Can India absorb up to $75 bn of inflows?

Discussion in 'Economy & Infrastructure' started by LETHALFORCE, Nov 17, 2010.


    LETHALFORCE Moderator Moderator

    Feb 16, 2009
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    The recent acknowledgement by the Seoul G20 communiqué that excessive capital flows might require the adoption of “macro-prudential measures” by some countries with “increasingly overvalued flexible exchange rates” is a significant development as the challenge faced by economies flooded with capital inflows has been finally recognised. This has renewed expectations of more regulations from the Asian economies. Already eight economies including China have imposed such regulations. And South Korea is widely expected to follow soon.
    Surprisingly India has been an exception till now, despite $28.6 billion of flows from foreign institutional investors (FIIs) since July 2010. This has generated much discussion about whether such inflows are large enough to warrant controls as it has exceeded the overall amount recorded historically in such a short span of time. I think India is still far away from such a situation because things are playing differently and favourably for the economy this time.

    To start with, the quarterly current account deficit (CAD) was only about $4 billion during the earlier boom period, versus $13-14 billion so far in FY11. This more than trebling of the CAD, along with a significant reduction in external commercial borrowings and foreign direct investment has created room to absorb more FII flows without adding substantially to the balance of payment (BoP) surplus. This is apparent if we do simple math. For example if we pose the $75 billion figure of capital flows against a $50 billion CAD (assuming the wide quarterly $13-14 billion CAD is replicated in the rest of the quarters which looks likely), the economy is left with a surplus of only $25 billion or 2 per cent of GDP. Apart from smoothing out lumpy capital flows, this surplus is easily manageable.

    Thus, domestic policymakers’ comfort with the current external situation is not surprising. In fact, early this week Deputy Chairman of the Planning Commission Montek Singh Ahluwalia said India can handle up to $75 billion of capital inflows easily without resorting to any controls. I agree with this stance as India’s investment requirement remains huge and foreign funding is indispensable (according to 12th five year plan $ 1 trillion worth of investment is required during 2012-17).

    In fact, even when capital flows surge (highly probable because economies like US have already embarked on another round of liquidity injection), India needs to design measures so as not to damage either the domestic economy or international investors’ long-term image of the country. The questions that assume importance are: (i) how much is too much? and (ii) how should such flows be handled.

    In my view capital flows of close to $100 billion or a BoP surplus of $50 billion (assuming the CAD remains wide at $50bn) can still be managed by a combination of rupee appreciation, foreign exchange intervention and sterilisation. Currency appreciation is one of the easiest ways to absorb such increases. Using the RBI’s 36-country real effective exchange rate (REER) index as a proxy for valuation, it is hard to justify the argument that the rupee is overvalued any more. In addition, given higher inflation in FY11, the Reserve Bank of India (RBI) may have a higher tolerance for orderly currency appreciation. Tight liquidity in the domestic banking system (close to Rs 1 lakh crore) has left RBI with comfortable room to intervene in the foreign exchange market without fears of whipping up inflationary pressure via excess liquidity. However, if the need arises tools like sterilisation bond issues are also available.

    Capital flows in excess of $100-120 billion, however, might force India to take stricter measures. This could include macro-prudential measures aimed at curbing asset prices, counter-cyclical fiscal policy or encouraging outflows to offset inflows. But, in isolation, these measures do not fully address the problem. And so attention turns to capital controls. In such a situation India needs to make clear that short-term inflows are not welcome. Controls can take many forms: unremunerated reserve requirements as implemented by Chile in 1991 or Thailand in 2006; time requirements, as in Malaysia in 1997; limits on the size of inflows, as in Taiwan in 2009; or a direct tax, as in Brazil recently.

    A V Rajwade
    Foreign exchange risk management consultant

    We still look at the deficit from the angle of financeability, rather than its impact on output and jobs in the tradeables sector

    Both the electronic and print media have headlined the comments of C Rangarajan, chairman, Prime Minister’s Economic Advisory Council, and Montek Singh Ahluwalia, deputy chairman, Planning Commission, to the effect that (net) capital flows up to $70 billion to $75 billion in the current fiscal year should not pose a problem. After going through the reports on the subject, I feel that both of them expect the current account deficit to be $45 billion to $50 billion and that “(India) can also accommodate comfortably up to $20 billion as additional reserves” as Rangarajan has been reported saying. The actual net capital inflows in fiscal 2009-10 were of the order of $51.9 billion, and $17.5 billion in the first quarter of the current year. The largest single element in the capital inflows is of course portfolio investments, which exceed the net foreign direct investment, in both fiscal 2009-10 and Q1 of 2010-11.

