Terror threat to the economy

Terror threat to the economy

While the nation is focused on how to respond to the scourge of terrorism, there is also need to evolve a coherent economic policy response. Here’s why.

International investors allocate capital across the world according to how they perceive risks and potential returns. Empirical studies on the impact of sustained terror attacks on capital inflows show that investors tend to be more careful in sending money into countries where governments are unable to protect life and property against terrorists. Alberto Abadie of Harvard University and Javier Gardeazabal of the University of the Basque Country says in a recent paper published by the John F. Kennedy School of Government that “one standard deviation increase in the intensity of terrorism produces a 5% fall in the net foreign direct investment (FDI) position of the country".

The details may differ in India, but the government must have a plan on how to fight investor worries. And this is particularly important at this juncture. India has a large current account deficit that was till now being comfortably financed by foreign investment in the stock market and overseas capital issues by companies. The global financial crisis has led to a flight of foreign capital from the local stock market: More than $12 billon of foreign portfolio investment has already fled India since the beginning of this year. The market for Indian external commercial borrowings and convertible bonds too has dried up.

India needs strong capital inflows to finance its external deficit. The alternative scenario is a run on the rupee and a macroeconomic crisis. The two most obvious sources of dollars right now are FDI and remittances from overseas Indians. The Reserve Bank of India has already raised interest rates on non-resident Indian deposits to make them more attractive. More needs to be done on the FDI front.

There are several possibilities. FDI caps in sectors such as insurance can be raised. Projects can be cleared faster. The auction of 3G telecom licences can be fast-tracked.

In short, we need a reforms push to minimize the risks that the terror attacks can indirectly impose on a slowing and deficit-ridden economy.

Does the government need to work on an economic policy response as well? Tell us at views@livemint.com