The capital conundrum
How should India respond to the flood of capital gushing into its economy?
The Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) have, for better or worse, stepped knee-deep into the flood?water and tried to control its flow. And have courted controversy in the bargain.
RBI has done either of two things, depending on the circumstances. It has tried to buy up the dollars and pump more money into the domestic economy. Or it has let the rupee appreciate. The first policy weakens it in the fight against inflation and the second could hurt export competitiveness. Sebi has tried to turn away one category of investors in the stock market—hedge funds and other shadowy investment pools that invest indirectly through offshore derivatives. This has shaken the stock market.
It is time the government, too, got into the act in a meaningful way—by slashing the fiscal deficit.
First: how big is the flood?
The finance minister says the inflows are “copious", an adjective that has gained wide currency over the past 10 days. The International Monetary Fund (IMF) says in its new World Economic Outlook that the amount of private capital cumulatively flowing into India since 2002 is equal to 18.3% of its GDP, far more than the 6.9% in 1988-90 (in the run-up to the crisis of 1991) and the 3.2% in 1994 (the first big burst of foreign institutional investors activity in India).
How does this compare with other countries? It’s middling. Many in Europe’s north are dealing with capital inflows that are three to five times larger than ours, for every unit of GDP. In Asia, Vietnam has been getting cumulative inflows of 38.5% of its GDP. In that sense, India is by no way being soaked in foreign capital.
Between 1990 and 1996, Korea received cumulative capital flows equal to 18.9% of its GDP in the last year of that period. That did not protect it from the wave of capital outflows that wrecked East Asia and South-East Asia in 1997. The others affected were in deeper water: Indonesia (26.3%), Malaysia (79.1%) and Thailand (88.8%, between 1988 and 1996).
Any way you look at it, India does not seem to have had threateningly large capital inflows in the past five years. But this does not mean that Indian policymakers are mistaken in their flurry of discussion and policy. IMF has identified 109 episodes of “large net private capital inflows" since 1987; of these, 87 were completed by 2006. IMF says that “one-third of the completed episodes ended with a sudden stop or a currency crisis, suggesting that abrupt endings are not a rare phenomenon."
Two further issues need to be looked into. First, what is the nature of these private capital flows? Are they predominantly long-term foreign direct investment or are they short-term speculative capital that can be withdrawn by hitting the enter key on a laptop in the Bahamas?
It is quite well-known that India has been more popular with portfolio investors than with corporate investors in the past decade or so, though the balance between the two is less skewed than before.
The other troublesome question is the state of the economy’s fundamentals. India needs to worry about two things: its current account deficit and its fiscal deficit.
The former puts India at greater risk of a sudden reversal of capital than those countries that have large trade and current account surpluses. “The consequences of large capital inflows are of particular concern to countries with substantial current account deficits..." says IMF.
Then there is the fiscal deficit. Capital inflows usually stoke up economic growth but put the overall economy to the risk of overheating—thus creating the conditions for eventual loss of investor confidence and capital outflows. The textbook way to deal with such a situation is either to run a tight monetary policy and/or a tight fiscal policy. RBI has been doing the first, as a result of which we have seen some deceleration in bank credit and consumer demand.
The government needs to back this with a tighter fiscal policy to cool final demand in the economy. The finance ministry is busy making self-congratulatory statements about how it will meet its fiscal targets this year and will eventually bring the revenue deficit down to zero by 2009.
But surely the government can do better. The bipartisan deal to bring India government finances back on track through the Fiscal Responsibility and Budget Management Act was hammered out at a time when economic growth and tax collections were sluggish. The subsequent economic boom has led to huge increases in tax collections, which ideally should have been used to slash the fiscal deficit, something that the Clinton administration did in the 1990s in the US. The Mumbai sisters have a huge battle on their hands. Isn’t it time the big brother in New Delhi entered the fray?