Lessons of the 1990s

Both quality and quantity of public debt are important dimensions in a financial crisis

In the last article I had argued that allowing liabilities to foreigners to grow beyond a limit can lead to financial colonisation by multilateral institutions such as the International Monetary Fund (IMF). This generally takes the form of “conditionalities” like tight monetary and fiscal policies the cost of which is too often borne by the poorest, who had little role to play in the creation of the liabilities. (It is worth noting that after the crisis Malaysia imposed capital controls, did not need to go to the IMF and recovered much more rapidly than the other three. The then Malaysian prime minister blamed global speculative capital for the crisis.) One example in today’s world is Greece since its sovereign debt crisis almost a decade back. 

Its liabilities were/are in the domestic currency, which the national government/central bank cannot create; the supranational European Central Bank alone can supply the euro. The result for Greece has been macroeconomic/budgetary policies dictated by Brussels, leading to recession, unemployment, a sharp fall in gross domestic product (GDP) and living standards. In other words, for the euro zone economies, debt in the domestic currency is, in effect, debt in foreign currency.

The other lesson is for the current debate in India about the quantum of public debt. The panel that recently reviewed the Fiscal Responsibility and Budget Management Act has recommended a ceiling of 60 per cent of GDP. Thailand’s public debt was just 15 per cent of nominal GDP in 1996 — the year previous to the crisis. Is the quality rather than quantity of an economy’s debt more important to financial stability and growth? Quality has several dimensions:

* The end use. For expenditure or investment?

* Who are the holders of the debt? Residents or foreigners?

* The currency of the debt/liability, etc.

The issue of quality as distinct from quantity is equally relevant to a country’s reserves of foreign exchange. The Bank for International Settlements, the “central banks’ central bank”, in its recently released annual report, while discussing central bank balance sheets, has argued that “foreign exchange reserves are more important for non-reserve currency countries, especially small open advanced economies and EMEs”. (It is worth noting that China, the world’s fastest grown economy over the last 35 years, considers the level of reserves important even when the yuan is effectively a reserve currency: 

Sometime back, it imposed capital controls to mitigate reserves erosion.) Here again, I would argue that the quality of reserves is at least as important as the quantity. Have they been built out of surpluses on revenue account (as in China’s case) or by increasing external liabilities (as in our case)? 

Arguably, the maturity of external liabilities is equally important to the issue — are they long term or short term, liable to be withdrawn when most needed?

From all these perspectives, it is perhaps more meaningful to look at the reserves not in isolation but as part of the international investment position. To take our own case, the Index of Industrial Production (IIP) statement as on March 31 shows reserves at $370 billion, but the total external liabilities on that date were $950 billion; out of the latter, portfolio investments, which can go out any time, amount to $240 billion and trade credit $90 billion. In other words, 90 per cent of our reserves are financed by short-term, or potentially short-term, liabilities. The net external liabilities on March 31 were $390 billion and have gone up eight times in the last seven or eight years, as a result of the exchange rate policy. No wonder, the IMF last week cautioned India about its vulnerability on the external sector. 

The Asian crises (as also those in Mexico in 1994 and Argentina in 2001) also teach us the dangers of “pegging” the nominal exchange rate even when domestic inflation is higher. It improves the economics of carry trades for portfolio investors and unhedged foreign currency borrowings for the domestic corporate sector. In our case, the exchange rate is not “pegged”, but the Real Effective Exchange Rate (REER) index suggests an overvaluation of 30 per cent plus. This has led to persistent trade deficits, a huge increase in the non-performing assets of the tradeables sector and a loss of potential output and jobs — all for some marginal impact on inflation? Will policymakers realise before it is too late that REER/IIP targeting may today be more important than inflation or public debt targeting?

One positive outcome of the crisis for the IMF’s ideology was that the efforts to amend the articles of agreement to make capital account convertibility mandatory were abandoned.

The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com