survey attributes to India's market power in services exports, "where demand has become less price dependent and more reliant on quality and specialised expertise".

That last finding is worth an extra mark in any answer. India's goods respond to the exchange rate and its services do not, because its services are sold on skill rather than on price. So a devaluation is a weaker instrument for India than it once was, precisely because the strongest part of its export base has stopped competing on price.

The statutory background. Section 40 of the Reserve Bank of India Act 1934 provides that the Bank shall sell to or buy from any authorised person who demands it, at its offices, foreign exchange at such rates of exchange and on such conditions as the Central Government may from time to time determine, having regard so far as rates of exchange are concerned to its obligations to the International Monetary Fund, with a proviso that no person may demand a transaction below two lakh rupees. The Explanation still defines "authorised person" by reference to the Foreign Exchange Regulation Act 1973, which was repealed by the Foreign Exchange Management Act 1999. It is an unamended cross reference, of the same kind noted in [The Finance Commission], and a reminder that a section in force may carry a citation that is not.

Direct trade measures

1. Tariffs, which raise the domestic price of imports and yield revenue.

2. Quotas and quantitative restrictions. In India the power is section 9A of the Foreign Trade (Development and Regulation) Act 1992: if the Central Government is satisfied after enquiry that goods are being imported in such increased quantities and under such conditions as to cause or threaten serious injury to domestic industry, it may impose quantitative restrictions. The section is disciplined: a proviso exempts goods from a developing country whose share of such imports does not exceed three per cent, or nine per cent in the aggregate from several; and sub section (2) provides that the restriction ceases after four years unless extended, and in no case may continue beyond ten years.

3. Trade remedies under the Customs Tariff Act 1975, treated fully in [Commercial Trade Policy]: section 9 countervailing duty on subsidised imports, section 9A anti dumping duty, and section 8B safeguard measures.

4. Export promotion: duty exemption on imported inputs, credit at concessional rates, market development assistance, and the schemes of the Foreign Trade Policy described in [India's Trade Policy: The Institutions and the Current Policy].

5. Exchange control, under sections 5 and 6 of the Foreign Exchange Management Act 1999. Note which is which, because it is the whole architecture. Section 5 permits current account transactions, subject to a proviso allowing the Central Government, in public interest and in consultation with the Reserve Bank, to impose reasonable restrictions as prescribed. Section 6 permits capital account transactions subject to what the Reserve Bank specifies for debt instruments and the Central Government prescribes for the rest. So India's first line of defence in a crisis is the capital account, where the discretion is wide, and not the current account, where a restriction must be reasonable and in public interest.

Structural measures, which are the only real cure

Everything above manages a deficit. Only this changes the country's position.

1. Diversify exports by product and by market, so that no single commodity or destination can sink the account. India's ranking on the diversity of trade partnerships, third in the Global South, is the measure of progress here.
2. Move up the value chain, which is what the shift from jute and cotton to engineering, pharmaceuticals and software described in [Structural Changes Since 1991: What India Buys and Sells] amounts to.
3. Reduce dependence on a single import. India's petroleum share of imports has been about a quarter since 1990-91, and every serious programme of energy transition is also a balance of payments policy.
4. Attract stable capital rather than volatile capital, that is direct investment rather than portfolio flows and short term deposits. The 1991 crisis began with the withdrawal of non resident deposits.
5. Control inflation, since a country whose prices rise faster than its partners' loses competitiveness continuously and must devalue repeatedly to stand still.
6. Hold adequate reserves. Reserves do not correct anything, but they buy the time in which a correction can be made without panic. India's 701.4 billion dollars, about eleven months of imports, is that insurance.

A worked example: how India corrected in 1991, and afterwards

Stage one, the emergency, 1991.

• Financing: drawals from the International Monetary Fund of 1,858 million dollars in 1990-91 and 1,240 million in 1991-92.
• Expenditure switching by exchange rate: devaluation in two steps on 1 and 3 July 1991.
• Expenditure reduction and import compression: in 1991-92 imports fell 19.4 per cent and the trade deficit fell from 5,932 million dollars to 1,546 million.

