New Delhi: Last week’s burst of liberalization measures to encourage foreign inflows is reminiscent of past crises’ responses. Thus the government allowed foreign direct investments in single-brand retail sector and raised investment ceilings for foreign investors in government and corporate bonds; to match, the Reserve Bank of India raised interest rate limits for domestic firms’ borrowings abroad as well as on foreign currency deposits by nonresident Indians and asked exporters to repatriate export earnings to reduce the lags.
Crises are a time to take stock. Moving beyond the desperate liberalization, authorities could thus engage in somber introspection at this inflexion point. To start with, it is incongruous that the two deficits – fiscal and current account - that flashed red when the economy sank into a macroeconomic crisis in 1991 still have the capacity to push the economy towards vulnerability twenty years down the line.
The fiscal dynamics persists as before: the structural gap remains unaddressed with temporary improvements driven by the economic cycle. Notwithstanding some fiscal reforms, the tax base remains low in international comparison while expenditures have risen with alarming deterioration in quality; much worse, the revenue deficit that had shrunk to 1% of GDP by 2007-08 has expanded three times that number since 2009-10 with market borrowings financing more than a third of the mounting expenditures.
The external position is a cause for concern too even as the economy has leaped ahead in exports and attracting considerable amounts of foreign capital. Not only is the current account gap too wide for comfort – in the range of 3% of GDP for almost two years – its financing quality has worsened considerably: there’s excessive dependence upon short-term portfolio inflows, overseas loans and trade credit, while the role of debt-creating private flows in bridging the growing deficit has increased sharply. As a result, the economy has become highly vulnerable to sharp, sudden swings in global capital flows that are procyclical to boot; all of this has been reinforced disastrously by recent events. At the same time, buffers against external shocks have weakened: external debt, especially short-term - by residual maturity, this was 44% of foreign exchange reserves at end-June 2011 - has risen, while reserve coverage – the reserves’ adequacy ratio just about covers overall debt – has fallen considerably.
Crises are also a time to change tack. Unlike 1991, India’s global economic integration is now gone too far ahead to allow sanguinity about important macroeconomic indicators, which determine confidence levels externally as well as within the country. It’s important to change course and redeem the fiscal position; could the preparatory beginnings for the 2012-13 budget signal a departure? Likewise, a shift towards better quality, long-term foreign capital flows to meet the economy’s growing needs would be a better option to close the external gap. Finally, it is worth pondering over whether these chronically weak characteristics support the freely floating currency of recent years; or whether a partially-flexible exchange rate supported by reserves accumulation would better address the rupee’s wild gyrations to provide a beneficial environment for the real sector.
Renu Kohli is a New Delhi based macroeconomist and former staff member of the International Monetary Fund and the Reserve Bank of India.