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Indian Express, 8th May 2012

Slamming the brakes on budget proposals may stave off crisis, restore confidence

While introducing the finance bill, Finance Minister Pranab Mukherjee postponed the General Anti-Avoidance Rules (GAAR) and promised not to introduce tax policy changes retrospectively. Proposals to give arbitrary powers to taxmen and numerous retrospective tax changes were incredibly bad policy and the government should never have introduced them. But with the country running a large current account deficit, even if the government believes that these policy changes are important, India cannot afford to turn foreign investment away at the moment. A greater dependence on foreign loans to finance the deficit can weaken fundamentals further. The rollback of budget proposals will help reduce the risk of a balance of payments crisis.

The rupee has been under pressure to depreciate in recent days. As foreign investors turned away, the RBI not only stepped in to intervene, it took measures to ease foreign debt inflows that may stabilise the rupee for some time. But in case of a crisis this move could create an even bigger contractionary effect. Capital account liberalisation is good for a country, but can be a source of risk. Especially when an emerging economy chooses to finance a large current account deficit by borrowing abroad.

The recent pressure on the rupee is not due to a one-off temporary shock, say, a hike in US interest rates or a nuclear test by India. It is the result of a slow deterioration in macroeconomic fundamentals of the Indian economy. With the government on a spending spree, fiscal deficits are rising and the country as a whole is spending more than it is producing. This profligacy is visible in net imports. India imports more than it exports by 4 per cent of the GDP today.

The identity of the current account deficit on the one hand and expenditure minus production on the other is often forgotten or ignored in policy circles when they attempt to address the symptoms rather than the disease. In recent months, the first level of response by Indian policymakers was to address the demand and supply of foreign exchange by selling foreign exchange reserves to prevent rupee depreciation. This could not solve the fundamental problem of overspending.

The second level of response by Indian policymakers was to treat the problem as one of imports growing faster than exports. A microeconomic perspective suggests that if the price of something rises, people will substitute other goods for that one. Since gold forms a big chunk of imports, the government has chosen to raise custom duties on gold, assuming that the increase in gold prices would make people buy less gold, and they will buy something else instead, which is hopefully not imported. By this logic, the price of diesel should also have been raised. The difficulty here is, not only is gold a consumption good, but it is also a financial asset for households which, in times of rising inflation, see bank deposits as a poor financial asset. Over the next year, if households expect bank deposits to lose value, while the value of gold stays stable, they will buy gold. Making gold more expensive can have an impact on imports, but does not address the basic problem of overspending.

The third level of response is to try to increase net inflows to the capital account so that the pressure on the rupee goes away. Barring RBI intervention, which can only be limited, the current account deficit of 4 per cent of GDP has to be financed by capital inflows. The menu of options includes official or private flows, debt or equity flows, rupee denominated or dollar denominated flows.

It is well understood from the experience of many countries that debt denominated in foreign currency can be a source of balance sheet mismatches. If the rupee weakens from Rs 50 to Rs 75 per dollar then the firm that borrowed a million dollars when it was Rs 50 would have to pay 50 per cent more for the principle. This can cause the firm to go bankrupt. On an economy-wide scale this could have disastrous consequences.

India has no desire to go to multilateral agencies like the IMF for official flows. Policymakers clearly prefer private flows. In recent times, private foreign capital inflows into India have been declining. As noted with concern in a recent speech by the RBI governor, D. Subbarao, the balance has shifted away from equity inflows (FDI and FII) to debt inflows rising. The appropriate policy response in this situation would have been to encourage equity flows to come back to India.

However, as the rupee fell, the RBI eased controls on foreign debt. But this can be risky. Foreign debt can be denominated in rupees or in foreign currency. The RBI has not eased restrictions on rupee denominated debt, where the risk of depreciation is on the balance sheet of foreigners. It has eased restrictions on inflows of dollar denominated debt. This step might increase dollar inflows and the pressure on the rupee could decline. However, financing a large current account deficit by dollar denominated debt could prove risky. In the event of an unforeseen shock, if there is a sharp currency depreciation, it could result in bigger balance sheet mismatches than might have happened without the additional foreign debt that will be taken on now. So while one might temporarily reduce pressure on the rupee, one may be planting a potential time bomb in the economy.

Foreign investment is preferable to foreign debt flows. However, budgetary proposals about the tax treatment of foreign equity inflows did damage to foreign investor confidence in India. This is what the finance minister has tried to address. Even if he believes that the Mauritius treaty needs to be scrapped, GAAR needs to be implemented and Vodafone-like deals need to be taxed by changing the law retrospectively, the time to do it is not now, when India needs equity inflows. Hopefully, these steps will, to some extent, help restore investor confidence in India, and bring back equity flows. This could help reduce the risk of a crisis. However, in the long run, there is no option but to reduce the fiscal deficit.

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