Any doubts about India’s dependency on cheap dollars to fund its strong growth were dispelled by the welcome accorded to QE2, the second round of quantitative easing (QE), by the US. A large payments deficit and significant capital controls set India apart from other nations that have to mop up the mess of hot money that follows. The greeting, therefore, serves India’s interests, as does the endorsement of market-determined exchange rates at the recent Group of Twenty (G-20) summit: Both are necessary to keep the party going. But as we hop on the capital flows merry-go-round to drive growth, let the speed and spin not blind us to some incipient distortions in the economy.
There is little doubt about India’s growing ability to absorb significant foreign capital; up to $70-75 billion is no problem, according to senior policymakers. The large external deficit also helps moderate currency appreciation pressures to an extent. And there’s considerable ammunition in the armory to manage capital inflows: exchange rate appreciation, intervention-cum-reserve accumulation, macro-prudential measures and varying the partially liberalized components of the capital account.
Hence the confident stance, while the rest of the world curses the recklessness of US monetary policy.
There are also fundamental reasons for foreign portfolio investments to shift to countries such as India and China that are seen to power global growth while advanced economies nurse a recovery. Assessments of the current tide of capital into Asia emphasize its structural component, which is expected to persist into the medium-term. The International Monetary Fund considers the portfolio rebalancing by institutional investors—including long-term investors such as endowment and pension funds—a “secular” shift. It estimates that a 1 percentage point reallocation of global equity and debt securities held by real money investors (ones who haven’t borrowed for the investment) in the Group of Four nations will release an additional portfolio flow of $485 billion to emerging markets.
India is at the forefront of this blizzard: Along with China, it is projected as the highest recipient out of an average $330 billion expected to flow into Asia in 2010 and 2011. This is because of the “pull” exerted by its growth prospects, rising asset prices and appreciating currency.
Amid these good tidings, concerns arise from the behaviour of asset prices and investors. Witness, for example, the ebullient stock market response to QE2; the rising property prices that have already invited an increase in provisioning on bank loans to the sector; the unease in the central bank’s request to the government to prevent a real estate bubble—please lock in foreign direct investment (FDI) in hotels and tourism, and monitor end-use of funds; the unanimous view of investors that fresh bubbles are brewing, with differences only in whether they are in equities, commodities, property prices, appreciating currencies or all together; the implied volatility of one-year options on the rupee, which have doubled from mid-2007 levels; the steep premiums paid by Indian firms over companies in Brazil, Russia and China for foreign acquisitions—an average 28% above the share prices of their targets, the highest since 2003, and helped by an appreciating rupee, according to Bloomberg.
Possibly, the real economy is absorbing some of these distortions. For instance, the post-crisis rebound in growth led by consumption is yet to be followed by the revival of private investment. At one level, this questions the sustainability of future employment, incomes and growth. But at another, it’s a signal of the possibility that money is flowing into speculative investments instead of good projects that raise the productive capacity of the economy. Further, the construction and services sectors—the non-traded segments of the economy—have seen far higher inflation rates in recent years, relative to the manufacturing, or traded sector. The comparably higher profitability of these sectors is obviously attracting resources, diverting them from the less competitive parts of the economy. A recent disaggregate study of total factor productivity growth by economist DK Das et al (August 2010) shows that productivity growth in the post-reform period has been led by the services sector. It’s not surprising, therefore, to see FDI flows dominating these sectors, outpacing that in manufacturing. The virtually standstill share of manufacturing in gross domestic product (17%)—70% of whose output is exported and whose revealed comparative advantage is declining (RBI Annual Report)—is telling in this context, as is the faster growth in some parts of the non-tradable sector.
This is not an exhaustive list. But it is sufficient to illuminate the future path, as a structural shift in the level of capital flows steadily pounds the markets, pushing asset prices and exchange rates beyond their fundamental valuations and magnifying the influences upon the real economy, notwithstanding absorptive capacity. For example, an excessive growth of the trade deficit with an appreciating currency—which encourages consumption and import-substitution—can shift production and capital spending overseas; this, indeed, has been the case with the US. And too rapid an appreciation can result in the loss of competitiveness, while large fluctuations in the real effective exchange rate undermine incentives to invest in non-traditional sectors.
The sustained 8% plus growth cannot be achieved without an equal pitch from manufacturing—which still has a long way to go—and services, and from production and consumption. Using foreign resources to achieve this will ensure the roundabout does not stop.
Renu Kohli is a former staff member at the International Monetary Fund and the Reserve Bank of India
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