After the stimulus phase-out

Govt errs in focusing only on financing current account deficit

The US Federal Reserve has dropped clear hints that its long phase of quantitative easing, in which it bought bonds in an "open-ended" manner, will come to an end. It will not cease abruptly - which is why it is now being called a "tapering". However, even the prospect that the end of the Fed's massive stimulus, which flushed global markets with liquidity, is on the horizon has been enough to cause jitters among investors. The question that many should now ask is: what will be the medium-term fallout of the shift in the Fed's stance? In particular, how will it affect emerging markets - especially India? So far, under the influence of easy money, the stock market index in India has run up 4,000 points to around 19,000; bond markets, too, were long buoyed by one-way inputs. The Sensex has taken a few losses. But it's the debt market that has seen the real action, with well over $3 billion of foreign money flowing out of Indian government bonds in the last two weeks. The rupee, in its recent rapid depreciation to close to 59 against the dollar, has suffered a fate similar to the currencies of other growth-challenged emerging market countries - both Brazil and South Africa have seen their currencies hit a four-year low against the dollar. India, however, has a particularly large current account deficit, around five per cent of GDP, making it particularly dependent on foreign investors being willing to take on emerging market risk so that their inflows finance India's imports.

On Thursday, Finance Minister P Chidambaram spoke obliquely about this situation when he called for a "long-term view" on the part of investors, and promised more reform that would address the problem. There weren't too many details on offer, but even the broad hints that Mr Chidambaram dropped suggest the government is looking at the problem primarily from a limited perspective of financing the current account gap, without addressing the fundamental cause of the deficit. He referenced, in particular, the reviewing of caps on foreign direct investment (FDI) in various sectors. Meanwhile, the Securities and Exchange Board of India on Wednesday raised investment limits for long-term foreign investors in government debt by another $5 billion to $30 billion. These two measures are, broadly, more of the same approach that the government has tried so far. They are not in and of themselves a problem, and should even be welcomed. But measures to promote FDI and FII holding of debt merely paper over the current account deficit problem - they do not solve it. As long as there is an imbalance on India's books with the rest of the world, these steps will never be enough.

The focus on financing the current account deficit is, thus, the wrong focus. What is needed instead is to boost exports, and to improve India's macroeconomic fundamentals. The latter is complicated by the fact that the effects of the end of quantitative easing elsewhere may well upset India's monetary schedule, making the Reserve Bank of India less likely to reduce interest rates. The space to do so has to be provided from somewhere, however, and thus fiscal correction must accelerate - allowing borrowing rates to come down and investment to rise. Without that, investment-led growth - as well as consumption in rate-sensitive sectors like automobiles, real estate and so on - will not recover. Meanwhile, the lopsided balance of trade shows the need for fundamental reform. A good proportion of the current account deficit, for example, is due to imports of pulses and cooking oil. Pushing foodgrain-specific food security will make this problem worse, not better. And promoting exports will need basic labour law reform. This is where the government should be looking.