Last week, when the rupee took a nosedive against the dollar, banks in Dubai came out with loan offers for Indian expats. They were looking to tap a market of people seeking extra gains on their repatriations accruing from the exchange rate devaluation.
On Friday, the Reserve Bank of India (RBI) decided to free interest rates on non-resident foreign currency accounts—a decision that has overnight skewed the odds in favour of this new line of business for banks. It is almost certain that expats will seek to undertake interest-rate arbitrage—borrow at rock bottom rates in Dubai and park the proceeds in foreign currency non-resident accounts (FCNR) of Indian banks offering higher interest rates.
This is a transaction rife with macroeconomic risks as these kind of inflows are often termed as hot money—they will inevitably be for a short duration (three months to a year) and will reverse with the same alacrity. Those with a good memory will recall that a similar reverse flow in 1990-91 was what brought about the balance of payments (BoP) crisis that took the Indian economy to the brink of an external debt default.
It is obvious that the latest policy move reflects a sense of urgency. Especially if viewed in light of similar relaxations— enhancing the ceiling for foreign institutional investment in debt, reducing the lock-in period for foreign investment in infrastructure bonds and so on—over the last few weeks to spur overseas fund flows into the country.
This is not 1990. India’s foreign currency reserves aggregate $306.77 billion and the size of the economy has grown to a staggering $1.7 trillion. Yet, it is apparent that this is an action to shore up foreign currency reserves, despite underlying risks, in the short term.
The decision is even more intriguing keeping in mind the fact that RBI is conservative by nature and not prone to rash decisions—in fact, often the charge is that it errs on the side of caution.
So what is it that RBI knows and we don’t, but should know?
The central bankers are obviously reading the tea leaves differently from those in North Block. They are, though they won’t say as much, preparing for the real possibility of a macroeconomic shock that has its origins in the rapid deterioration of the fiscal imbalance; the bleak global outlook is only exacerbating the problem. It is déjà vu. An identical structural imbalance in the economy had triggered the BoP crisis of 1990.
To almost everyone who wishes to see it, the worsening of the fiscal deficit—the Union government’s gross borrowings—has been long apparent. Right from the beginning the assumptions underlying this year’s budget have been flawed and premised on hope and prayer rather than fact. With the onset of the euro zone crisis these assumptions—including a growth projection of 9%—have come apart even faster than anticipated. (In fact, Mint’s lead story after the presentation of the Union budget for 2011-12 read “Mr Mukherjee’s mirage”; back then we were beaten up by self-appointed cheerleaders as being wantonly pessimistic.)
The Congress-led United Progressive Alliance (UPA) frittered away the best years—when the economy averaged 9% growth—in not pushing ahead with long overdue taxation reforms (putting in place a direct taxes code and a single goods and services tax) and expenditure overhaul.
The business-as-usual approach meant that even the poor measure of fiscal balance—driven by unprecedented growth in tax revenues—was dependent on the growth rate of the economy being sustained. But fiscal mismanagement was leading to a situation where even the tax gains from rapid growth were being gobbled up by the government’s growing appetite for debt.
What happens in such circumstances is that this excess consumption, unless financed domestically, starts spilling over onto BoP—manifesting itself in the current account deficit. In macroeconomy this is described as the twin fiscal and current account deficit problem and if unchecked is a harbinger of troubles to come. At the end of June, the current account deficit was estimated at 3.1% of gross domestic product (GDP). This is likely to worsen as exports are visibly slowing.
Even at this level the deficit is manageable. But clearly RBI believes that in the short run there is a need to shore up foreign currency inflows. Friday’s decision, and bankers confirm this, will lead to liquidity-short banks offering lucrative terms to Indian expats to raise foreign currency deposits—only making the interest rate arbitrage opportunity that much more attractive.
An acquaintance reveals that in Dubai, banks have even begun to offer free iPads to customers seeking loans above a threshold. Who can resist a freebie and, even better, the prospect of earning a few extra bucks alongside.
Finance ministry officials concede that this is in the nature of hot money flows, but argue that they are part of a grand design to ease foreign currency inflows. According to them, a fresh burst of market-friendly reforms are in the offing that will not only whet the appetite of foreign investors, but also send out a signal that the ruling United Progressive Alliance is serious about reforms.
It may well be that they turn out to be right and that RBI is probably overreacting. Regardless, it would be prudent to remember that other members of this dubious twin deficit club include Ireland and Greece.
Anil Padmanabhan is a deputy managing editor of Mint and writes every week on the intersection of politics and economics.
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