The Reserve Bank of India (RBI) last week increased the limit for foreign institutional investors (FIIs) in government and corporate debt by $5 billion each. Clearly, the idea is to attract foreign inflows in order to fund the current account deficit (CAD) and support the Indian rupee. Although the relaxation on the capital account is welcome, the decision comes against a background that is bound to raise questions.
India is running a massive CAD, which reached a high of 5.4% of the gross domestic product in the second quarter of the current fiscal, and requires a capital inflow of about $7 billion a month to fund the gap. Raising limits for FII investment and relaxing conditions for external commercial borrowing may help in the short term, but will complicate balance of payments management in the long run. Furthermore, if the central bank on Tuesday cuts its policy rate in order to address growth concerns, the problem of funding CAD will only magnify.
An interest rate cut, presumably, will help revive growth. However, any revival in growth is likely to push up demand and further widen CAD, aggravating financing needs. Moreover, in the global context, where developed countries are busy pushing down their respective currencies, India’s attempt to prop up the rupee will only escalate the problem in the medium to long term. This artificial support to the rupee by encouraging debt flows could lead to higher import dependence and turn the problem on the current account into a structural imbalance. Therefore, rather than finding ways to fund CAD and supporting the value of rupee, which has been relatively easier due the easy liquidity condition in global financial markets, steps need to be taken to address the causes of this rise in external vulnerability.
The improvement of prospects, both on growth and current account, in India at this stage depends on the action of the government and not on a 25 or a 50 basis points repo rate cut by RBI. The government, despite all the noise in last few months, still has a long way to go in addressing the fiscal problem, creating conditions for speedy clearance and implementation of projects, and attending to the problems in the mining sector.
Higher CAD is a reflection of problems with the fundamentals of the economy and encouraging debt flow is no solution.
Will raising FII limit on debt flows help address current account imbalance? Tell us at email@example.com