T H E E C O N O M I C W E E K L Y August 4, 1962

The Government, in a variety of ways, has now admitted that export promotion measures which arc tantamount to export subsidies can improve India's export earnings. In other words, the Government admits that the elasticities of demand facing the export of non-traditional items are large enough to justify an export subsidies programme or a devaluation.

The contention that a devaluation would be inflationary is very definitely a specious argument.

Indeed, if one reckons that under the Indian system imports are considerably in excess of exports because of foreign aid a very substantial, opportunity opens up for a deflationary effect following devaluation.

Assuming that the foreign aid is used substantially by the public sector and that the public sector will pass on the increased cost of imports to the private sector customers, devaluation will in fact amount to a rise in the price of Government sales and hence would amount to an indirect tax.

This opportunity to collect a lot of purchasing power from the private sector and to put it to use for investment purposes, which a devaluation makes available, is so attractive that it would be foolish to lose it.

THE recent, heavy shortage of fore ign exchange, the applica­

t ion to the Fund for stand-by assist­ance and the prospects of reduct ion in the amount of fo r thcoming aid have brought sharply in to focus the balance of payments difficulties be­setting the Ind i an Government. These difficulties are not merely temporary in nature but are certain, by all accounts, to characterise the I n d i a n economy for many years to come.

The years since the payments crisis at the beginning of the Second Plan have witnessed a continuous shortage of foreign exchange to impor t the inputs and materials necessary to keep act ivi ty at the levels feasible in the l ight of i n ­stalled capacity. The creation of new capacity which would create a d ra in on the balance of payments either th rough the impor t of capi­tal equipment or through the i m ­port of raw materials has been heavily discouraged. In many years recently, applications for impor t licenses for capital goods have been entertained only when the a p p l i ­cant himself could make arrange­ments for raising fore ign exchange or when payment arrangements had been entered into by the Govern­ment w i t h foreign countries to finance such imports .

Consolidation of Import Control This shortage of foreign exchange

has resulted in consolidation of the i m p o r t control system w h i c h takes back to 1947. At the moment, all pr ivate impor t s , and par t of Gov­ernment impor ts , are licensed by one of three au thor i t i es : (1 ) Chief

Control ler of Impor t s & Exporte ( C C I & E ) ; (2 ) I r o n and Steel Cont ro l le r ; and, (3 ) Development Officer. Tools, Development W i n g of the M i n i s t r y of Commerce and I n ­dustry. The bulk of the impor ts are cleared through the CCI & E.

The licenses are d iv ided into the fo l lowing main categories ;

1 ) Established Impor ters ( E l ) ;

2) Actua l Users ( A U ) ;

3) New corners (not covered by A U and E I ) ;

4) A d hoc;

5) Capital Goods ( C C ) :

(6) Heavy Electrical Plant ( H E P ) ; and

7) Other miscellaneous types The E I , A U . CO and H E P provide the bulk of the impor t licenses.

Self-Defeating Export Measures

On the export side, the Govern­ment have now begun to subsidise exports actively. Several varieties of export measures have been devised. These range f rom drawbacks of duties, rebates, concessional prices for certain .inputs and "expor t pro­mo t ion" raw material licenses ( to replace or more than replace the input content of exports) to conti­nuous exhortat ion and appeals to the exporters to do their du ty by the nation. Most of these measures are cumbersome and sometimes frustrate their own purpose. For instance, unless the "export promo-t ion" AU license is issued qu ick ly enough and impor t s against it are immediate ly made available, diver­sion of output f rom domestic to the foreign markets at a loss could re-

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suit in a net loss to the exporters and cease to be an incentive scheme. Th i s argument applies also to de­lays, only much too frequent, in securing rebates and drawbacks.

The present Minis te r for Inter­national Trade seems to th ink that by merely appo in t ing special officers to look into problems of delays he can el iminate them. This opt imis t ic belief that one can cure the bureau­cracy of its p r inc ipa l hereditary defect is unfortunately bound to be disastrous for our export prospects. In any case, it is clear, and this is impor tant , that the Government in a varieties of ways has now admit ted that export p romot ion measures which are tantamount to expor t subsidies can improve India 's ex­port earnings. In other words, the Government admits, in its present inefficient way. that the elasticities of demand facing the export of non-t radi t ional items are large enough to jus t i fy an export subsidies pro­gramme or a devaluation. I shall be using this par t icular i m p l i c i t ad­mission, on the part of the Govern­ment, about the efficacy of a deva­luation (on the export side), in the course of my argument later in this paper in favour of a devaluation.

