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Sustained capital flows into India caused a real appreciation accompanied by a very high trade deficit and a rising current account deficit. The Indian contribution to this entirely predictable story was that somewhere along the way it picked up high inflation that has now become entrenched in expectations.
Partha Sen (partha@econdse.org) is at the Centre for Development Economics, Delhi School of Economics, Delhi.
This piece was written before the United States Federal Reserve decided to continue with its purchase of long-term securities. I am not tempted to revise what I had written because I believe the euphoria will wane in the coming weeks.
The Indian economy is facing a macroeconomic crisis. The external imbalance (whether measured by the trade balance or the current account) is well beyond what can be called normal. The nominal value of the rupee has fallen more than the currencies of other emerging market economies this year. The looming macroeconomic crisis should make us pause a little and reflect on recent history, so that if and when we come out of this mess, we do not repeat the mistakes that have brought us to this sorry pass.
Indian economists, with a few exceptions, do not understand macroeconomics. Most of the macroeconomic analysis is a hand-me-down from American macro textbooks. This presumes a closed economy, one that is “opened up” at the end of the textbook.1 Hence the clamour by some, loudly in an American accent, that all we need is a resumption of growth, capital flows will follow.
How misleading is this? For a small open economy, like India, the external dimension is very important. Both because it constrains domestic policies in the short run but more importantly, handled correctly it can help in industrialisation (as it did in east and south-east Asia).
A Chronicle Foretold?
What has happened in India in the last few quarters was entirely predictable; it is like the chronicle of a death foretold. Sustained capital inflows caused a real appreciation accompanied by a very high trade deficit and a rising current account deficit. The Indian contribution to this entirely predictable story was that somewhere along the way it picked up high inflation that has now become entrenched in expectations (and the Reserve Bank of India (RBI) is solely to be blamed for this). This happened as the economy was slowing down. Gold imports, acting as a hedge against inflation, have shot up. The crisis would have occurred at the time of Lehman’s collapse but was averted because of the introduction of quantitative easing (QE) that generated liquidity in the international financial markets. Now the slightest whisper about QE being eased out causes panic in India.
Let us first look at the short-run consequences of neglecting the external constraint (and show how clueless Indian economists are in grasping even the basics). Everyone agrees that India’s current account deficit is “too” high. This includes people like P Chidambaram, who does not know the definition of the current account. He (and many others) defines it as dollar payments less dollar receipts. It is indeed strange (and alarming) that no one (not the former finance minister present in the Rajya Sabha nor the Ministry of Finance bureaucrats) has corrected him. Even if he is not a trained economist, he has presented the union budget so many times that he should know there is a difference between, for instance, current expenditure and capital expenditure. He then proceeded on the basis of his very original definition to say that since we are short of dollars, let us get more foreign direct investment, foreign institutional investment, external commercial borrowings or ECBs (which are capital account items).
We have a situation here where we need to plug the current account deficit but we do not know what the current account is:
Hum ko un se wafa ki hai umeed
Jo nahin jaante wafa kya hai.2
The trade balance is the difference between exports and imports of goods and services. Add “net income from abroad” (like transfers) and we have the current account.
Defining the Current Account
Alternatively, the gross domestic product (GDP) less total expenditure by all the sectors (consumption investment and government expenditure on currently produced goods) gives us the trade balance. Add net income from abroad to both the sides to get gross national product (GNP) less total expenditure as the current account of the balance of payments.
A slight manipulation of this gives us total savings minus investment which is identically equal to the current account. A current account deficit is then our negative saving vis-à-vis the rest of the world. The capital account equivalent is that with a deficit we are either running down our claims against foreigners, or they are running up their claims against us.
All this is true as identities (that is by definition).
We now look at these as equilibrium conditions. The equilibrium current account is then the difference between the GNP and planned expenditure of all domestic agents. Or equivalently it is the difference between the savings of all domestic agents minus the (planned) investment by domestic firms. Note here, it is not true that if we know savings and investment then the trade balance (as exports minus imports) “comes out in the wash” (as I have heard a former chief statistician of the Government of India say on TV).3 A change in the exchange rate will change the trade balance (and invisibles) and, in equilibrium, also savings and investment. When we focus on the exchange rate and its effects on exports and imports, we are cutting some corners (unless we are in a one-good world). Again when we look at the trade balance as the difference between saving and investment only we are cutting some corners.
A current account deficit has to be financed by someone. Capital flows mean that the rest of the world is willing to lend to us. Unless these are unrequited transfers, these have to be repaid with interest. So the question arises whether the current account deficit comes from a consumption binge (of course, not all consumption in excess of income is a binge – consumption smoothing is made possible by capital inflows), or investment. If it is investment, does it generate foreign currency?4 Indian policymakers run budget and current account deficits in good times, leaving no space to smooth consumption in bad times.
