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Arvind Subramanian: Favouring foreigners in finance

Forcing banks to hold govt assets while opening up to foreign capital flows winds up penalising small Indian savers

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Can nationalism be harnessed to promote sound economic policies? That seems an odd question to raise at a time when Indian policy makers have rightly been taken to task in recent months for the heavy-handed and arbitrary treatment of foreign investors. But, yes, in the financial sector, policies penalise or tax Indians while treating foreigners more favourably. Even more worryingly, all the signs are that this wedge may even diverge to the advantage of foreigners and to the detriment of the economy.

One of the two policies in question is the (SLR), a seemingly arcane measure under which Indian banks are forced to hold a hefty portion (23 per cent) of their assets in government bonds. This policy would rank high among the bad relics of pre-reform India. The second is the openness to foreign capital, especially foreign financial flows. Consider each.

The SLR reflects what economists call “financial repression” and, at least in today’s environment, exacts large costs on the economy. It taxes savings, makes the financial sector less efficient and reduces the availability of resources for the private sector. Just a few days ago, figures from the Reserve Bank of India (RBI) showed a decline in savings through the financial system from 12 per cent of GDP to eight per cent because higher inflation – another form of financial repression – had reduced real deposit rates.

But it exists for a simple reason, which is also one of the policy’s biggest economic costs: to sustain the profligacy of India’s political class. India runs large fiscal deficits and if savers were not forced to finance them, interest rates would go up, forcing politicians to own up to their rapacity and populism.

It would be desirable to gradually eliminate or significantly reduce SLR. Asking the government to eliminate SLR would be akin to asking a binge drinker to close down the booze shop that he himself owns. Credible reductions in SLR can only be achieved if fiscal consolidation is feasible. So, when Vijay Kelkar, chairman of the 13th Finance Commission, presents ideas to the finance minister on fiscal consolidation, he should call for an explicit link between the two.

The second policy in question relates to capital account opening. Unable to implement “good” reforms such as reducing subsidies, implementing the goods and services tax , and establishing rules on land acquisition, keen to redress its reputation of being harsh on foreign investors, and desperate to restore its pro-reform credentials, this government and the have been opening the economy to foreign financial flows.

Whatever the merits of this policy in normal circumstances (explored with my colleagues and in our recent book, Who Needs to Open the Capital Account), it is less likely to be good policy under current economic circumstances. Indeed, a combination of high inflation, high fiscal deficits and widening external imbalances is just about the perfect time not to embrace foreign capital inflows. The flows that are attracted will be speculative, they will render the exchange rate uncompetitive affecting manufacturing exports, and when the inevitable sudden stop materialises financial chaos will ensue. Unless India is somehow unique, that is the evidence from recent history.

Going forward, though, it is likely that one bad policy – the SLR – is unlikely to be eliminated while the other – capital account opening – is likely to be pursued vigorously. Interestingly, it is the liberals in policy-making that are likely to persist with this course of action. Their not unreasonable justification will be that SLR reductions are off the table because the underlying fiscal consolidation is politically infeasible and that that should not come in the way of pursuing economic opening. Unfortunately, they remain unconvinced that capital account opening today is bad policy, especially if SLR cannot be eliminated, and that it might be better to maintain the status quo.

So how should the liberals be persuaded? The time seems ripe for playing the populist, even jingoistic, card to head off a worsening of the policy stance. That card amounts to making the link between the two policies and contrasting their relative impact on Indians and foreigners.

Go back to SLR. Although, it is a policy that immediately impacts on banks, its real economic effect is to deprive Indian savers – those who deposit their money in banks – of the opportunity to invest in the full range of private sector assets, effectively lowering the return that they make on their savings. The counter that savers have the choice not to put their money in banks but to invest it directly in private sector assets ignores the crucial fact that banks are perhaps the only provider of financial services, including as a savings vehicle, for a vast majority of not-so-financially-sophisticated Indians.

At the same time, consider the implications of an open capital account. Foreign savers/investors can have relatively unencumbered access to a wide range of Indian private sector assets. To be sure, foreigners cannot invest fully in Indian government assets and they cannot acquire certain claims on Indian private sector assets (for example, corporate bonds). But these relatively less important exceptions apart, their choice is less limited than that of the poor Indian saver, a quarter of whose savings cannot legally be invested in remunerative Indian private sector assets.

In other words, the combination of the financial repression inherent in SLR and a relatively open capital account is discriminatory: unfair to India’s savers and advantageous to foreign savers. And given that India’s savers are on average much poorer than the average foreign investor, Indian policies seem bizarrely inequitable.

The response of the liberals will be: what better way to rectify this inequity than by completely liberalising the capital account so that domestic savers can enjoy full access to foreign assets (and domestic investors can have access to cheaper foreign borrowing)? In other words, having penalised savers domestically through SLR, the best way to overcome that is to provide unrestricted choice internationally.

Conceptually, this is a fair point. But in practice, for the very reasons that banks are important savings vehicles, most Indian savers are unlikely to be capable of benefitting from the expanded choice. More importantly, as discussed above, the fact of high deficits and macroeconomic vulnerability makes these unpropitious times for further opening to capital flows. 

So, the next time we see a further bout of capital opening with little being done to correct the fiscal imbalances and eliminating the SLR, we should be clear about the impact, if not the intent, of these policies: the Indian government favouring rich foreigners while penalising poor Indian savers. The populists can unite in this cause against the economic liberals. For a change, they could be on the right side of the economic argument.


The writer is a senior fellow at Peterson Institute for International Economics and the Centre for Global Development, Washington

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