as opposed to the short-lived shocks associated with monsoons. It shows a recovery of
profits through 2002-03, one of the worst monsoons in recent experience - an example of
the diminishing importance of agriculture. It shows a large difference between profitability
in the downturn - below 2% over 2000-2002 - and that seen in an upturn - roughly 8%
after 2006. These movements appear to coincide remarkably well with the global business
cycle.
2.4 Exchange rate inflexibility
There is a widespread belief in India that in the early 1990s, the rupee became a ‘market
determined exchange rate’. However, currency flexibility actually went down in the early
1990s. INR/USD volatility was 8.35% per year from early-1973 till end-1991. This dropped
to 4.3% in the period from early-1994 till September 2007.6
With this near-halving of currency flexibility, India embarked on a monetary policy
framework of a pegged exchange rate with a de facto opening capital account in the 1990s
(Patnaik, 2007). A key insight of modern open economy macroeconomics is the ‘impossible
trinity’: when a country pursues currency policy while having an open capital account, the
lever of monetary policy gets ‘used up’ in achieving the currency target. In India, the
pegged exchange rate coupled with growing openness on the capital account has induced
a growing loss of monetary policy autonomy. The lever of monetary policy is repeatedly
‘used up’ for achieving currency targets. Monetary policy is not able to stabilise the local
economy.
While these difficulties have been brewing since the late 1990s, they have become starkly
visible in recent years (Patnaik, 2003, 2005; Joshi, 2003). When capital has come into
India, the attempt by RBI to peg the exchange rate has led to a surge in reserve money.
Exchange rate pegging has hijacked monetary policy. The impossible trinity, which was
once dismissed as ‘just a theory’, is on the front pages of Indian newspapers.
2.5 The fiscal crisis has partially abated
The central gross fiscal deficit escalated dramatically from 3.17% in 1974-75 to a peak of
8.3% in 1986-87. While the reforms of the early 1990s dented the deficit, it resurged to 7% in
1998-99. Through the late 1980s and the 1990s, fiscal stability was the most important issue
in macroeconomic policy. This led to an enormous effort in transforming fiscal policy, which
included improvements in tax policy, improvements in tax administration, the enactment
of the Fiscal Responsibility and Budgetary Management (FRBM) Act, and the Twelfth
Finance Commission (Rao, 2005; Kelkar, 2004a).
As Figure 4 shows, in recent years, there has been a considerable change in the fiscal
outlook.
6High INR/USD volatility in the pre-1991 period was not caused by pegging to the GBP. INR/GBP
volatility was higher - at 10.2% - than INR/USD volatility in the 1973-1991 period.
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