Thus the ability to borrow internationally is crucial to the story. It provides funding for a current account deficit. But it can also cause problems for an economy, especially a developing one. Let us turn to this.
Three Areas of Concern
Without going into a very detailed account of what the opening up of the capital account does to the economy, let us focus on some areas of concern. I want to highlight three areas: (1) problems with inflows; (2) the problem of carry-trades and ECBs; and (3) the “foeticide” of India’s industry.
By way of preliminaries, let me repeat two points that are well-established in the literature: First, developing economies’ macroeconomic time series show more volatility than the corresponding ones for more developed ones. There are many reasons for this, e g, weak governance,5 “thin” markets,6 etc.
Second, a big problem with capital inflows is that they may be prone to “sudden reversals”. Even if a country is very “virtuous” it can still be hit by the reversal. The Latin American experience following the Russian default in 1998 spared no country (including Chile that had carried out deep pro-market reforms under Pinochet). Similarly the Asian crisis cut capital flows to every country in the region.7 But if like India the economy has been profligate, then it is definitely going to be hit really hard as capital dries up in the international markets.
Problems with Inflows
Let me now turn to a more detailed discussion of the three points mentioned above.
So what are the problems with inflows? In a frictionless neoclassical world, a poor economy is capital-deficient, so receiving capital (presumably physical capital) can only be good. Note that this statement that comes out of a simple growth model comes from a one-good world, so loved by the Americans. If there are two goods (or indeed two monies), then there will be changes in relative price of these goods (and/or monies).
A capital inflow causes a real appreciation in the receiving economy8 – this is akin to people buying flats in Gurgaon driving up the relative price of real estate there. This real appreciation makes the domestic goods less competitive and causes a trade balance deficit. This process is at the heart of the so-called “Dutch Disease”. In the Indian context to prevent this, the RBI intervened in the foreign exchange market with domestic money and then went out and sold government bonds to suck out the money it had created in the first round. The effect of its intervention (called sterilised intervention) was that its assets went up by the amount of foreign exchange and its holdings of government bonds (also assets) fell, leaving its liability, high-powered money, unchanged (or “sterilised”).
That the RBI’s actions have not really succeeded in realising its objective to prevent the “Dutch Disease” can be gauged from the fact that India’s trade balance deficit was rising over time9 (and so was the current account). Thus the real effective exchange rate (REER), although fairly constant over time, was not an equilibrium one.
India accumulated foreign exchange reserve against which there are liabilities (government bonds). The foreign assets pay a lower interest than what the government has to pay on its bonds; this constitutes a quasi-fiscal cost of intervention. It is worth repeating that unlike China, or the other east and south-east Asian countries, India’s reserves have not been accumulated by running current account surpluses (i e, India’s foreign exchange reserves are not “owned” by India).
Capital inflows, then, pose a policy challenge and the RBI has been found wanting in tackling this. One may ask: Why not, in symmetry with the above argument, liberalise outflows? Well, over time the RBI has done this but still the current account deficit persists.
The problem with liberalising outflows is that when India needs foreign exchange (when Bharat Mata is in trouble), Indians who have bought assets abroad are not likely to be overcome with patriotic fervour and liquidate them. As a matter of fact with an impending crisis there is every incentive on the part of those who were planning to do so, to delay the repatriation of foreign currency.10
Problems with Carry Trade
With sustained capital inflows, the exchange rate appreciates continuously (because appreciate it will). This will give rise to even more inflows. Investors in the US and Europe look at low nominal returns at home compared to high returns in India (with no exchange risk). These “carry-trades” can cause significant overvaluation. The counterpart of this is the incentives it gives to Indian businesses11 to borrow internationally and not hedge against depreciation.
This is, of course a gamble, because over time, either with the current account deficit building up, and/or something like the US long rate creeping up – both have happened – causes this bubble to burst. In the early years of capital inflows to India, Y V Reddy used to say (in the light of the Asian crisis) that the RBI would keep a tight lid on debt flows. Then came the period of foreign exchange acquisition by the RBI bringing hubris in its wake (or did it precede it?!) and all caution was thrown to the winds. Now with a sizeable ECB, unhedged at that, a slight depreciation would cause default.
This balance sheet effect nullifies some of the gains that would follow from a depreciation of the currency. A depreciation creates demand for domestic goods (with the usual Marshall-Lerner-type condition being satisfied) but it could cause banking problems. This is very distinct from the posh people being opposed to a depreciation because of foreign universities and holidays becoming expensive. The point of a depreciation is precisely to make foreign goods and services expensive.
