Policymakers are rolling out the season’s best offers to woo foreign investors. Close on the heels of contemplated hikes in Foreign Institutional Investment (FII) limits in local currency government debt come easier norms for such investors in infrastructure bonds: foreigners need not stay invested in these for the three years currently mandated, but can rather sell out up to $5 billion in one year instead. They can also invest in different maturity papers against the five year residual maturity, only earlier. This comes at a time when capital flight has brought about a large fall in currency value because of the size of the country’s external imbalance.
The sudden drought of short-term foreign capital is in stark contrast to its abundant bonanza in the last two years. This provides an opportunity for policymakers to introspect over the growing engagement of the economy with such a fickle lover.
At the forefront is the rupee, whose 13.5% plunge in a very short span of time reinforces the sharp rise in exchange rate volatility from 2009 onwards. On an average annual basis, currency volatility over 2009-11 has doubled over its value in the capital inflows’ boom years of 2003-07. Although global uncertainty is undoubtedly higher since the crisis unfolded from 2008, a hands-off exchange rate policy has contributed too, by wedding the rupee’s fortunes totally to short-term capital flows. The sharp escalation in currency volatility needs to be considered vis-à-vis the effects upon the real economy to weigh the tradeoffs. In the current instance, rapid erosion in the rupee’s value has not just hurt firms with un-hedged foreign currency positions, but the magnitude of the fall has also hit hedged companies via conservative risk covers, according to Jamal Mecklai (Business Standard, November 4, 2011) who adds that “…the near-vertical rise in rupee volatility (from 5.4% to 9.5%) since mid-August…has rattled most companies.”
The chronic current-account deficit exacerbates the shocks to the rupee because of its rising dependence for funding upon foreign portfolio investments. Such dependence has the potential to push the current account into the vulnerability zone without any warning as short-term portfolio capital is notoriously hard to forecast. And with the rising proportion of short-term overseas debt – commercial loans, trade credit, and non-resident deposits – come higher liquidity, interest rate and currency risks; in other words, increased vulnerability to both endogenous and exogenous shocks. A recent research study (Renu Kohli & Agnes Belaisch at http://www.ncaer.org/popuppages/EventDetails/IPF_2011/Program_IPF_2011.pdf) finds that the extent of spillover from financial market disturbances to the real economy is rising with India’s financial integration with the global economy.
The direction of economic policy, which is overtly driven by attracting foreign capital of the wrong kind, needs to take stock of the risk of a sudden stop of capital inflows. The quality of current-account funding must improve by lowering the share of short-term capital flows and a rising contribution from net exports. The excessive flirtation with short-term capital flows has to yield to stable, long-term partners instead.
Renu Kohli is a macroeconomist based at ICRIER, New Delhi; she is a former staff member of the International Monetary Fund and the Reserve Bank of India.
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