Foreign Exchange Needs Underestimated

t h ink a few observations are in order to argue, despite the current crisis, that the payments situation over the next few years is l ike ly to be characterised by as great diffi­culties as in the past five years. It may be naively assumed by some that just because the T h i r d Plan

The Case for Devaluation Jagdish Bhagwati

August 4, 1962 THE ECONOMIC WEEKLY

THE ECONOMIC WEEKLY August 4, 1962

neatly balances the fo re ign resour­ces against the i r use, there should be no shortage of fore ign exchange. Leaving aside the fact that fo re ign aid of the magni tude impl ied in the Plan is unl ike ly to be fo r th ­coming, one can argue that there are at least three reasons why one would expect a serious shortage of foreign exchange in the fu tu re .

(1 ) I t is commonly known that the fore ign exchange requirements of projects, both pr ivate and publ ic , are del iberately understated in all the calculations because their spon­sors wish to work their projects i n ­to the Plan. Th is bias towards underest imation is considerable and widely, admi t ted in the governmental circles.

(2) It is also equally well known that the estimated stock requi re­ments of the T h i r d Plan are incre­d ib ly low. Of course, there are pol i t ical reasons why the impossibly low f igure of the T h i r d Plan inven­tory estimate has been wr i t ten down. Given the fact that nobody wants more than Rs 10.000 odd crores wor th of investment over the f ive years, (erroneously assuming that more cannot be done) , i t fol lows that, if you raise the stock f igures to what may be regarded a reason­able level, the result would be to e l iminate some projects such as, for instance, a steel p lant or some fer­t i l iser plants, which few would l ike to do. Natura l l y , this understat ing of stocks means that we are delibe­rately p lann ing fo r in f la t ion. The result, of course, would be to add to the in f la t ionary pressure wh ich creates pressures, in t u rn , on the balance of payments. However, this understat ing of stocks also adds directly to the balance of payment difficulties because many of these stocks would consist of imported materials.

(3 ) I t is also being admi t ted by many officials that most of the for­eign exchange resources of the T h i r d Plan are already commit ted to projects and that there is certa in to be a great diff iculty in financing impor ts o f inputs.

I wou ld argue, therefore, that, notwi thstanding the serene assur­ance wh ich the planners have dis­played in the T h i r d Plan document, there is l i t t l e doubt that the pro­b lem of a severe fo re ign exchange shortage," especially to impor t raw

materials, is overwhelmingly l ike ly to cont inue over the next decade.1

Subsidy : How Much?

Given these difficulties, the Gov­ernment 's reaction has clearly been to mount what I have described as a cumbersome (and sometimes self-defeat ing) expor t p romot ion pro­gramme. This p rogramme, as I have argued, is reducible substanti­al ly to an export subsidies pro­gramme al though i t would requi re a great deal of empi r i ca l work to f ind out the extent of effective ex­por t subsidies wh ich emerges f r o m all these measures. On the other hand, the Government has cont inued w i th heavy impor t controls, re ly ing upon the l icensing system to ra t ion out fore ign exchange. I t is this system, w i th an inefficient export subsidies programme combined w i th impor t restr ict ions, that I wish to compare here w i t h a devaluat ion. l have already compared such a system exp l ic i t l y w i th a system of expor t subsidies plus exchange auctions in the Oxford Economic Papers, February 1962. I have shown there how an exchange auc­tions plus export subsidies scheme would represent an enormous i m ­provement, both f r om the v iewpoint of allocative efficiency and in f la t ion, over the current system. I would only refer the reader to that paper, in case he wishes to examine the case for such a re fo rm, Here I wish instead to discuss the case fo r devaluation which, whi le s imi lar to the exchange auction plus export subsidies scheme in several ways, di f fers f r o m i t in two respects:

(1 ) Whereas the exchange auc­t ion scheme wou ld be ak in to a fluctuating exchange rate, a devaluat ion would be a once-for-al l change in a fixed exchange rate,

(2 ) An exchange auct ion system, continued over a reasonable length of t ime, would give one a clue to the extent to wh ich the exchange rate is current ly overvalued where­as under devaluation there is a genuine diff iculty about

1 This prognostication is corroborated by Sir Donald MacDougall in his paper in The Economic Weekly (Apri l 22 and 29, 1961) where he argued persuasively concerning the under-estimation of foreign exchange needs in India's plans.

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est imat ing the extent by which one should devalue.2

I shall abstract f r o m all a rgu­ments other than that wh i ch I re­gard as const i tu t ing the central obstacle to a devaluat ion. Th is is the content ion that a devaluat ion would be in f la t ionary. I have come across this argument in several places, both academic and govern­mental . Th is argument , however, is very def ini tely specious.