Stage one is not a success and should not be presented as one. The deficit closed because the country could not pay, which is the harshest form of expenditure reduction there is, and it was paid for in output.

Stage two, the structural correction.

• Trade and industrial liberalisation, described in [The New Industrial Policy 1991] and [What the 1991 Policy Achieved, and What It Did Not].
• Exports responded: growth of 20.0 per cent in 1993-94, 18.4 per cent in 1994-95 and 20.8 per cent in 1995-96, after a fall of 1.5 per cent in the crisis year.
• Reserves rebuilt: foreign currency assets from 2,236 million dollars at end March 1991 to 5,631 million in 1992, 15,068 million in 1994 and 20,809 million in 1995.

Stage three, the present position. A current account deficit financed by autonomous capital inflows, reserves of 701.4 billion dollars, external debt at about 18.4 per cent of gross domestic product, and a services surplus and remittances that between them cover most of a very large goods deficit.

The lesson in one line. The emergency measures of 1991 stopped the bleeding and cost output; what actually corrected the position was changing what India produced and sold. Financing buys time, switching and reduction manage the symptom, and only structural change cures the disease.

What beginners get wrong

"Devaluation always improves the trade balance." Only if the Marshall Lerner condition holds, and even then the J curve means it worsens first.

"Devaluation and depreciation are the same." Devaluation is an official act under a fixed rate; depreciation is a market movement under a floating rate.

"Using reserves corrects a deficit." It finances it. Nothing about the underlying position changes.

"Raising interest rates fixes the balance of payments." It reduces imports and attracts short term capital. The second effect can leave the country more fragile than before.

"Import restrictions are the obvious cure." They raise costs for domestic producers who use imported inputs and invite retaliation, and India's own history in [India's Foreign Trade Before 1991] is the argument against them.

"India can devalue its way to a surplus." Its merchandise trade responds to the exchange rate, with an elasticity of about minus 1.45, but its services trade barely responds at all, at minus 0.38, and services are where India's surplus is.

Limits

Elasticities are estimated, not known, and they differ by period, by commodity and by method.

Measures interact. A devaluation that raises the price of imported oil raises domestic prices, which erodes the competitive gain, and a tight monetary policy that attracts capital pushes the currency up again.

Trade measures are constrained by treaty. A member of the World Trade Organization cannot impose restrictions at will, and the statutory powers under section 9A of the Foreign Trade Act and sections 8B, 9 and 9A of the Customs Tariff Act are the domestic expression of what the agreements permit.

No measure works on the timescale of a crisis except financing, which is why reserves exist.

Quick revision

1. Three families: expenditure reducing (monetary and fiscal contraction); expenditure switching (exchange rate, tariffs, quotas); financing (reserves and official borrowing, which corrects nothing).
2. Monetary: raise the policy rate, which cuts demand and attracts short term capital, the second being dangerous; credit control; deflation, which falls on output before prices; exchange control under FEMA s.3, the background prohibition on dealing otherwise than through an authorised person.
3. Fiscal: cut spending, raise taxes, refund domestic indirect taxes on exports, and attract foreign investment.
4. Devaluation is an official act under a fixed rate; depreciation is a market movement under a floating rate. India devalued on 1 and 3 July 1991.
5. Marshall Lerner condition: devaluation improves the trade balance only if the sum of the price elasticities of demand for exports and imports exceeds one. J curve: the balance worsens before it improves.
6. For India, the Survey estimates: a one per cent appreciation reduces net total trade by 1.26 per cent; merchandise elasticity minus 1.45; services elasticity only minus 0.38, because services sell on quality rather than price.
7. Direct measures: tariffs; FTDR Act s.9A quantitative restrictions on serious injury, with a three per cent developing country exemption, ceasing after four years and never beyond ten; Customs Tariff Act s.9 countervailing, s.9A anti dumping, s.8B safeguard; export promotion; FEMA ss.5 and 6, the current account restrictable only by reasonable restrictions in public interest, the capital account by whatever is specified.
8. RBI Act s.40: the Bank shall buy and sell foreign exchange at rates the Central Government determines, having regard to its obligations to the International Monetary Fund; minimum two lakh rupees. Its Explanation still cites the repealed FERA 1973.
9. Structural cure: diversify products and markets; move up the value chain; reduce single import dependence; attract stable capital; control inflation; hold reserves. India: 701.4 billion dollars, about eleven months of imports.
10. India 1991: Fund drawals 1,858 and 1,240 million dollars; devaluation July 1991; imports fell 19.4 per cent and the deficit to 1,546 million; then exports grew 20.0, 18.4 and 20.8 per cent in the three following years and foreign currency assets rose from 2,236 to 20,809 million by 1995.

