Desperate attempts to woo foreign capital by boosting investor sentiment is unlikely to result in a lasting solution to India’s currency travails
The recovery of the rupee and the euphoric rebound of the markets in the last few days would appear to suggest that the economy is back on track again. Nothing could be more wrong. The flurry of policy announcements in recent weeks is based on the diagnosis that the relentless slide of the rupee, attributed to the widening Current Account Deficit (CAD), can be arrested if and when capital inflows — as investments or borrowings — fill the gap.
Reserve Bank of India governor Raghuram Rajan’s recent announcement allowing banks to borrow from global capital markets at a time when interest rates are rising because of the expected reversal of the United States Federal Reserve’s easy money policy is tailored to this logic. Indian banks can now borrow up to 100 per cent of their combined net worth and long term borrowings from the international market (compared to 50 per cent earlier) and then “swap” them with the central bank. This is expected to augment the supply of foreign exchange by an estimated $30 billion, which is about one-tenth of Indian foreign exchange reserves. The markets reacted euphorically, but the risks of the country borrowing its way out of trouble have been much less appreciated.
The two-track policy — of making India more attractive to foreign investors by deepening “reforms” and of borrowing more — is fraught with serious consequences. The policy response suggests that the ongoing crisis is only a temporary blip in the Great Indian Growth Story. But it appears that the seeds of the crisis were sown in that very story.
The great credit binge
A striking feature of the story is that Indian corporates borrowed like there was no tomorrow — from not only Indian banks but also from overseas capital markets. Consider this: between 2003-04 and 2010-11 the Indian corporate sector’s share of net bank credit increased from 31 per cent of Gross Domestic Product (GDP) to over 37 per cent. In fact, since 2006-07, their share has been consistently higher than net bank credit to the government.
Infrastructure companies’ (power, roads and telecom) share in total bank credit increased from about 9 per cent in 2003 to more than 33 per cent in 2011. The spectacular increase is responsible for the mounting burden of non-performing assets in the Indian banking sector today. According to an oft-cited report in the media, prepared by the Credit Suisse Group in 2012, the debt of 10 Indian corporate groups whose interests range from oil and gas and steel to infrastructure increased from about Rs. one lakh crores in 2006-07 to Rs. 5.4 lakh crores in 2011-12 — a compounded annual rate of 40 per cent.
The fact that private fixed investment did not increase at the same pace is perhaps because a large portion of the credit was diverted by Indian companies to what would appear to be an asset bubble — in land, shares in companies and other speculative assets. The clamour by corporate lobbies that interest rates be lowered has no respect for economic logic, given the state of the country’s external balances. They fail to appreciate that the era of cheap-credit fuelled growth is well and truly over.
But this increase in domestic credit was dwarfed by the remarkable increase in the inflows of foreign capital following the global economic meltdown in 2008.
The share of capital inflows — external borrowings, foreign direct investment (FDI) and foreign institutional investors (FII) — increased from about 5-6 per cent of GDP to about 9 per cent in 2011. The share of costlier short-term borrowings (almost entirely by private companies) in overall borrowings increased from 4.5 per cent in 2002-03 to 25 per cent in 2012-13. Companies, lulled into borrowing at illusorily low interest rates, have been surprised by sharp increase in the rupee-denominated value of their loans.
Inflows of FDI registered a spectacular rise — from $9 billion in 2005-06 to $33 billion in 2010-11. Popular understanding is that while FII investments are volatile, FDI is much more stable, long term in nature and contributes to improving the competitiveness of recipient nations. However, the story of India’s dalliance with FDI is shockingly different and raises serious doubts about whether the ongoing attempts to woo investors is sustainable or even desirable.
A study co-authored by Biswajit Dhar, Director General, Research and Information Systems for Developing Countries, based on a painstaking dissection of every FDI project entailing an investment of $5 million and more between 2004 and 2009, provides shocking insights that prove that a large proportion of FDI is just as volatile and transitory as portfolio capital. The study that considered 2,748 projects, which accounted for almost 90 per cent of all FDI in the 2004-2009 period, found that the lowering of norms prescribing the minimum level of equity stake in an “FDI invested” project — from 40 per cent to 10 per cent — offered perverse incentives to capital flowing in the garb of FDI.
Less than half of the investment was actually FDI; private equity, venture capital and hedge funds, which are volatile and normally associated with short investment horizons, accounted for 27 per cent; and about 10 per cent was actually portfolio investment. Over 10 per cent of the “investment” was round tripping by Indian entities, which funnelled money back through tax havens in order to take advantage of tax concessions and other inducements available to FDI projects.
A large proportion of the investment was by entities masquerading as investors committed to the long haul or investments that enhanced the productive capacity. Indeed, manufacturing, which advocates of FDI said would be a key beneficiary, received only one-fifth of the investment; but even in this case portfolio and other short-horizon investors accounted for almost 40 per cent of the total investment. Interestingly, while much attention has been focussed on the rising import of oil and gold, little attention has been paid to the fact that the trade deficit in manufactured goods has widened from $1.5 billion in 2004-05 to $45.5 billion in 2011-12 (about 2.5 per cent of GDP).
If there is any truth in the old cliché that a crisis is also an opportunity, surely this is a time to rebalance the Indian economy on a more sustainable path that allows policymakers to use levers that are more easily within their control. Of course, this would require import curbs and other measures suited to these hard times. But rebalancing would also require the use of measures such as the fiscal deficit, which have been for far too long a strict no-no in the policymakers’ handbook.
The fiscal deficit obsession
The stubborn opposition to the good old-fashioned Keynesian logic of using a fiscal deficit to get the economy back on its feet is grounded in the apparently intuitive logic that equates a government deficit with a household deficit. A classic example of such misguided thinking is evident in the loud opposition to the Food Security Bill. Quite apart from the fact that such a measure would provide a measure of security to the poor, the implementation of the legislation promises economy-wide benefits.
First, the guarantee of subsidised food grains, which constitutes a significant proportion of the consumption basket for most people, will have the immediate effect of increasing their disposable income. This is not trivial, given that the growth of consumption expenditure has halved between 2009 and 2012.
Second, the provision can play the role of an economic stabiliser because food prices determine the floor wage level, which is why they are termed a wage good. The guarantee would thus not only help in controlling food prices but also stabilise wages. Indeed, it is perplexing that industry lobbies are attacking the provision of an enhanced social wage, from which they stand to benefit significantly.
Third, if the fiscal deficit is run in an imaginative way, even more can be achieved. For instance, coupling the food guarantee to the MGNREGA can help in the construction of a countrywide network of godowns for the Food Corporation of India.
Of course, a cash transfer scheme would negate much of the potential economy-wide benefits that would accrue from the implementation of the food security legislation.