Themes > Current Issues
11.07.2002
Danger Signals for the Indian Economy
Jayati Ghosh
The new
Finance Minister, Mr. Jaswant Singh, has already
declared his intention to try and increase purchasing
power, especially of the domestic middle classes.
Clearly, the government has designed this particular
Cabinet switch of portfolios to restore the government's
popularity, and therefore its electoral fortunes, before
the next general elections. The aim, presumably, is to
undo the damage to the BJP's middle class constituency
which was caused by the last Budget presented by Mr.
Yashwant Sinha.
But if this is going to be Mr. Singh's sole, or even major, preoccupation in the immediate term, then it may prove to be counter-productive. In fact there are far more serious danger signals looming, which suggest future trouble for the macroeconomy, and the Finance Minister will need to address these on an urgent basis if a future financial crisis is not to unravel all the attempts at economic recovery through generating more middle class purchasing power.
Consider the following features of the Indian economy at the middle of 2002. The economy is widely acknowledged to be still in recession, and though optimists have detected a turning point in recent months, there is little evidence to support this so far. The recovery in agricultural production was from the collapse of the previous year, and has been accompanied by further increases in the excess level of foodgrain stocks held by the public sector.
Industrial production decelerated further in fiscal 2001-02. The aggregate manufacturing index went up by only 2.7 per cent, and capital goods production actually declined by 4 per cent. Only consumer durables bucked the trend; in all other industrial sectors, including infrastructure, the growth rate was well below 4 per cent. Investment has probably continued to stagnate, if not decline. One important indicator of this, the assistance sanctioned and disbursed by all the All-India Financial Institutions taken together, actually declined even in nominal terms by 23 per cent over 2001-02, to less than Rs. 56,000 crore.
Nevertheless, the balance of payments indicators are, if anything, booming. One extraordinary feature of the past fiscal year has been the dramatic and unprecedented increase in the external reserve position of the RBI, by more than $12 billion just over twelve months. By the end of May, external reserves stood at more than $56 billion.
What is behind this tremendous spurt in reserves ? What is clear is that it is not any development on the trade front which has contributed. Exports over 2001-02 were stagnant, growing at a negligible 0.1 per cent over the previous year (which was substantially below even the downscaled target of 4 per cent set by the Commerce Ministry.) Meanwhile, imports actually increased slightly, by 1.1 per cent, leading to a slight increase in the trade deficit. It is true, of course, that the current account has still been kept in check, essentially because of invisible payment inflows in the form of large-scale remittances from Indian workers abroad.
The real factor behind the increase in reserves has been the large increase in various short-term and debt-creating flows, as well as a dubious category in the balance of payments data called "errors and omissions", which essentially represents extra-legal capital flows. Foreign direct investment inflows (which includes mergers and acquisitions as well as Greenfield investment) amounted to just above $3 billion. But more short-term portfolio inflows by Foreign Institutional Investors along with purchase of shares by non-residents amounted to nearly $ 3 billion as well.
Also, there has been a substantial increase in the inflows of what are classified as "banking capital", to the tune of $4.6 billion. These are debt-creating flows; indeed, most of this amount was in the form of NRI deposits, probably in the Indian Millenium Bonds and similar deposits. Since these deposits bear higher interest than available on domestic deposits or even many international bank deposits, they are really also part of the total external debt.
So what exactly is going on ? It appears that the Indian economy is now attracting capital inflows which are not being utilised productively for investment, but are simply going into piling up the external reserves held by the central bank. Of course this represent s significant fiscal loss, since the interest being paid on the various form of debt instruments which are part of the inflow is very much higher than the interest available on the deposits of foreign exchange reserves.
But even more than that, it should be borne in mind that, just as is true in the case of the excess food stocks, excess foreign currency holdings reflect an excess of ex ante savings over ex ante investment. This suggests an economy operating well below potential, and an enormous slack in terms of the use of resources. It is both a reflection of the current economic recession and a contributor to it. Also, insofar as this process is associated with rising real exchange rates (the real exchange rate of the rupee has appreciated by about 16 per cent over the past two years) it can become a further factor in domestic recession.