Test yourself

1. Explain the measures available for correcting a deficit in the balance of payments. They fall into three families. Expenditure reducing measures lower aggregate demand so that imports fall with it, and comprise monetary contraction, namely a higher policy rate, credit control and in the extreme deliberate deflation, and fiscal contraction, namely cuts in public expenditure and higher taxation. Their cost is that they work by making the country poorer, curing the deficit at the price of output and employment. Expenditure switching measures do not reduce total spending but change relative prices so that spending moves from foreign to domestic goods, and comprise devaluation or depreciation of the currency, tariffs, quotas and quantitative restrictions, export subsidies and incentives, and exchange control. Their cost is that they depend on demand actually responding to price, and that trade restrictions raise the input costs of domestic producers and invite retaliation.

Financing, the third family, comprises the use of foreign exchange reserves and borrowing from the International Monetary Fund or under official credits; it is not a correction at all, since nothing about the underlying position changes, but it buys the time in which a correction can be made without panic. To these should be added the structural measures which alone constitute a cure: diversification of exports by product and market, moving up the value chain, reducing dependence on a single large import such as petroleum, attracting stable direct investment rather than volatile portfolio flows and short term deposits, and controlling domestic inflation so that competitiveness is not lost year after year.

2. What is the Marshall Lerner condition, and what is the J curve? The Marshall Lerner condition states that a devaluation or depreciation will improve a country's trade balance only if the sum of the price elasticity of demand for its exports and the price elasticity of demand for its imports is greater than one. The reason lies in the two opposing effects a devaluation has. It raises the quantity of exports sold, because they are cheaper in foreign currency, and reduces the quantity of imports bought, because they are dearer at home, both of which improve the balance; but it also reduces the foreign currency price received for each unit exported and raises the domestic currency price paid for each unit imported, which worsens it. Where demand is inelastic, the price effects dominate the quantity effects and the balance deteriorates: a country selling a commodity whose world demand hardly varies with price, and buying oil it must have at any price, can devalue and find itself paying more.

The J curve describes what happens even where the condition is satisfied. In the short run the balance worsens before it improves, because contracts already concluded are priced in the old terms, so the domestic currency cost of imports rises immediately while export volumes take months to grow as buyers renegotiate, adjust supply chains and place new orders. Plotted against time, the trade balance therefore falls and then rises, tracing the shape of the letter J. The practical implication is that a government which devalues and abandons the policy when the figures worsen has misread its own remedy.

3. Distinguish devaluation from depreciation, and assess how effective a weaker rupee is for India. Devaluation is a deliberate official reduction in the value of a currency by the government or central bank under a fixed or pegged exchange rate regime, announced on a particular day; India devalued in two steps on 1 and 3 July 1991. Depreciation is a fall in a currency's value brought about by market forces under a floating or market determined regime, and occurs continuously; the rupee's movement since the early 1990s is of this kind. The corresponding terms for a rise are revaluation and appreciation.

