Views | Yet another quick-fix

Views | Yet another quick-fix

The proposed doubling of foreign institutional investment (FII) limits in government debt from the current $10 billion to $20 billion is yet another example of temporary quick-fixes that are becoming a hallmark of Indian policymaking. In this instance, the move attempts to fix two problems in the short run.

The second is the external deficit and the rupee: With foreign investors pulling out of emerging markets, their desertion is felt most by India whose large current account deficit – this stood at 3.1% of the gross domestic product in April-June 2011 with a trade balance of more than double this number – is heavily dependent upon foreign portfolio flows for its financing. The rapid reversal of portfolio flows from August onwards has battered the rupee – a 13% fall from peak to trough - in a way that is strongly reminiscent of the bruises inflicted in the post-Lehman phase in September-December 2008. A counter-cyclical liberalization therefore will come in handy in supporting the rupee’s plunging value as well as bridging the deficit.

The nature of short-term portfolio capital is fickle, and the outcome may or may not correspond to the quick-fix solutions being explored. Compare 2010 with 2011, for instance. Capital flows were robust in 2010 and Indian markets were flooded with $25 billion of equity and $10 billion of debt investments. Ten months into the following year, 2011, and equity is a net outflow of $0.5 billion; debt inflows, although exceeding equity, have totaled $ 3.4 billion net so far. Yet domestic-foreign interest differentials are way higher than last year! The difference is the global environment, which was risk-on for most of 2010 and has been mostly risk-off in 2011.

Using up the slack in capital account restrictions is good only up to a point. It cannot substitute for generating sustainable resources, viz. higher export earnings and foreign direct investments, to bridge the chronic current account deficit and reduce the currency’s growing exposure to wild to-and-fro swings in capital flow cycles.

The upshot may thus remain uncertain for who can predict the on-off mode of risk that drives global capital flows. If policymaking sought long-term remedies instead, that, by itself, would introduce greater certainty and reduce risk, both of which will attract foreign funds for sure.

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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