A positive trait of the Indian economy has been its remarkable macroeconomic stability after 1991. That resilience is fast eroding. As the wobbles at the end of last year showed, the economy is increasingly driven by the boom-bust dynamics of flighty capital flows that feed its growing deficits. Recent balance of payments statistics show an accelerating deterioration: current account deficit at 4.3 per cent of GDP in October-December 2011 – following 4.1 per cent and 3.5 per cent previously – met by a $12.8-billion erosion in reserves as the hot money servicing these deficits abruptly reversed. The gap is likely to expand as much as four per cent of GDP for 2011-12, from 2.8 per cent and 2.7 per cent in the preceding years. Some more of such deficits and debt-creating flows that finance them and India will be a lot less resistant to sudden stops. How has this come to pass?
For all its strong rebound after the crisis, the country’s dependence on external financing – mostly portfolio stock and bond purchases by foreigners, external loans and banking flows – has made it more prone to volatile cycles driven by foreign sentiments. The dangerous quivers late last year are a warning sign: the sudden flight of short-term capital as investors turned fearful plunged the currency value by some 18 per cent, depleting more than $20 billion of reserves. The upside of this capricious cycle was the preceding year’s boom when global risk-taking switched on: then, foreign money poured into the country in search of higher investment returns and the currency soared, appreciating an average four per cent monthly, boosting consumption and imports and widening the current account deficit.
Macroeconomic policies of recent years have contributed by supporting consumption and asset prices, causing inflation and denting savings.
- Fiscal policy has boosted aggregate demand since late 2008, much beyond what is justified as a shield. Increasing welfare spending has sustained excessive growth of consumption, fanning inflation as supply constraints remain unaddressed. A fair bit of the oil import bill, nearly 30 per cent of the current account deficit, can be directly assigned to the fiscal policy choice that subsidises fuel, encouraging demand despite rising global prices.
- A hands-off exchange rate policy since 2009 managed short-term capital inflows through exchange rate appreciation. Alongside large-scale fiscal expansion, this only boosted consumption further, increasing absorption and pushing up prices of services, or non-tradable goods’ inflation; cheap imports hurt domestic production capacities as well. A strengthening currency, however, helped contain imported inflation, especially oil and commodities. Imported input prices dominate India’s headline and core inflation indicators; this allowed lower domestic interest rates, while boosting stock prices and easing financing pressures. Not accreting reserves saved sterilisation costs too, making for lower bond yields that assisted government borrowings.
- Monetary policy was too loose for too long in the Lehman aftermath, even as inflation rose from 2009. At least a trillion rupees of surplus cash swirled at the overnight repo window, on average, each month through 2009-10. The excess liquidity benefited asset prices, that is, stocks, property and gold. Negative real interest rates, however, hurt financial savings; savers increasingly held cash or invested in gold. With capital inflows dwindling and growth slowing in 2011-12, equity investments shifted to gold as well; why, even firms are investing surpluses in gold funds, pointing to the distorted investment incentives in the economy. Gold and oil imports constituted almost 45 per cent of the import bill in 2011-12.
- Rapid monetary tightening from mid-2010, as the central bank caught up, widened the domestic-foreign interest rate gap, which in combination with an appreciating currency, made foreign loans cheaper for domestic firms that increasingly borrowed abroad; high-yielding Indian debt attracted foreign investors at the same time. This helped the government, which further lifted caps on sovereign bonds to lower yields as it gobbled more domestic resources. As a result, the debt component rose to half of the overall volatile flows (that is, portfolio debt plus equity, commercial loans and bank capital) by 2010-11; and whose sudden reversal from September 2011-12 rocked the economy.
The casualty of such policies has been savings, the shortage of which current account deficits represent. Despite a strong recovery, an 8.4 per cent growth for two straight years has not translated into higher savings because of rampaging inflation, which erodes the culture of savings; welfare-induced spending, too, offers less reason for households to save. The savings rate remains almost five percentage points lower than its 2007-08 peak of 37 per cent; it likely fell lower to 30 per cent in the year just ended.
It is equally startling that the prudent need to insure against the drying-up of this volatile capital reduced, even as debt-creating financial flows have risen. Numerous research studies confirm portfolio debt flows are riskier and far more volatile than their equity counterpart, while their association with growth is nebulous, even negative. Yet, financing from short-term, debt-creating flows shot up to 70 per cent of the current account deficit in 2010-11 – from 30 per cent the previous year – while proportionate reserve holdings fell. Foreign currency assets were 16 per cent of GDP in March 2011, from a 26 per cent peak of 2007-08, and further lower at 14 per cent at end-March 2012. These cover less and less of the mounting external debt: 87 per cent at end-December 2011 from 107 per cent in March 2010. The cover for residual debt, the key external vulnerability indicator, was 44 per cent of reserves in September 2011 but is widely believed to have crossed 50 per cent as foreign short-term debt is recalled or not rolled over by European banks, overseas bonds by domestic firms fall due for payments and a depreciating currency makes foreign currency deposits riskier.
Has strong economic growth fostered complacency? Did the quick, robust rebound from the crisis shock encourage the belief that such fickle foreign capital would endure? Ironically, the unsustainable situation now is forcing policymakers towards an even higher dependence on hot money in a vicious, addictive cycle that can only spell eventual disaster, if not urgently addressed. Hard decisions, as the finance minister recently said, need to be taken. These can no longer be deferred.
The author is a New Delhi-based macroeconomist; she is a former staff member of the International Monetary Fund and the Reserve Bank of India