As to effectiveness, the Economic Survey has estimated the elasticities for India directly. It finds that a one per cent appreciation of the rupee reduces net total trade by 1.26 per cent, and that the merchandise trade balance is highly responsive, with an elasticity of minus 1.45, so that on a net basis a weaker currency is good for India's merchandise trade balance. But it also finds that services trade is relatively inelastic, at minus 0.38, which it attributes to India's market power in services exports, where demand has become less dependent on price and more reliant on quality and specialised expertise. The conclusion for an answer is therefore a qualified one: a weaker rupee still helps India's goods trade, but the exchange rate is a progressively weaker instrument for the external account as a whole, because the strongest part of India's export base, its services, has ceased to compete on price. A further caution is that a weaker rupee raises the domestic cost of imported oil, which is a quarter of the import bill, and so feeds domestic inflation that erodes the competitive gain.

4. What legal powers does India possess to restrict trade and payments when the balance of payments deteriorates? Four sets. On payments, the Foreign Exchange Management Act 1999 provides in section 3 the background prohibition, that save as otherwise provided or with the Reserve Bank's permission no person shall deal in or transfer foreign exchange to a person who is not an authorised person, make any payment to or for the credit of a person resident outside India, or receive any payment otherwise than through an authorised person. Section 5 then permits current account transactions, subject only to a proviso allowing the Central Government, in public interest and in consultation with the Reserve Bank, to impose such reasonable restrictions as may be prescribed, while section 6 permits capital account transactions subject to whatever the Reserve Bank specifies for transactions involving debt instruments and the Central Government prescribes for those that do not. The architecture is deliberate: the discretion is wide on the capital account and narrow on the current account.

On the exchange rate, section 40 of the Reserve Bank of India Act 1934 obliges the Bank to buy and sell foreign exchange on demand from an authorised person at such rates and on such conditions as the Central Government determines, having regard so far as rates are concerned to its obligations to the International Monetary Fund. On quantities, section 9A of the Foreign Trade (Development and Regulation) Act 1992 empowers the Central Government, on being satisfied after enquiry that goods are being imported in such increased quantities and under such conditions as to cause or threaten serious injury to domestic industry, to impose quantitative restrictions, subject to an exemption for a developing country supplying not more than three per cent of such imports, a cessation after four years unless extended, and an absolute limit of ten years. And on prices, the Customs Tariff Act 1975 provides in section 9 for countervailing duty on subsidised imports, in section 9A for anti dumping duty, and in section 8B for safeguard measures.

5. Work through India's correction of the 1991 crisis. It proceeded in three stages. The emergency stage used all three families of measure at once. India financed the immediate gap by drawing 1,858 million US dollars from the International Monetary Fund in 1990-91 and a further 1,240 million in 1991-92. It switched expenditure by devaluing the rupee in two steps on 1 and 3 July 1991. And expenditure was reduced, or rather compressed by necessity, so that in 1991-92 imports fell by 19.4 per cent, exports by 1.5 per cent, and the merchandise trade deficit collapsed from 5,932 million dollars to 1,546 million. That stage should not be described as a success: the deficit closed because the country could not afford to import, which is the harshest form of expenditure reduction there is, and it was paid for in lost output.

The structural stage was the liberalisation of trade and industry announced in the Statement on Industrial Policy of 24 July 1991 and carried through in the years that followed. Exports responded, growing 20.0 per cent in 1993-94, 18.4 per cent in 1994-95 and 20.8 per cent in 1995-96, and the Reserve Bank's foreign currency assets rose from 2,236 million dollars at the end of March 1991 to 5,631 million a year later, 15,068 million by March 1994 and 20,809 million by March 1995.

The present position is the third stage: a current account deficit financed entirely by autonomous capital inflows, foreign exchange reserves of 701.4 billion dollars covering about eleven months of imports, external debt of about 18.4 per cent of gross domestic product, and a services surplus and remittances that between them cover most of a very large merchandise deficit. The lesson is that financing bought the time, devaluation and compression managed the symptom, and only the change in what India produced and sold actually cured the disease.