There was a lot of buzz over the weekend about a policy blitz to bolster investor confidence in the Indian economy. The Reserve Bank of India (RBI) has made the first move. On Monday, the Indian central bank announced a few policy changes that could help increase inflows of global capital into India and support the weakening rupee. First, foreign institutional investors will be allowed to buy $20 billion of government bonds, $5 billion above the current limit. Second, the residual maturity on $10 billion of these bonds can be three years rather than the earlier five. Third, the market for government bonds has been opened up to sovereign wealth funds, insurance funds, endowment funds, pension funds etc. Fourth, Indian manufacturing and infrastructure firms that have foreign exchange earnings can raise external loans to repay rupee loans.
These moves are part of a process through which RBI has gradually opened up the Indian debt markets. India has traditionally been less keen on foreign debt inflows compared to equity inflows, and for good reason. Critics rightly ask whether policy makers are not playing with fire by gradually dismantling this category of capital controls.
But there is a more fundamental issue as well. The latest RBI move is part of an attempt to quell pressures on the external account. India runs a large current account deficit that needs to be funded through inflows of foreign capital. Indian policy makers have been heavily focused on increasing such inflows.
It is also time to look closely at the current account deficit as well, rather than just think about how to fund it. Fast-growing economies often run such deficits. The only time in recent years when Indian had a current account surplus is during the growth slowdown in the first years of this century. The question thus is not whether India should have a current account deficit but to ask what deficit it can sustain. It has often been said that India can comfortably run an external deficit of around 2.5% of gross domestic product, or around 1.5 percentage points lower than right now.
A current account deficit equals the difference between domestic investment and savings. The structural way to reduce the deficit will be to either cut the investment rate or raise the savings rate. The former will worsen the slowdown. It would be far better to try increase the domestic savings rate, which has been slipping primarily because of the decline in government savings thanks to fiscal profligacy. But corporate savings too could be hit if balance sheets worsen. The risk to household savings comes from the possibility that families reduce their savings in an attempt to maintain their consumption levels in a time of high inflation.
In other words, while the new moves announced on Monday may be a useful tactical response to the pressure on the rupee, the more strategic need is to raise the domestic savings rate through stronger public finances and lower inflation.
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