Will a strong rupee win votes?

High inflation means that the Congress-led UPA government is in serious danger of losing the next general election. Voters tend to revolt when inflation exceeds their tolerance level, which today is probably no more than 5%.

Wholesale price inflation is currently a whopping 12%. Consumer price data are not available for recent weeks, but are less alarming, suggesting consumer inflation of maybe 8%. Still, that is well above what is electorally tolerable.

In recent years, voters have tended to oust four-fifths of incumbent governments, notwithstanding record economic growth. This reflects widespread dissatisfaction with the quality of governance. Add high inflation to misgovernance, and the chances of an incumbent being re-elected fall close to zero.

What will the Congress do to improve its chances? I offer two predictions. First, the government will seek to strengthen the exchange rate of the rupee, making imports cheaper and thus, creating downward pressure on prices. Second, after having raised interest rates thrice in the last two months, it will raise them further soon, but then lower them shortly before the poll date. This strategy will aim to check inflation right now, while reducing the sting of high EMIs before the election.

A stronger rupee will reduce the profitability and competitiveness of exports. And higher interest rates will hit investment as well as consumer credit, which is crucial for selling property and consumer durables (like cars and two-wheelers). But at election time, politicians naturally favour inflation control over growth.

Politicians have used many financial gambits over the years to try and influence elections. The farm loan waiver is one such. But never before has the exchange rate been used as a vote-winner. That may be about to change. In past decades, India was largely self-sufficient, and had high import barriers. In such circumstances, the exchange rate had only a minimal effect on inflation — other factors mattered much more. But today, imports of goods and services account for over 25% of GDP, and so have a substantial impact on prices. World commodity prices have skyrocketed in the last year, raising the spectre of imported inflation.

The government has already imposed a series of trade controls to de-link India from the global economy, and thus, insulate it from world prices. It has banned the export of foodgrains, save basmati rice. This, along with a bumper crop, has kept food inflation at no more than 6-7%.

An export duty of 15% has been levied on several grades of steel, and SAIL — the government-owned company that accounts for one-third of total steel production — has been ordered to hold its price line. Exports of cement have not been curbed, as was once threatened. But the import duty and even countervailing duty on cement has been cut to zero, a policy that discriminates in favour of imported cement and against domestic production.

Prices of petrol and diesel have been raised very modestly compared with the global price rise, so the government is implicitly offering a huge subsidy of Rs 100,000 crore to consumers. Fertiliser prices have also been frozen, to woo farm voters, although world prices have tripled. The import duty on some edible oils has been cut to zero.

Despite this awesome list of anti-inflation measures, prices have kept soaring. Further trade control measures would have very limited anti-inflationary potential, though there is talk of curbing petrochemical exports. Every congressman hopes that world commodity prices will crash in coming months, as the global economy slows. But that is uncertain as long as China keeps growing fast. Besides, Israel may bomb Iran, sending oil above $200/barrel.

So, the government has to look for other ways to check inflation. Slowing the economy with high interest rates is an obvious but distasteful way of achieving that. A slowing economy means fewer increases in jobs and incomes, improving chances of re-election. A slowing economy also means less revenue that can be spent on a plethora of vote-catching schemes.

Now, some economists argue that the sort of inflation is mostly imported, and so, cannot be checked by slowing down growth. Maybe so, but politicians facing an election cannot take chances. They seem certain to opt for stern monetary medicine.

This is hardly a vote-catcher, since it means a higher equated monthly installment (EMIs) for middle-class borrowers. High rates make it more difficult for consumers to buy property, cars or two-wheelers. Nevertheless, the anti-inflationary gains of tighter monetary policy will probably be judged higher than the political negatives of rising EMIs. There’s time enough to lower rates just before the polls.

Finally, I predict the government will oblige the RBI to strengthen the rupee. The rupee reached a peak of Rs 39/dollar late last year, but the rising price of oil — and hence India’s rising trade account deficit — has induced a fall in the rupee, to around Rs 42.50/dollar. Expect it to rise again close to Rs 39/dollar in coming months. This can check a variety of import-sensitive prices, the more so if world commodity prices fall. This will be the first time the exchange rate will become part of election strategy. It will not be the last.

What do you think?