A year ago the Indian economy was cruising nicely on a 9 per cent growth path with low inflation and a viable current account.  Today the situation looks very different with high inflation and a change in the willingness of foreigners to hold Indian assets.  The investment led growth boom is threatened by the slowing down of profit growth, higher interest rates and tighter conditions in global capital markets.  Those in charge, while they control the skidding economy, blame the sub-prime crisis in financial markets and the extraordinary increase in world oil and commodity prices.  If they are right the pain will only end when these global problems are resolved.

The roots of the disequilibrium in the global economy lie in the large current account surpluses in East Asia and in the corresponding deficit in USA.  In addition we have the massive surpluses in the Gulf countries and other oil exporters that have emerged with the big oil price hike and their counterpart, the widening deficits in many developing countries because of this and the food price hike.  These current account imbalances reflect underlying domestic macro imbalances.  One doubt though is how to treat the oil exporter’s surplus (which is really a monetisation of natural wealth), particularly if the proceeds are sterilized and saved as in Norway and, to a lesser extent, in the Gulf countries.

A current account deficit is not in itself inconsistent with equilibrium as long as foreigners are willing to hold assets issued by the government or enterprises in the deficit country. But this willingness is not a constant.  It depends on risk perceptions and liquidity needs and this has changed as the crisis in financial markets has led to a flight to quality by investors and a scramble for liquidity by financial intermediaries.  One thing is clear-the new equilibrium has to involve current account deficits (and surpluses) that are significantly different from what prevails at present. 

A recent calculation by two researchers at the Petersen Institute in Washington, William

Cline and John Williamson, (see the reference at the bottom of the table) provides an interesting projection of what a new global equilibrium would look like.  The key is to move the current account deficit (or surplus) to a level consistent with the willingness of foreigners to lend (or borrow) to the country concerned.  In their model the proximate instrument is the real effective exchange rate which depreciates (or appreciates) to reduce the current account deficit (or surplus).  Of course the change in the current account deficit will be matched by a corresponding change in the domestic savings-investment gap, but the researchers do not specify the domestic measures that would do this.  The exchange rate changes also have to be coherent across countries as the correction of global imbalances will involve simultaneous and consistent adjustments of current account balances in all countries.

Cline and Williamson assume that a current account deficit or surplus of 3 per cent of GDP is sustainable in the sense that it could be financed through voluntary capital flows with some departures from this norm, on practical grounds, for a few countries.  They apply these targets to the IMF’s 2009 projections and compare two snapshots- current account balances as they are likely to be on current policies and as they should be on the basis of their targets.  In their central case they leave out the oil exporters and do not impose any equilibriating goal on them.  The direction of change is on expected lines; but the magnitude of the adjustments, shown in the table alongside, is revealing. 

The core of the adjustment process to a new equilibrium involves a large upward revaluation and major current account adjustment in China, Japan and in most of East and South East Asia, a modest reduction of the Real Effective Exchange Rate (REER) in India, Europe (except Sweden and Switzerland, which would have to appreciate), Brazil and Russia and a substantial devaluation of the dollar.  In fact the dollar devaluation is such that even countries like India, which need to bring down their REER, would still appreciate against the dollar.  Of course the simulation results are relative to a February 2008 base and the actual equilibrium rate, if and when the equilibrium is reached, would be different depending on relative rates of inflation among other things.

That is the real question- if and when a new equilibrium will be reached.  One way of judging the pace at which the world economy is moving to a new balance is to compare the equilibrium exchange rates projected by Cline and Williamson with the rates in mid-August, six months on from the February 2008 base.  (See the last column of the table).  It would seem that the European exchange rates are now quite close to the target equilibrium but that Asia has still a long way to go. 

In fact the movement in the rupee-dollar rate is in a perverse direction, not fully explicable in terms of differential inflation.  Could it be that with the changed environment in global capital markets the current account deficit in India would have to be below 3 per cent if it is to be readily financed? Would that explain the behaviour of the rupee-dollar exchange rate in recent months?

However the key to restoring a global balance is not in India.  Everything depends on how rapidly the current accounts of China and USA adjust. Of course we have to be a part of this process as the depreciation of the rupee vis-à-vis the yuan secures competitive advantages that compensate for the current over dependence on the US market.

There are some signs of acceleration in US exports because of the dollar depreciation, but little sign as yet of the desired downward movement in China’s surplus.  The yen-dollar rate also has a long way to go to get to equilibrium.  Inflationary trends may moderate with falling crude oil and commodity prices, but the turmoil in capital markets continues. Hence the world economy is not going to get to anything resembling an equilibrium any time soon.  The pain will continue and the Government would do well to be ready with some policy-aspirins for the headaches that are still to come.