Devaluation Mot Inf lat ionary

(1 ) I f , indeed, devaluat ion w i l l earn one more fore ign exchange w i th wh ich one can b r ing more capacity in to operat ion w i th the use of impor ted inputs, this should represent an improvement in real income (assuming that one has already levied the requi red taxes to handle the compl icat ions introduced by the op t imum tar i f f a r g u m e n t ) . If the real income rises, w i t h a given money expendi ture, clearly the pr ice level ought to fa l l rather than rise. The standard fear that a devaluation wi l l raise the pr ice level stems f rom a false comparison between a si tuat ion where the pay­ments def ici t is met by the use of reserves and a si tuat ion where it is e l iminated by a devaluat ion. How­ever, the real comparison ought to be, as is now increasingly realised, between a si tuat ion where the pay­ments deficit is e l iminated by the use of tar i f fs and restr ict ions and a si tuat ion where it is e l iminated by a devaluat ion.

(2 ) The argument that money expenditure, may be sensitive to a rise in the pr ice level of impor ted commodit ies is i r re levant because this argument applies equal ly to the (cur ren t ) system of tar i f fs and a devaluat ion. Even i f th is were not so. it wou ld be a fa l lacy, in my opin ion- to argue that the level of money expendi ture in I nd ia would rise to match an increased pr ice level of impor ted goods, since trade un ion pressures in our country have st i l l not reached the stage where this possibi l i ty becomes plausible. 2 It was pointed out to me by Professor

Shenoy that, when sterling was de­valued in 1949, the Chancellor re­portedly looked at the value of ster­ling in the transferable sterling mar­ket and devalued a little in excess of that. Of course, it is possible to argue that this is not a fully satis­factory procedure: the free market is necessarily a restricted market and also unduly subject to speculative fluctuations

August 4, 1962 T H E E C O N O M I C W E E K L Y

(3 ) T h i r d l y , I wou ld argue that the current system of p lann ing is itself in f la t ionary as against a de­valuat ion, on two grounds. The first is t h a t assuming that t rade is balanced, under a devaluat ion the extra money paid out to exporters because of the devaluat ion would be p icked up (by the Reserve Bank) f r o m the impor ters . However, under the current system, the Government pays out money to the exporters by way of effective subsidies bu t does not p ick up an equal amount f r o m the impor ters . Hence, the current system contrasted w i t h a devalua­t ion , at balanced t rade, puts more purchasing power in to the hands of the public.

(4 ) Fur ther , i f one reckons that, under the Ind ian system, i m ­por ts are considerably in excess of exports because of fo re ign a id , a very substantial oppor tun i t y opens up for a "de f l a t i ona ry " effect fo l lowing upon devaluat ion. Assum­ing that the fo re ign aid is used substant ial ly by the pub l ic sector and that the pub l ic sector (hav ing pa id more rupees to get i ts impor ts af ter devaluat ion) w i l l pass on the increased cost to the pr ivate sector customers, we find that devaluat ion wi l l in fact amount to a rise in the pr ice of Government sales and hence this would be tantamount to an in­direct tax. Thus, if the Govern­ment enterprises work on a cost-plus basis, a devaluat ion w i l l g ive rise to a substantial ind i rect tax and abstract ion of purchasing power f r o m the p r i va te sector. I n ­deed, this oppor tun i t y to collect a lot of purchasing power f r o m the pr iva te sector and to pu t i t to use for investment purposes, wh i ch a devaluat ion makes avai lable, is so at t ract ive that i t wou ld be fool ish to lose such an oppor tun i t y . Of course, the market prices would rise and hence devaluat ion would be " i n f l a t i o n a r y " in the popu la r sense, jus t l ike an ind i rec t tax system. However , in the Keynesian sense, the system would , of course, s iphon off purchasing power, as argued here,

I do not see any reason w h y a devaluat ion wou ld be in f la t ionary as compared w i t h the current system. On the cont rary , every argument wh i ch I can th ink of points in the con t ra ry d i rec t ion . Thus the only argument wh i ch can possibly be ci ted against a devaluat ion, in the

l igh t of the fact that the Govern­ment have already admi t ted that the pr ice elasticit ies fo r non- t rad i ­t ional e x p o r t , are favourable to a devaluat ion, turns out to be unten­able. The onus of p rov ing that a devaluat ion would prove h a r m f u l rather than beneficial would now seem to rest upon the Government /

I would recommend a devaluation

which would be offset by export taxes on some of the traditional ex­ports. I would also recommend, in view of the fact of short-run inela­sticity of supply, that the entire de­valuation be neutralised by export taxes and that the export taxes be removed on the non-traditional items, gradually over a period of, say, five years at 20% per annum, I have discussed this proposal in my paper in the Oxford Economic Papers, op cit