Losing the balance

Indian Express, 6th July 2012

Fixing exchange rates only tackles the symptoms of the brewing BoP crisis

Last week, the RBI released the latest balance of payments data for India. This data highlights the grim economic situation faced by the country. Unless corrective steps are immediately taken, the problem could quickly turn into a bigger disaster. It could mean further rupee depreciation, stress on balance sheets of companies who have borrowed in dollars, a higher import bill, difficulties for banks whose clients have borrowed in dollars, higher inflation as the price of tradables rises, and capital flight from India.

The data shows that for the year 2011-12 India ran a current account deficit of 4.2 per cent of the GDP. This is the first time India has run such a large current account deficit. It means that India overspent to the extent of $78 billion during the year. In the last quarter of the year, from January to March 2012, the current account deficit had risen to 4.5 per cent of the GDP. In these three months alone, India overspent to the tune of nearly $22 billion. The main sources that financed this overspending were portfolio flows of $14 billion and dissaving through depletion of reserves by $5.7 billion. In the coming quarters we cannot expect these two to be the stable sources to fund our overspending.

Many observers argue that FDI is a stable source of funding. But during the period in which there has been a crisis in international banking and poor investment sentiment, and lack of FDI-related reforms in India, many foreign firms have pulled money back. In recent years, foreign firms repatriated money from India. This reached a high of $10.7 billion in 2011.

The above data is till March 2012. The period April to June 2012 has been equally difficult. Although the balance of data for this period is not available yet, the volatility in the exchange rate market reveals the supply demand mismatches in the foreign exchange market. What happens to the rupee may be good for some and bad for others, but that is only part of the story. A sharp depreciation gives us information on how the economy is behaving. It tells us what investors feel about the country. It informs us about how households and firms value Indian assets.

One view of the large current account deficit is that it is driven by gold imports, and is thus not truly a current account deficit as gold is an asset. So the money spent on gold imports should be treated as a capital account outflow rather than an outflow on the current account. Buying gold is like buying an international asset. If central banks buy US treasury bills (T-bills) with the dollars they buy when they intervene in foreign exchange markets - because they feel that US T-bills are liquid, risk free and a good inflation hedge - households feel that gold has similar properties and is suitable for them as an asset.

When a central bank buys US T-bills, they are an asset for the country. Similarly, when households buy gold, if we treat it as an asset and move the entry to the capital account, the assets and liability sides match and the current account deficit looks smaller. In principle, there can be little disagreement with such an accounting change.

However, the discussion above misses out on one important story. It ignores the question of why there has been a sudden fall in bank deposits and an increase in gold purchase by Indian households in the last one year. It ignores the message this gives us on what households feel about the value of the rupee. If we ignore this story, we do not take into account the problem of inflation and the household response to it, and the implications for the balance of payments.

Recently, the finance ministry announced a number of measures that would increase the flow of capital into the economy. Most of those measures made it easier for India to borrow for her overspending. There were no corrective steps on how India will reduce the overspending. In addition, the RBI has asked oil companies to buy dollars directly from banks. This means it doesn't want the rupee-dollar exchange rate to be determined in the foreign exchange market. Even if the rupee becomes more stable after these steps, does it mean that we would have addressed the basic problem? We would only have tried to hide the bad news and made it easier to go into denial mode. Hiding the bad news will allow us to continue longer with unsustainable policies. This way the problem with only grow bigger.

The fundamental problems that are causing India's balance of payments crisis are well known by now. On the one hand, on the current account, the country faces a twin deficit situation - a large fiscal deficit spilling over into a large current account deficit. At the same time, spending on the most import-intensive consumption item, oil, does not fall even when the rupee price of oil changes as firms and households do not face higher prices, thanks to a product subsidy. Inflation has undermined the value of the rupee, and households have moved towards gold where again additional demand is met through imports.

On the other hand, on the capital account, the inflow of foreign capital has become highly unstable. The global economic situation was bad enough with European banks deleveraging and foreign portfolio investors flipping between risk-on and risk-off mode after the crisis in the US and Europe. We added to our woes by announcing the GAAR, violating rule of law through the Vodafone tax issue, stalling large projects, proposing investor unfriendly policies and killing the India growth story.

Given the past experience Manmohan Singh and his advisor, C. Rangarajan, have with a balance of payments crisis, it can be hoped that there is a change in the manner in which the BoP problem is handled in the coming months. Instead of killing the messenger, in this case, the exchange rate of the rupee, and hiding the problem, the government will need to address the disease and not its symptoms.

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