Impact on Industry
Development economics in the old days, before it started monitoring mid-day meals full-time, used to discuss the need for a labour-surplus economy to move its zero marginal product labour into a “modern” industrial sector.12 This was not an easy task because industry required a “big push” (due to increasing returns to scale that are external to each agent). Central planning was a response to this. A more successful alternative was the east Asian model that used exports to the international markets to get over the “hump”.
India, of course, has not moved at all on the industrialisation front.13 The share of industry in GDP has remained constant over the last three decades. Failure, in this case, has many fathers, e g, labour market rigidities, lack of infrastructure, etc. But in the discussions, a highly-appreciated real exchange rate is rarely mentioned.
A real exchange rate appreciation, then, kills the incipient labour-intensive price-sensitive industry.14 We are reduced to importing even crude items, where transport costs are not an insignificant proportion of the cost, from China.
One, therefore, needs more of a push to trade in goods, and less of trade in financial assets. Open capital accounts have been pushed surreptitiously by the International Monetary Fund (IMF) (although recently even they are also not unequivocal on this). No one stopped to ask them whether there is a large body of evidence that shows that open capital account countries do well. Casual empiricism suggests that closed capital account countries of Asia have done spectacularly well, while open capital account countries in Latin America have between phases of growth lurched from one macroeconomic crisis to the next.15
Finally I want to address one issue in passing, since otherwise it will take us too far afield. One sees many well-trained (and well-heeled) economists arguing that the way to plug the current account deficit is to export more minerals.16 If one looks at the statistics of India’s trade with China, it resembles India’s trade with Britain in the colonial days, with India importing industrial products and exporting raw materials.
Pushing for mining (and minimal value-addition industries in India, as with Vedanta and Posco) is a sure sign that we have given up on industrialisation. Mining that dispossesses the tribal population and degrades the environment (permanently) is required so that a certain class can import foreign goods at a lower price. And then they complain about the Maoists!
Concluding Remarks
A macroeconomic crisis has to be tackled as a macroeconomic one. Increasing capital inflows may provide temporary relief but will aggravate the lack of competitiveness over time. Taking resort to aggressive mining, apart from the disastrous social and environmental consequences, also does not attack the problem at its source. In this context it is very disheartening to see the politicians from the two major alliances saying that they would take the reform process forward. “Reforms” are not a holy book of a revealed religion. These have to be debated and whatever is found wanting has to be jettisoned. Failure to do so would be very costly. At the very least, it would make the new governor of the RBI look like Don Quixote rather than the knight in shining armour that the financial market makes him out to be.
Notes
1 I recently attended a “lecture” by a junior economist from the IMF who held forth on growth and inflation, completely ignoring the external constraint. A lot of the Indian economic glitterati present were lapping up every word of this flawed-from-the-start analysis.
2 Loosely translated: “We expect loyalty (fidelity) from one who is oblivious of its existence”.
3 This statement is true as an identity, or as an equilibrium condition for a small open economy in a one commodity world.
4 It has been pointed out that one difference between a rich country and a poor one is that the latter has two budget constraints – one in domestic currency and another in a “hard” currency. The rich country can aggregate all its assets into a single budget constraint. It is not merely a question of capital account convertibility as Argentina, even with a currency board, found out.
5 In the light of the sub-prime crisis one is entitled to ask whether the US is also a developing economy!
6 Very loosely speaking, thin financial markets refer to a situation where, possibly due to small numbers of participants, there is no diversity in the opinions about the future among market participants. If markets had been thick the new RBI governor could not have “talked it up” the way he has.
7 These two episodes are also interesting because of the different types of capital flows showed different volatility – bank lending was very volatile in Asia and portfolio flows in Latin America.
8 A real appreciation cannot, by definition, happen in a one-commodity world.
9 Currently over 10% of GDP.
10 This constitutes a “one-way bet” – if the rupee tanks one makes a lot of money, if it does not one’s losses are minimal (just the interest cost over a few days).
11 I cannot bring myself to use the fashionable expression “corporates” (who send out “invites”).
12 This was also a one-size-fit-all focus. I have friends from Latin America and Greece who resented this characterisation of their underdevelopment (most developing countries were not labour surplus).
13 In a country with the environment (water and air) already very polluted, one cannot view industrialisation with the rose-tinted glasses of the Nehruvian era (temples of modern India!). Industrialisation, I believe, is the only solution to mass poverty in an overpopulated poor country – the nettle has to be grasped.
14 Indian engineering and automobiles have done reasonably well in spite of the hostile exchange rate environment. This is true of software exports also. The foeticide refers to “crude” labour-intensive industries.
15 It is very strange that there are a lot of liberal economists in the west who want stricter norms for the financial sector in their countries but absolutely none in emerging markets. Surely, this is money speaking!
16 Subir Gokarn, the recently retired deputy governor of the RBI, in a TV interview had no macroeconomic solutions to offer but this.
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