MacroScan - Too Little, Too Late

Everybody learns at their pace. It is not surprising therefore that it has taken Finance Minister P. Chidambaram an unduly long time to realize that large capital inflows into India can adversely affect growth and the price level. More than three years after India became the target of an unprecedented surge in foreign investment inflows, he has finally declared, when tabling in Parliament the Mid-Year Review of the Indian economy, that this was a cause for concern.

This admission does point to a major change in the Finance Minister’s earlier understanding that capital inflows were not just benign but unquestionably beneficial. But on that understanding, he has stretched himself and the nation’s budget to attract such flows. The most telling instance of such an effort was his decision in 2004, "to abolish the tax on long term capital gains from securities transactions". By doing this he made the tax regime applicable to stock market investments in India much more favourable than in most other developing and even developed economies. Subsequently, when FII inflows were resulting in an unprecedented boom in capital markets that many observers felt was not warranted by fundamentals, he sought to assuage such fears by arguing that better corporate performance meant that price-earnings ratios in India were still below acceptable levels. Foreign institutional investors were coming to India, he argued, because the economy was doing well under his leadership. Finally, when the Reserve Bank of India was expressing concern over these flows and calling for moves to stop inflows through speculative channels such as participatory notes (PNs), the ministry he heads not merely disagreed but sought to silence spokespersons from the central bank who expressed such views.

Thus, experience seems to have taught the Finance Minister an important lesson, resulting in a significant change in his view on the benign and beneficial nature of capital inflows. But in this case the lesson learnt may be too little and too late. Too little, because the Finance Minister does not seems to have fully understood the problems that the capital surge has created and is still creating. Too late, because the Finance Minister looks unwilling to face the consequences of actions aimed at slowing, let alone arresting, capital inflows. Foreign capital flows have the quality that the more you have of them, the more difficult it is to say that you do not want any more. Choosing to say no does not just close the tap on new flows but triggers a drain of capital that has already come in. The larger is the stock of past inflows, the more damaging this may be, necessitating stronger action. And the Finance Minister’s past actions and current perceptions, do not suggest that this government would be willing to make the necessary moves. In the event capital would continue to flow in till such time that the foreign investors themselves choose to turn their backs on this country. And if and when they do, the damage can be severe.

The Mid-Year Review tabled by the Finance Minister explains why he now sees capital flows as a potential constraint on macroeconomic management and growth. The problem is not that India has with a liberal financial policy allowed itself to be the target of unprecedented capital inflows that the country does not need to finance its balance of payments. Rather, to quote the review, the problem is that: "The economy’s capacity to absorb capital inflows … has not risen as fast as the inflows." Needless to say, this inability to "absorb" in the context of large inflows, results in an excess supply of foreign exchange that puts pressure on the rupee in the form of a tendency to appreciate. In the event, the rupee has appreciated against the dollar by 15.1 per cent over the year ended October 2007 and by close to 10 per cent between April 3 and November 20 this year.
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An appreciation of that magnitude, by raising the dollar value of India’s exports, would adversely affect exports, since exporters would not be able to reduce margins and prices to that extent. It gives little comfort that the rupee has not appreciated as much vis-à-vis other currencies such as the euro, since the dollar is the currency in which much of India’s trade is denominated. Forced by exporters to recognize the effects that appreciation is having on the exporting industries, the Review admits that this could "moderate" growth and lead to "temporary" job losses in some of India’s major export industries such as textiles, handicrafts and leather.

This occurs despite the efforts of the government and the central bank to stall rupee appreciation through means that have their own side effects. The Reserve Bank of India (RBI) has consistently sought to deal with the problem of an excess supply of foreign exchange by buying up foreign currency in the market. But this results in the injection of rupees into the system and increases money supply by more than what the central bank has targeted. To mop up the excess rupees the Finance Ministry has allowed the RBI, under the Market Stabilization Scheme, to issue government bonds, the interest on which is paid out of the budget. This is an additional burden that the Finance Ministry has to bear. The Budget for 2007-08 had provided for an outgo of Rs. 3,700 crore on this account. But the Mid-Year Review estimates that interest payments on bonds issued for this purpose would amount to Rs. 8,200 crore, necessitating a supplementary demand of Rs. 4,500 crore. Even more money may have to be allocated for the purpose before the next financial year.

