Build on high ground

Economists have been crying wolf about global macro-economic balances for a while now. Concern has been expressed about the combination of: the large US fiscal deficit; the large US current account deficit; the fixed or pegged exchange rates of Asia; the large current account surplus in China; and the reserves build-up in Asia. There are many convincing reasons why this configuration is unsustainable. Nevertheless, the dollar defied all dire prognostications in 2005, and strengthened significantly. While this was a surprise, and serves as a reminder of how difficult it is to forecast short-term currency movements, the fact remains that the global economy is faced with deep and important problems even though growth powers along.

The US current account deficit is substantially funded by purchases of US government bonds by central banks. If these purchases falter, for any reason, it could induce a sharp depreciation of the US dollar and a sudden increase in US interest rates. For this reason, despite the continuing upswing in the global economy, scenarios that warn of a downturn in the global business cycle, and growth deceleration in the US and China, continue to be credible. This is the backdrop to the hint dropped by China the other day that it might diversify its reserves portfolio and move away from US bonds. China's problem is that it is riding a tiger: with massive holdings of US securities, its interests lie in preventing dollar depreciation, not precipitating it. Nevertheless, even a limited Chinese shift away from US bonds will make it more difficult for the US to fund its twin deficits.

What does this mean closer home? Traditionally, India has been a closed economy, and the global business cycle has mattered little. That is no longer the case. Gross flows on the current account and the capital account, put together, are now roughly 75 per cent of GDP. India is more open than most people realise. A global business cycle downturn will therefore impact India. Leveraged firms, and export-oriented ones, will take a beating in such a scenario. Such a downturn could come at a particularly bad time, given the fiscal stance of the UPA and the deadline for achieving zero revenue deficit under the fiscal responsibility law.

A reflexive RBI response, based on 1970s and 1980s thinking, would be to batten down the hatches, introduce more capital controls, and wait out the storm. This is not feasible today. It is impossible to put restrictions on the huge current account. Tens of billions of dollars will move across the border through over-invoicing and under-invoicing if there are one-way bets on the currency. The capital account is also big enough to make closing it down infeasible. The RBI got a taste of the new political economy of capital controls on December 12, 2004, when the country vehemently rejected restrictions on FII flows that would have been tamely digested in the 1970s and 1980s. The proposed ban on participatory notes is shaping up as an interesting litmus test of the RBI's ability to reverse reforms. India is now too deeply enmeshed in the world economy to go back to controls.

The only thing to do, then, is to gear up for the inevitable business cycle downturn in a modern, open, market economy, as is done by the central banks of other modern, open, market economies. This involves currency flexibility, liquid and efficient financial markets, and well-regulated banks. There is plenty to do on all three fronts!