A capital account conundrum

A capital account conundrum

A current account deficit widening at a furious pace, high inflation, a tightening monetary cycle, foreign inflows driving stock prices and an appreciating currency—these form an unusual macroeconomic constellation for liberalizing the capital account.

Yet, these beeps have been ignored, even as fresh pastures are opened for foreign investors. This also comes at a time when Western grasslands remain dry, the US Federal Reserve is poised to unleash a fresh round of liquidity, investors are rebalancing portfolios towards emerging markets, and other Asian nations are contemplating capital controls to stem the global tide of hot money. India is no exception to this flood: Indeed, with its currency yielding the maximum bang for investors’ bucks, the country is the star among emerging markets.

Also See | Macroeconomic position (Graphic)

The doubling of foreign investment limits in sovereign debt, topped by a $5 billion raise in the corporate debt cap, comes in the context of “…lndia’s evolving macroeconomic situation, attractiveness as an investment destination, need for additional financial resources for lndia’s infrastructure sector while balancing its monetary policy", according to a 23 September press release from the finance ministry.

The “evolving macroeconomic situation", meanwhile, is a visible matter of concern. The snapshot view on the chart explains why. The current account deficit—led by a trade deficit—is widening at a rapid pace. The trade gap grew by some 19% in April-June over the preceding quarter. More recent data shows it increased a further $2 billion in July-August—a 21% jump over the previous quarter.

A capital account surplus is increasingly feeding the deficit. The surplus comes from accelerating short-term inflows, i.e., trade credit and rate-sensitive commercial borrowings, and banking capital. Other data show a gush of portfolio equity inflows—$7 billion in September alone—threatening to turn into a deluge.

The price of the domestic currency fully reflects these temporary capital movements. In 2010, year-on-year real exchange rate appreciation, or Reer, exceeded 10% every month, and sequentially, an average 1.2% each month. To compare, the six-currency Reer index (trade weight, 1993-94=100) reached 2007—or the previous boom—levels this July. Currency value is thus wholly influenced by capital movements instead of by real economic activity.

In addition, there’s persistent and high inflation, a tightening monetary cycle, and the possibility that the central bank may not have finished increasing interest rates yet.

This knowledge, plus some conservative assumptions, is used to profile the “evolving macroeconomic position" in the “Projections" part of the chart. This shows the fickle-financing (short-term loans) component rising significantly along with the current account deficit. And this does not factor in the additional debt flows that may come in due to liberalization: Chances are that foreign investors may not be interested in long-term bonds of a country with high inflation risk; chances also are that they might.

When fundamental indicators suggest a weakening currency (and monetary tightening), but market forces are such that speculative, short-term capital flows dominate the capital account, it is critical to pay attention to the current account and exchange rate movements. Instead, a “hands-off" exchange rate policy and a pro-cyclical liberalization to invite more capital is the policy choice.

This strategy is exacerbating the imbalance. Not preserving external competitiveness in an environment of depressed demand and currency depreciations abroad hurts exports and discourages foreign direct investment in this sector. From a macro policy point of view, too, the impact of strong versus weaker currency needs to be judged in terms of expenditure shares: If the Reserve Bank of India’s own estimates show 72% of manufacturing output is exported, how is growth supported by merely increasing the availability of capital? This capital must eventually finance economic activity to produce growth.

Higher investments in exporting industries contributed significantly in raising the investment rate to nearly 40% in 2003-07; so, the impact of competitiveness loss is far higher than the directly observed 20% output share of exports. Plus, a falling investment-GDP ratio, with no sign of recovery in private investment, means a sharper decline in the savings rate.

If exports are steadily losing out while the increased supply of finance is used to make money out of money, it leads to an unsustainable situation. Opening up to more foreign capital when “push" factors (low interest rates abroad, high global liquidity) are potently interlocked with “pull" ones within, is courting instability. It increases external vulnerability through the risk of sudden reversal of foreign capital; a slight shift in market views—unsustainable stock prices or a bubble—could trigger this as investors remain wary.

One would have thought that the 2006-07 dalliance—an ill-timed liberalization of debt caps amid a boom, much against the central bank’s wishes—would have served a lesson. This exacerbated the surge, destabilizing monetary conditions with severe real appreciation pressures, eventually leading to curbs on overseas borrowings to break the carry-trade arbitrage-rupee appreciation-money supply expansion spiral.

It is crucial that capital account liberalization is synchronized with the macroeconomic situation so that positive and negative shocks are well absorbed. A wiser strategy would be to narrow the current account deficit, incentivize exports and reduce dependence on short-term capital flows.

Renu Kohli is an economist and a former staff member at the International Monetary Fund and the Reserve Bank of India.

Graphic by Ahmed Raza Khan/Mint

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