Funding the current account deficit - focus on the real economy

My column for "Wealth Insight" for July 2013. It was a follow up on the earlier theme.

Rupee weakness continues

In July, a desperate RBI allowed asset financing non-banking financial companies (NBFC’s) to raise external commercial borrowings (ECB’s) under the automatic route for financing import of infrastructure equipment. This comes as part of a series of moves by the government and the RBI to raise foreign resources. The rupee continues to remain under pressure.

Earlier moves to “allow” investments in Indian debt have boomeranged. Starting in Jan 2013, India increased the limit for foreigners seeking to invest in government debt in India. Instead, by the end of June, foreigners had withdrawn $1.2bn from Indian debt in the calendar year. Most of the outflow happened in June. The rupee fall was collateral damage, but once it started, it added to the panic and the outflow. The government has blamed the current account deficit for the falling rupee, but is that the whole story?

A look at the theory

A country’s current account is defined by the following equation:

Current account = (private savings – Investments) + (Tax – Government expenditure)

If the government runs a fiscal deficit i.e it spends more than it earns as taxes, it has to be financed either by a fall in investments (for a given level of national income/savings) or, the country will run a current account deficit(CAD). In other words, domestic consumption has to be financed by foreign inflows. This in itself is not a problem. Countries like the USA and Australia have managed persistent CAD’s without negatively impacting growth rates, or pressuring their currency. India too has had many years of CAD without the rupee depreciating. Of course, these years had increased inflows from invisibles or investments.

Fiscal deficit too is not always bad. In fact for developing countries running below full employment of resources, it can be argued that the government can increase growth rate by running a deficit. Indeed, it must. In effect, an economy operating below potential will benefit from government spend and foreign investment. India has for long run these twin deficits. So why are the policy makers acting as if they have been caught unawares?

Perfect vision – imperfect solution

In 2010, the ministry of commerce put out a strategy plan and a paper. The paper was titled “Strategy for doubling exports in the next three years”. In it, the ministry, assumed that near term trend growth of exports and imports would continue. Based on this, it forecast that India would have a negative merchandise trade balance of $210bn by 2013. This has proved remarkably accurate (the actual figure is $196bn). 

Interestingly, the paper also identified areas where India would have to improve to increase its exports – necessary to avoid pressure on its currency. To quote “Infrastructure bottlenecks remain the single most important constraint for achieving accelerated growth of Indian exports”.  Specifically, it identified a shortage in port capacity of 600 Million MT, 4400kms of 6 lane and 66000 km of 4 lane highways, 750 million tons of cargo handling capacity by the Railways. The other areas noted for improvement were bilateral trade agreements, lowering of transaction costs by simplifying compliance and regulatory requirements, and a stable policy environment. 

Anyone following the developments in the economy over the last few years would be aware of the lack of forward movement on most of these identified problems. In fact, significant problems have since been created, among them the uncertainty of application of tax laws to foreign investment transactions. The end result is seriously eroded investor confidence and investment climate. It is noteworthy that the likely pressure on the rupee was identified as a problem over 3 years ago, and the current blame attributed to the US Fed action is only perhaps a trigger for the inevitable. The real problem is high CAD and a decline in invisibles.

Trade Deficit worsens  while invisibles decline

 

Government focussed on “foreign money”

Of late, it is rare to hear any pronouncements from the finance ministry without it being focussed on foreign direct investment (FDI). Ignoring the findings of the commerce ministry outlined above, North Block continues to believe that all that is needed to remove the pressure on the rupee is to raise FDI limits across various sectors.  This appears a “solution” reflective of a mindset of a “command” economy. With India’s “growth story” seemingly in the past – “permission” to invest is no longer the constraint for international investors – “reason” to invest is!

Even this “liberalization” comes with micro controls. Having risked becoming a minority government by pushing FDI in single brand retail, the government has managed to ensure that there is not a single credible proposal for investment on the table.  Among the most difficult to understand requirements in this case, is that foreigners cannot invest in an existing venture. If allowed, the local entrepreneur would release capital - which would have the same effect as foreign investment in fresh capacity. For some, money is not fungible. Perhaps “our” money is not as green!

 Lack of consistency in policy and a persistent “central micro planning” mindset will ensure that the economy performs below par. Undue focus on financial markets while completely ignoring the problems of the real economy is not likely to make India an investment destination of choice. The faster our government understands this, the better for our unemployed millions.