    For me, the positive aspect of Rangarajan’s statement is that it seems to specifically envisage Reserve Bank of India (RBI) intervention in the market (to the extent of $20 billion, the capital inflows in excess of the expected current account deficit), something RBI has avoided for a long time, and that too on an unsterilised basis to “help ease the liquidity situation”.

    Looking at the issue with the current account deficit as a “given” is not a very logical proposition. In fact, lately, I find too many economists arguing that we need the capital inflows because we have a large and growing deficit on the current account: the deficit in the current year as a percentage of GDP (even as conventionally calculated) could exceed that of the far more publicised case of the United States. (Our gap between external income and expenditure, i.e. deficit net of inward remittances that are not the domestic economy’s “earnings”, is, in any case, far higher.) Sadly, while the US has at last recognised the link between the deficit on the one hand, and domestic output and jobs on the other, as manifested in the pressure on China to bring down its surplus, we still seem to be looking at the deficit more from the angle of its financeability, rather than its impact on output and jobs in the tradeables sector.

    The fact is that capital inflows are not just a means of financing the deficit, or independent of it. In the absence of intervention by the central bank in the market, as has been the case in India for the last 20 months, the excess flows appreciate the exchange rate, which discourages exports and encourages imports by making the tradeables sector of the domestic economy less competitive in the global market, and thus are an indirect cause of the current account deficit and the consequential loss in domestic output and jobs. To be sure, in macroeconomic accounting terms, the deficit also represents the excess of domestic investments over domestic savings. Too many of us seem to believe that, in our present macroeconomic situation, the deficit is caused by our need for investments. There is, of course, an equally logical explanation that directly links the two ways of looking at the issue: an overvalued exchange rate can as well lead to lower savings, rather than larger investments, because of both less output and greater consumption of imported goods and services than what they would have been at a lower exchange rate. I personally am biased towards the latter argument.

    In many ways, we seem to be an exception to how the rest of Asia is looking at the issue of capital inflows, particularly in the context of the quantitative easing proposed by the Federal Reserve. Despite many of them having surpluses on the current account, they are looking at reducing flows and/or otherwise sterilising their impact on the exchange rate and the domestic output; on the other hand, we seem to be glorying in the American pat on our back for our exchange rate policy, the current account deficit — and for creating jobs in the US. One danger signal is that the market fundamentalist editorial pages of The Wall Street Journal (November 11, 2010) have started praising our policies!

    LETHALFORCE Moderator Moderator

    Feb 16, 2009
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    'India-bound capital inflows to continue'
    The upswing in private capital flows to emerging market economies, including India, is likely to continue for another five years driven by high interest rates, robust growth prospects and improved fundamentals.

    According to a report by DB Research, a part of the German banking major Deutsche Bank, the current "upswing in private capital flows to the EM (emerging market) that started in April 2009, following the G20 meeting, may only be in its early stages and may have another five years to run".

    The report further said capital will be pushed out of developed markets due to extended period of unprecedentedly low interest rates, sub-par economic growth and higher financial risks into emerging market economies which are at a much stable position.

    Besides, at a time when developed markets are being downgraded, the emerging markets are being upgraded, this in turn has enthused greater "strategic" asset allocation to
    emerging market by developed market institutional investors.

    Moreover, large forex reserves and flexible exchange--rates and favourable foreign-currency mismatches provide the emerging markets with significant buffers in the event of a "sudden stop" in capital inflows.

    The level of capital flows to the BRICs differs markedly. Brazil has been experiencing the highest level of inflows during 2009-10 due to its more open capital markets compared to China and India.

    Both China and Russia are experiencing lower levels of gross capital inflows (and, indeed, much higher levels of gross private outflows) than Brazil. But large current - account-related inflows contribute to much larger balance -of-payments surpluses in both countries, the report said.
    India falls somewhere in between Brazil, on the one hand, and China and Russia, on the other hand, as regards its capacity and the perceived need to absorb (smaller) external surpluses, it added.

    However, Brazil's forex reserves do remain well below those of the other BRICs. Concerns over "excess" currency appreciation and rising sensitivity to a "sudden stop" have contributed to Brazil's decision to incrementally tighten controls on capital inflows.

    Their greater capacity and willingness to prevent nominal currency appreciation have resulted in greater official reserve accumulation, the report said.

    As a result, China and Russia perceive less of a need to tighten controls on capital inflows than Brazil, whose capital account is very open and whose currency has appreciated tangibly, from weak immediate-post-crisis levels, it added.

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