By Akhil Raj Gupta

The last section of this report will identify the concerns and challenges regarding international finance in India. As mentioned before, it will elaborate on the volatility and fragility of short-term debt and equity portfolio instruments as a ‘necessary evil.’ However, it will first attempt to tackle the problems of sustaining a large current account deficit and massive fiscal deficit as part of the ‘twin deficit theory’ that is currently the bane of India’s policymakers.

In 2013, India’s current account deficit peaked at 4.8% of GDP causing an alarm amongst policymakers. We will first examine the issue of how sustainable a current account deficit from the perspective of ‘how persistent is too persistent.’

1. “If the deficit reflects an excess of imports over exports, it may be indicative of competitiveness problems[1], but because the current account deficit also implies an excess of investment over savings, it could equally be pointing to a highly productive, growing economy. However, if the deficit reflects low savings rather than high investment, it could be caused by reckless fiscal policy or a consumption binge. “ – Atish Ghosh, International Monetary Fund, Research & Development Wing [2]

In light of the above statement, the trends in Indian fiscal deficit are presented below (for the past eight years) –

 Source- Planning Commission

Year

Centre’s Fiscal Deficit (% of GDP)

2005-06

3.96

2006-07

3.32

2007-08

2.54

2008-09

5.99

2009-10

6.46

2010-11

4.79

2011-12

5.75

2012-13

4.83

Recall the uses-of-savings identity presented above,

 Spvt = I + (- Sgovt) + CA

CAD ≅  Snational – I

From the above identity, we can clearly see that budget deficits and public- sector savings – investment gap must necessarily be financed out of domestic savings. This phenomenon crowds out private investment by raising interest rates, and thereby raising the cost of funds. Another issue that must be pointed out is that budget deficits are largely composed of consumption expenditures as well, and do not always generate a multiplier effect, as envisaged by the Keynesian school of thought. A report by the Hindu suggested that only 24% of government outlays generate productive capacity for the Indian economy, while the remaining utilizes resources inefficiently through artificial employment generation schemes like NREGA.

2.  High inflation rates have also caused a paradigm shift in the financial space with many Indian consumers parking their funds in non-productive assets like gold. Apart from creating a debit in the current account, this reduces the pool of funds readily available for private corporate or even public sector investment.

a. The Indian lust for gold is commonly ascribed to high inflation. Consumer price inflation averaged 10% each year from 2009 to 2011, while real interest rates were negative over 2009-10 from loose monetary policy. Savers shifted to physical assets like gold from financial assets like bank deposits; deposit growth nearly halved from 20.4% in 2008-09 to 11.4% by 2010-11, recovering thereafter as monetary policy settings were adjusted.

b. Inflation alone however may not account for this extraordinary gold appetite. Given the coincidence with the global boom, portfolio factors possibly played a role. Gold outperformed all other assets in this period, offering savers annual returns in excess of 25% in 2008-11. Bank deposits compare poorly with that, even if real rates are positive as happened in 2012 — gold demand remained undampened, inviting fiscal restraints. Income growth was strong too—in the four years to 2011-12, Gross Domestic Product growth averaged 7.7% annually, while per capita incomes grew an average 6% each year. Indian gold demand is highly income elastic.

c. With the US monetary stimulus in reversal mode, its economy recovering firmly and interest rate increases on the horizon, the settings are now reversing for gold. Global gold prices fell 28% in 2013. A changing global macroeconomic framework may thus reflect in India’s gold demand.

It is hoped that with recent monetary tightening to rein in inflation, savers will be re-incentivized to invest in financial assets that can be used for financing private investment projects and improve efficiency of resource allocation as measured by the ICOR (Incremental Capital-Output Ratio). Higher domestic savings would also reduce firms’ dependence on short-term external debt instruments that are highly volatile and based on arbitrageur tendencies. It is this issue that we now turn to.

  •  Quantitative assessment of the impact of volatility in Foreign Institutional Investment
  •  In the year 2008-09, following the subprime crisis and global loss of business confidence, FIIs recorded a net capital outflow of approximately $14 billion. This was facilitated by near-perfect information and split-second trading in financial markets due to the advent of modern technology.
  •  There was net outflow of USD 7.2 billion from the Indian market in June and July 2013 of which USD 5.4 billion was from debt market triggered by global risk aversion and currency weakness. This sudden outflow caused a plummet in the value of Indian rupee (nominal depreciation), which hit an all-time low of Rs.68.18 against the US dollar.   The above situation is regarded as a vicious cycle as depreciation of the rupee could prompt even more investors to withdraw funds on accounts of exchange rate risk and the need for interest arbitrage parity.
  • There has been a gradual increase in the proportion of short-term debt (less than three months) to approximately 25% of all external debt. This is indicative of an increased exposure to bankruptcy and a payments crisis exacerbated by the tendency of higher medium-term interest rates in the United States due to its QE taper.
  • The above analysis submits that external finance has undoubtedly played a huge role in India’s development, as measured by the various economic indices. However, policymakers must view this tool as a double-edged sword and continuously make efforts to maximize domestic savings mobilization as a safer method (less prone to volatility and exchange rate risks) to finance investment projects in India. In certain sectors, Foreign Direct Investment of a permanent nature can have a beneficial impact due to technology and knowledge spillovers, but it is incumbent upon us to provide them with an atmosphere and framework conducive to business.

Akhil is currently in his second year at college, pursuing a Bachelor of Arts degree in Economics (Hons) at Sri Ram College of Commerce, University of Delhi. He has been passionate about writing since an early age and is currently involved with the official College magazine and Economics Department magazine at SRCC. His areas of interest include behavioural economics / finance, econometric analysis, macroeconomic policy, and political theory. He spends his free time reading extensively, watching interesting videos on YouTube, and trying to convince everybody around him that he really does know a thing or two about economics in the midst of all the pontification!

 [1] We define competitiveness as R = ePf/ P where R denotes the real exchange rate, e the nominal exchange rate, Pf  is the foreign price level, and P is the domestic price level

Posted by The Indian Economist | For the Curious Mind