Hasten Slowly, Mexican Turn Ahead

It is true that the economy has done well in notching up a growth of six plus in recent years, the foodgrains kitty is full, foreign investment inflow has been on the rise and the World Bank and the IMF have been benign in their assessment of the economy in the recent past. These strong signposts do not reveal the bumps on the road ahead. Industrial slowdown, a coy capital market, a slowdown in exports lately and a cautious approach of foreign institutional investors show that the Indian economy is not strong enough to arouse confidence. Confidence is a key to avoid the occurrence of the 1994 type of Mexican crisis that ended up in capital flight and a 50 per cent devaluation of the peso. It is necessary to remember that the IMF's articles of agreement does not mandate CAC.

 

The recommendations are based on a time based programme for three years (1997-2000) for full CAC. The Committee has set some pre-conditions such as reduction of non-performing assets from 13.7 per cent in 1986-97 to five per cent by 2000, reduction of cash reserve ratio from 9.3 per cent to three per cent, inflation rate of an average three to four per cent and the reduction of fiscal deficit from the budgeted 4.5 per cent in 1997-98 to 3.5 per cent in 1999-2000.

These conditions are not easy to meet. Fiscal deficit is already five per cent and is unlikely to fall to the desired level after accounting for the oil pool deficit and the states' deficit. It is difficult to see how the states can be bludgeoned into fiscal discipline. The inflation rate is hovering around six per cent now but is sure to rise once the inevitable hike in prices of petroleum products takes place. Fiscal consolidation, a pre-condition for the CAC, is a long way off and a lot needs to be done to strengthen the domestic financial system.

Forex reserves are required to be in the region of $40-47 billion. About $35-40 billion is required to finance imports and external debt obligations, and about $5-7 billion to take care of the mismatch between inflows and outflows resulting from the CAC. Currently, the country holds around $22 billion forex reserves. It is also essential that the export growth is sustained to take care of imports. In the recent past, Indian exports that grew by about 18-20 per cent in dollar terms have grown by just six-seven per cent lately. A minimum net foreign asset to currency ratio of 40 per cent should be prescribed by law. Large reserves are necessary to support the rupee from volatility in forex market due to capital flights resulting from sudden large outward remittance on current or capital account. As economist Bibek Debroy, remarks, It's not clear whether the improvement in forex reserves is a permanent or a transient phenomenon. This can be coupled with the external debt problem. India's external debt is estimated around $92 billion.

It is important to remember that countries with a better economic performance than India's such as China with $111 billion in forex reserves, Singapore $76 billion, Taiwan $88 billion and Hong Kong $70 billion have not gone in for CAC. The level of reserves would also depend upon the level of exchange rate that is to be supported. India does not have a sustainable surplus on trade account that imparts basic strength to the BoP. In this situation, CAC, however gradualist, appears to be more an exercise in