I write this piece for two reasons. First, the rupee seems to be back on appreciation track as capital inflows begin to outstrip current account outflows. While there could be some correction going forward, it is likely that the central bank will have to keep stepping in to retain export competitiveness. This will have consequences for the supply of money, inflation and so on as the RBI swaps rupees for dollars to stem appreciation.
Second, I see a new initiative among economists and analysts to take a harder look at the link between external capital and growth in emerging economies. The idea seems to be to first recognise that maintaining an open capital account entails significant economic costs (currency overvaluation, ‘sudden stops’ and so on) and then to question the entrenched orthodoxy that foreign capital is imperative for growth.
These are hardly radical or “new”. There has been a fairly large body of research work that has examined the link between flows of foreign capital and growth in developing economies .This started with a famous paper by Robert Lucas in 1990 that showed that quite contrary to the predictions of theory, the flow of capital from the rich to poor countries were modest. Thus capital was not flowing from capital rich economies that offered low return to capital scarce (and consequently high return) economies. This “puzzle” triggered a raft of empirical work that dug a little deeper. The focus was on the precise role that external capital played in stoking the engine of growth. Over the past few months, there seems to be an effort to resurrect some of this research that got short shrift over the past decade in which growth strategy was marked by a somewhat irrational obsession with foreign capital.
Of the number of papers in this area, let me talk specifically of just one—a National Bureau of Economic Research (NBER) working paper put together by Eswar Prasad, Raghuram Rajan and Arvind Subramanian titled “Foreign Capital and Economic Growth”, which was published in November 2007. If my (perhaps somewhat simplistic) interpretation of their work is correct, these are their key conclusions:
Countries that have relied less on foreign finance have grown faster. To take this a little further, Messrs Prasad and co show that countries that had high investment GDP ratios and low reliance on foreign capital grew by one percentage point more on an average than those with high investment GDP ratios and high foreign capital dependence.
It follows from the first proposition that higher growth seems to be a function largely of domestic savings, not external finance.
Countries like China that have given the impression of having grown on the back of large flows of external capital have been poor users of this capital. That China has run a sustained current account surplus underscores the fact that it has been a net exporter, rather than importer of capital.
In fact, an analysis of the entire sample of countries shows that the relationship between the current account balance (the measure of utilisation of external capital to augment domestic savings) and growth runs contrary to the predictions of economic theory.
What are the implications? The obvious conclusion is that the “external capital fetish” that policymakers often have has no real basis. However, Prasad and his co-authors are careful to emphasise that history needs to repeat itself. Thus the fact that high growth countries seem to rely on domestic resources does not necessarily mean that this is the best strategy for funding growth going forward. They claim that that excessive dependence on domestic savings means a higher rate of savings than is perhaps desirable. If the financial markets allow domestic consumers to borrow against future income, they might be able to ramp up their consumption rate. The gap between domestic savings and the targeted investment rate can be filled by foreign savings.
There are more radical views. Tushar Poddar of Goldman Sachs (“India can afford its massive infrastructure needs”, September 2009) claims that while domestic infrastructure funding needs will add up to a whopping $1.7 trillion over the next decade, almost all of it can be funded from domestic savings. Tushar’s analysis is based on a rigorous study of domestic savings, particularly the impact of changing demographics on the saving rate. He also issues a caveat: “excessive reliance on external financing can lead to periodic booms and busts—a sustainable model is to build on healthy balance sheets and a reliance on domestic savings channeled through long-term funds such as pensions and insurance.”
What is the bottom line then? First, there are large costs associated with a liberal capital account regime in the form of currency overvaluation (and its impact on exports) and the vulnerability to quick reversal of these flows in the event of a financial crisis. Are these costs justified by potential benefits? Recent economic history suggests that the contribution or benefits of foreign capital is grossly exaggerated perhaps because the absorption of this capital has been weak.
Can this contribution increase going forward? External capital is useful only if it is utilised better. Building a large buffer of foreign exchange reserves cannot be a long-term objective in itself. Utilisation can be improved only if we deepen financial markets and ensure that investment projects that are potential users of this capital are better implemented. This, in turn, means a larger current account deficit on average.
Third, it is important to give domestic savings their due. These are likely to be far more important in supporting growth than access to foreign capital. In fact, offering greater access to cheap dollars or euros is an easy way out from a policy perspective. It could distract from the more difficult imperative of developing deeper institutions for channeling domestic savings.
Does this call for immediate capital controls? Perhaps not. But in our bid to climb back on a 9 per cent growth path, it is important to assess the role that external finance should play.
The author is chief economist, HDFC Bank. The views expressed are personal
