The record portfolio inflows seem to have left the government unfazed. Finance minister Pranab Mukherjee has told us we haven’t reached the stage where we need to press the panic button. That’s a striking contrast to several other countries where the influx of dollars and the consequent appreciation of the currency is being viewed with increasing alarm. Brazil, Thailand, Indonesia, Taiwan and South Korea have all tried some measure or the other to reduce the inflows. India, on the other hand, is so confident that it has increased the limits for foreign investors in the local debt market. What explains our policymakers’ insouciance while others quake in their boots?
One reason seems to be the fact that unlike countries such as China and several other East Asian countries, India has a current account deficit. The logic is that while the dollars come in through the portfolio flows, a large part of that inflow goes out again through the current account deficit. The upshot: less pressure on the rupee to appreciate. After all, the rupee is nowhere near the 39 to the dollar levels it reached in 2007.
Also Read Manas Chakravarty’s earlier columns
But why then is Brazil so worried, with the Brazilian finance minister openly starting the debate on currency wars, when it, too, now has a current account deficit? Or are we complacent because ours is an economy predominantly reliant on domestic demand, unlike the export-oriented economies of East Asia? While it’s true that exports are lower as a percentage of gross domestic product (GDP) for India than for China or South Korea, Brazil’s exports to GDP ratio is even lower than India’s.
Data from currency website Oanda.com tells us that, year to date, the Indian rupee has appreciated against the Chinese yuan, the Brazilian real and the Taiwan dollar. More importantly, the rate of appreciation has increased sharply since September, which is when a rush of portfolio inflows started coming in. That is why the Reserve Bank of India (RBI) has finally started to intervene in the foreign exchange markets.
Also See Balance of Payments Snapshot (PDF)
There’s little doubt that the outlook for emerging market policymakers is becoming increasingly challenging. But is the environment for emerging markets now similar to that in late 2007, when fund managers pushed money into emerging markets in one last desperate hurrah before the inevitable bust? Frederic Neumann, co-head of Asian Economics Research at HSBC Holdings Plc, points out the similarities: “Currently, it all feels a little like late 2007: the Fed is about to engage in another round of easing, the dollar is weakening, soft commodity prices are rising, growth in emerging Asia is accelerating, and equity markets are on a roll. What’s missing, so far, is a more convincing push-up in oil prices. Still, the parallels are striking.”
For India, however, there are quite a few differences between the situation now and that in 2007. Here’s the crux of the matter: as Deutsche Bank AG economists Taimur Baig and Kaushik Das point out, the current account deficit in 2007-08 was only 1.3% of GDP, while the capital account surplus was almost 7 times that amount, at 8.8% of GDP. For 2010-11, however, Deutsche Bank estimates the current account deficit at 2.8% of GDP, while the surplus on the capital account is estimated at 3.7% of GDP, only 1.3 times higher. Most economists peg this fiscal’s current account deficit even higher, at 3-3.5% of GDP.
But then, the spurt in inflows started in September and external commercial borrowings, too, crossed the $3 billion mark last month. On the other hand, there are signs of a loss in momentum and the trade deficit is at a six-month low in September. These could be worrying trends if they persist.
Baig and Das consider the possibility of continuing monetary easing in the advanced economies leading to higher capital inflows and argue that, if that happens, the current account deficit might also rise as a result of increased liquidity pushing up commodity prices and, therefore, increase India’s import bill. And as the chart shows, capital inflows will have to be much higher and the current account deficit much smaller if the ratio of the capital account surplus to the current account deficit is as high as it was in 2007-08.
These are probably the reasons why Pranab Mukherjee has ruled out curbs on capital inflows for the moment. At the same time, relying on portfolio flows to fund the current account deficit is hardly a prudent policy. As the International Monetary Fund (IMF) points out, the best course of action is to have policies that “aim to enhance local market capacity to absorb capital flows, tilting the balance in favour of long-term capital and increasing the impact of foreign flows on employment and overall growth”.
Unfortunately, the government has done very little on that front. As Gaurav Kapur, economist at Royal Bank of Scotland NV suggests, the best course of action if strong inflows persist would be for RBI to build up its foreign exchange reserves, as protection against volatility.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at email@example.com