Already burdened with a large public debt and a huge interest burden and committed to meeting the irrational targets set by the Fiscal Responsibility of Budget Management Act, this additional commitment reduces the government’s fiscal maneuverability substantially. Profit inflation and high growth have no doubt helped the government, with direct taxes growing by 40 per cent and indirect taxes by 20 per cent during the first quarter of this financial year (as compared with the corresponding quarter of the previous financial year). But expenditures have also risen rapidly, so that the revenue deficit during the first quarter was already near the target for the fiscal year as a whole.

One consequence of these trends is that the government’s ability to cover rising petroleum, fertilizer and food subsidies has been eroded. The subsidies required in these areas have been rising rapidly because of the rise in petroleum and food prices in the international market and India’s traditional dependence on petroleum imports and more recent dependence on food imports, especially of wheat. Subsidies rise because the government cannot politically justify an increase in the prices of these commodities, and would not dare raise them in a period when crucial state elections and even elections to parliament are not far away. On the other hand, rising subsidies make it increasingly difficult for the government to meet its FRBM commitments while maintaining expenditures ate reasonable levels.

One way in which the government has sought to overcome the problem this creates is through the financial sleight of hand in which it issues bonds that are deposited with oil and fertilizer companies, which are not being permitted to raise prices to cover higher costs. The value of the bonds covers their losses, and they can sell the bonds in the secondary market if they need cash. Since the government receives no payment for these bonds which it uses to cover its expenditures, there is no cash outgo. So the sum involved is kept out of the revenue and fiscal deficit figures. But these bonds do add to the liabilities of the government, and would require large capital outflows when the bonds mature. The government is also required to pay the interest that is due on them, adding to the interest burden borne by the government.

This has a number of implications. To start with, the constraint on government spending is much greater than is suggested by the aggregate figures on receipts. This is bound to adversely affect capital outlays and social expenditures. Second, strapped for funds, the government would be less willing to compensate exporters for rupee appreciation with explicit or implicit subsidies. The Review derides such measures as a short-term answer and prescribes improvements in productivity as a lasting solution. Finally, as the burden of continuing with the so-called "deficit-neutral" measures to deal with subsidies increases, the government would, political circumstances permitting, increase prices to reduce subsidies. This would reveal the rate of inflation warranted by the government’s policies and the pace and pattern of growth they generate.

Thus the practice of using bonds that do not mobilize capital but require interest payments and involve a liability for the government is only a way postponing problems that the government does not want to recognize and address. The same is true of the tendency to see the problems created by capital flows as being the result of the inability of the country to absorb them rather than the fall-out of an excessive inflow of unwanted capital. A consequence of that perception would be policies directed at encouraging "absorption" through profligate foreign exchange use. The decision to allow every Indian (who has the wherewithal, fo course) to buy foreign exchange equal to $200,000 every year and use it abroad for any legal purpose whatsoever is an obvious indication of this tendency to encourage profligacy to increase absorption.

If successful, measures like this may reduce the excess supply of foreign exchange in the market. But that would not mean that the problems created by the surge in capital flows would go away. Such flows require payments of a return in foreign exchange. They also involve a foreign exchange liability for the country. This may not matter as much for a country like China which "earns" its surplus foreign exchange. That country currently records trade and current account surpluses of around $250 billion in a year. On the other hand, India incurs a trade deficit of around $65 billion and a current account deficit of close to $10 billion. Its surplus foreign exchange is not earned, but reflects a liability. Opting for a foreign exchange splurge in such a situation is to create conditions where when foreigners choose to cash their investments and move elsewhere, the foreign exchange needed to meet the country’s commitments may not exist. That implies a crisis created not because we attracted the foreign capital that we needed, but because we did not refuse what we did not need. That would be the price of having a Finance Minister who is a slow and poor learner.