Soon after “debunking” the Indian productivity surge relative to China’s, The Economist has pronounced its verdict on India’s three-year-long GDP growth rate of more than 8%. It declares that India has overheated and that this rate is unsustainable. The indicators it uses are India’s current account deficit and inflation rate. It also concludes that without reforms in India’s labour laws, its regulatory set-up and education system, this pace won’t be possible again.
If a high current account deficit were a sign of overheating, could one conclude that the US economy has overheated? Or, is China’s monstrous current account surplus a sign of economic depression? The newspaper cites the governor of the Reserve Bank of India (RBI) to suggest that the current account deficit, excluding remittances, could be much higher. If remittances are more of capital receipts, how would one classify the import of gold included under merchandise imports? Without gold imports, the current account in 2004-05 and 2005-06 would have been almost in balance or barely in the red. Gold imports accounted for more than $10 billion in each of these two years.
The Indian economy does not display the classic overheating signs seen in East Asian economies before the Asian crisis. Their current account deficits ranged from 4% to 6% of GDP. They had overvalued currencies in terms of real effective exchange rates and low interest rates. The rupee, if anything, is undervalued. Their banking sector was awash in short-term external liabilities invested in long-term domestic currency assets. India’s macro-economic management has, by and large, been prudent.
Yes, inflation is one sign of overheating. But, it is not too much above the target of the central bank, and the government recently lowered import duties on some commodities. If skill shortage is said to have boosted wages and thus contributed to inflation, doesn’t it confirm the productivity surge that has enabled firms to report rising profits every quarter for the last three years?
Though RBI seems to be only cautiously raising interest rates, it is using moral suasion on banks effectively to contain growth in bank lending. Were it to raise rates aggressively, it could attract more investment into Indian assets and cause the rupee to appreciate, triggering expectations of further appreciation, leading to more inflows. A mutually reinforcing cycle would result. The central bank is walking the fine line between classical tightening with undesirable outcomes and pragmatic tightening with more acceptable ones. Economic policymaking is a bit harder these days as Thailand found in December.
Another of the newspaper’s concerns is that too fast a growth surge would lead to ever-rising current account deficits, which wouldn’t be easily funded as India only gets portfolio inflows that are seen as short-term and fickle. With the sheer repetition, this perception of hot money has taken root. But statistics disagree. With the exception of 1998, which was a tough year for emerging markets, net portfolio flows into India have been positive. So, while theory suggests classifying portfolio flows as short-term merely because these don’t get trapped, portfolio investment in India has stayed on willingly—treated more as a proxy for direct investment since, until recently, many sectors were closed to foreigners. Cumulative net portfolio inflows into India stand at $49.1 billion.
If remittances from overseas Indians must be treated as capital inflows when much of these constitute current, recurring income that many families live off, the case for portfolio inflows to be treated as capital investment is very strong.
A lot could go better (or worse) in India. That applies to many nations. Even the optimistic projections by Goldman Sachs in 2003 did not anticipate the growth surge in the following three years. Nor did the sceptics expect India’s software exports to grow beyond the Y2K fix. Surely, there is no room for complacency. Terming India’s success as lucky and temporary does little for the quality of debate on potential growth in fast-developing nations.
V. Anantha Nageswaran is head investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views.Your comments are welcome at