Southern Europe is a live example of what happens when countries lose global competitiveness at a given exchange rate, and start incurring unsustainable deficits on current account, becoming even more dependent on foreign investors to finance them. And investor sentiment can change very quickly. Ireland is a good example of the latter, although its problem was a banking crisis and consequent fiscal deficits (see “Eurozone: the second domino falls”, December 13). As recently as mid-September, it did not face a problem in getting subscriptions to its bonds issues. Could investor sentiment change for India as well?
India’s current account deficit is likely to exceed significantly the official forecast of 3 per cent of GDP. Goldman Sachs in a recent research report has forecast a deficit of $67 billion, or 4 per cent of GDP, in the current fiscal year (and even higher than that in 2011-12). This is even larger than the US’ — this number seems more realistic. And, this still considers remittances as current “income” — as I have argued earlier, the gap between the domestic economy’s external earnings and expenditure is even higher at 8 per cent of GDP in 2010-11. The output loss in the tradeables sector has been going up year after year.
Owing to an increase in oil prices in recent weeks, the actual deficit could go up further. The Reserve Bank of India’s governor, in his post-policy interview last month (Business Standard, November 3), cautioned: “A sustained current account deficit beyond 3 per cent year after year will be difficult to manage by flows that are not of a stable nature.” Note the focus on the possible difficulty in managing the deficit by flows, not about the huge output loss it represents.
Curiously, even while raising questions about possible difficulties in managing the deficit, the authorities have refused to tackle the root cause — the rupee appreciation in real effective terms owing to capital inflows, without any intervention in the market or steps to curb inflows. (Obviously, for government intervention to be justified, air fares are far more important than the exchange rate.) Are we worried about the impact on equity prices and foreign institutional investor sentiment? If that is the case, it is difficult to appreciate this pandering to finance capital. As former RBI Governor Y V Reddy said (Business Standard, July 13): “If public policy is itself scared of the financial markets, the financial markets will know that it can pressure them against controls. If public policy is determined to manage, it can be managed better.” Far more competitive, and surplus, economies in Asia, and elsewhere, have announced measures to curb capital inflows — and many economists are advocating this, from Joseph Stiglitz and Michael Spence to the World Bank. But we are made of sterner stuff and do not hesitate to sacrifice the real economy’s output and jobs through current account deficits, in the interest of the financial economy. After all, as an aspiring superpower of the 21st century, should we not follow the policies advocated by the superpowers of the 19th and 20th centuries, and their faith in financial market efficiency, in market-determined exchange rates? If that means a huge output loss in the tradables sector, this is only a manifestation of the “creative destruction” on which capitalism thrives. If the exchange rate appreciation is the cause, so be it. After all, have the erstwhile superpowers not de-industrialised over the last three decades, even as their financial economies thrived, at least until the crisis? We should be concerned about the financiability of the deficit, not the output loss.
Is such complacency about the exchange rate in order so long as we are confident of financing the consequential current account deficit? And, what are the prospects for capital flows next year? Personally, I am not very optimistic: As it is, portfolio investors are getting cautious about the Indian market. And, it is difficult to see the sentiment change next year; particularly given the tight liquidity and deflationary exchange rate policy, margins and growth could be hit next year. It is worth bearing in mind that, just as portfolio investors rush in, they can rush out when the outlook for the currency or economy changes — many emerging markets have experienced this over the last two decades.
Again, the more stable foreign direct investment (FDI) inflows have dropped significantly in the current year. In sectors where they can come in quickly (retail, insurance and so on), we do not want them. Posco points to the difficulties in coming in; Cairn the difficulties in getting out; and Vodafone and Dow the difficulties after the investor has come in.
The corruption and governance problems that have made headlines in the global media over the last three months are hardly an advertisement. These could drive major Indian industry to invest abroad rather than in India. Net FDI inflows could fall even more than gross inflows.
What is the extent of the overvaluation and what can be done? I shall answer these questions in a later article.
