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As the Indian economy tries to gain a semblance of normalcy after a debilitating second wave of covid, a new storm is gathering on the horizon. With the US Federal Reserve likely to raise interest rates in 2023 and moderate its market interventions well before that, the spectre of 2013 has come back to haunt the economy. When the Fed had turned off its liquidity spigot in 2013, the rupee had gone into a tailspin and policymakers were thrown into a tizzy. The then Reserve Bank of India (RBI) governor Raghuram Rajan was compelled to use the FCNR-B scheme—for foreign currency non-resident bank deposits—to stabilize currency markets, despite being opposed to it in principle.

To many pundits, 2022 is likely to be a redux of 2013. Economic growth is much weaker today than it was back then. Despite the staggering destruction of demand by the covid pandemic, inflation is stubbornly high and the fiscal situation is much worse than what it was in 2013. For these pundits, the only saving grace for the economy is the biblical flood of liquidity that the Federal Reserve and the European Central Bank have unleashed upon the world, and which like a rising tide has lifted all boats, including that of India. They argue that once this tide subsides and yields begin to improve in developed economies, there would be a flight of capital from India, which could potentially sink an economy suffering from weak demand and high inflation.

To be fair, there are strong arguments against some of these assertions of economic Armageddon. While it is true that the Indian economy has been hit hard by the pandemic, this situation is not unique to the country. Our fiscal deficit and debt-to-GDP (gross domestic product) numbers are high, but biased upwards by a countercyclical fiscal response in a year of GDP contraction. Inflation is high, but as Alberto Cavallo points out in an excellent paper, traditional inflation measures are likely to be uninformative due to the radical divergence between the covid- impacted consumption basket of the general population and the “assumed" consumption basket used by statisticians to estimate inflation. Some have also argued that with India’s foreign exchange reserves at record levels, the threat of a US policy taper is minimal. However, foreign exchange reserves provide an incomplete picture of India’s vulnerability to capital flight. According to latest RBI data, while our reserves stand at $610 billion, India’s external debt is $570 billion and about $300 billion of this is due in the next two years. Therefore, while reserves may appear large in isolation, their ability to shield the economy from a flight of capital is less impressive in the context of the liabilities against them. Admittedly, our external debt coverage ratios are much better in 2021 than they were in 2013, but that does not alter the fact that the external balance sheet remains an Achilles’ heel for the Indian economy.

For several years, India has funded its current account with capital inflows. Helmut Reisen shows in Sustainable and Excessive Current Account Deficits that current account deficits cannot be run indefinitely and ultimately lead to “reversals" or “hard landings". A high investment rate is essential for the sustainability of current account deficits, which can be interpreted as an excess of investment over savings. Worryingly, India’s performance in terms of investment as a percentage of GDP and gross fixed capital formation has been extremely poor in the last decade. The only way to prevent such a hard landing for India once a taper starts is by ensuring that the investment environment and growth prospects for the Indian economy remain attractive enough, so that foreign investment and portfolio flows keep pouring in. While fiscal spending will help, this is where the reform agenda of the government has fallen short and needs to be realigned.

The government’s reform agenda has been beset with a kind of bipolar disorder. While it has displayed some zeal in reforming the delivery of public services, where its performance has been bold and spectacular, reforms to harness the potential of private enterprise have been less than stellar. Ground breaking reforms such as the Insolvency and Bankruptcy Code (IBC), the goods and services tax (GST) and the farm laws have got mired in the morass of politics and shoddy implementation, thereby diluting their effectiveness. Long lead times for cases under the IBC resolution mechanism have severely undermined its purpose. Further, while GST has improved tax compliance, an erratic and unreliable information technology backbone has greatly increased compliance costs for smaller firms. Big-ticket reforms for land acquisition, privatization, asset monetization and in the judiciary are a distant dream. It is unclear if this is due to the political compulsions of Indian democracy or the idiosyncrasies of government machinery.

The government should bear in mind that developing economies which have grown fast with high current account deficits are as rare as hen’s teeth. While reversing the current account deficit will require a more structural long-term response, in the short run, the best way to inoculate the economy against volatile portfolio flows is by implementing deep reform measures that improve the investment environment and facilitate durable capital formation. To face an oncoming ‘taper tempest’, the government should abandon its policy risk aversion and embrace the motto of Britain’s Special Air Service: ‘Who Dares Wins’.

Diva Jain is director at Arrjavv and a ‘probabilist’ who researches and writes on behavioural finance and economics. Her Twitter handle is @Divajain2

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