While the government could certainly lift the economy out of its current recession through increased productive spending which would also generate more employment and reduce the other evidence of slack (the large foodgrain stocks) so far it has proved to be remarkably inactive on this front. It is not clear whether this reflects lack of enthusiasm for such expansion, or simply incompetence.
It can be argued that in the more open capital account regime, such high levels of reserves are necessary as a precautionary measure against possible capital flight and currency crisis. This is certainly an important consideration, especially given the current political developments in the sub-continent and the likelihood that investors will turn and stay shy of the region at least in the short term. While the level of reserves is enormous by conventional standards, amounting to around ten months' value of imports, it is still substantially below (less than two-thirds) the stock of short-term capital in the country. Therefore some could even argue that the level of reserves should be even higher in order to protect against possible capital flight.
Unfortunately, however, the experience of numerous crises in emerging markets has made one unpleasant fact quite clear : no level of foreign exchange reserves is enough to ward off a determined speculative capital attack. Most of the countries that have experienced currency crises over the past decade had levels of reserves which were considered comfortable if not excessive, and in all these cases these reserves proved to be totally inadequate to deal with the situation and prevent bleeding outflows of capital.
Indeed, the conclusion is inescapable that large foreign exchange reserves are no substitute for capital account controls in terms of regulating both inflows and outflows and preventing destabilising movements of capital and volatility in exchange rate movements. Therefore, the currently high level of reserves should not lead to complacency with respect to averting future crises : the likelihood of these reserves being enough to protect the economy in the event of a genuine collapse in investor confidence and capital flight is extremely small.
In fact, quite an opposite conclusion can be drawn. The current pattern in the Indian economy, of large inflows of relatively "hot" money, accompanied by domestic economic recession or stagnation, may appear paradoxical but it is not particularly new. Exactly such a combination has been experienced by quite a few emerging markets over the past decade : Mexico in the early 1990s, Russia, Thailand and other Southeast Asian countries in the mid-1990s, Argentina, Brazil and Turkey thereafter.
It should be obvious from this list that this process has usually been a prelude to the balance of payments and currency crisis, as the inflows dry up because of perceived threats to future currency stability. Indeed, it is the very fact of large capital inflows, which push up real exchange rates and shift domestic incentives away from tradeable to non-tradeable sectors and re-orient domestic investment and consumption patterns, which leads eventually to current account problems. These then ultimately cause the reversal of capital flows and create the conditions for a balance of payments crisis.
Since so many developing countries have experienced this very process quite recently, all this ought to be quite well-known to our policy makers. The government – and the Finance Ministry in particular – really will have no excuse, if they choose to ignore these danger signals and do nothing at the present time, and if this eventually leads to financial stress.
But if this is going to be Mr. Singh's sole, or even major, preoccupation in the immediate term, then it may prove to be counter-productive. In fact there are far more serious danger signals looming, which suggest future trouble for the macroeconomy, and the Finance Minister will need to address these on an urgent basis if a future financial crisis is not to unravel all the attempts at economic recovery through generating more middle class purchasing power.
Consider the following features of the Indian economy at the middle of 2002. The economy is widely acknowledged to be still in recession, and though optimists have detected a turning point in recent months, there is little evidence to support this so far. The recovery in agricultural production was from the collapse of the previous year, and has been accompanied by further increases in the excess level of foodgrain stocks held by the public sector.
Industrial production decelerated further in fiscal 2001-02. The aggregate manufacturing index went up by only 2.7 per cent, and capital goods production actually declined by 4 per cent. Only consumer durables bucked the trend; in all other industrial sectors, including infrastructure, the growth rate was well below 4 per cent. Investment has probably continued to stagnate, if not decline. One important indicator of this, the assistance sanctioned and disbursed by all the All-India Financial Institutions taken together, actually declined even in nominal terms by 23 per cent over 2001-02, to less than Rs. 56,000 crore.
Nevertheless, the balance of payments indicators are, if anything, booming. One extraordinary feature of the past fiscal year has been the dramatic and unprecedented increase in the external reserve position of the RBI, by more than $12 billion just over twelve months. By the end of May, external reserves stood at more than $56 billion.
What is behind this tremendous spurt in reserves ? What is clear is that it is not any development on the trade front which has contributed. Exports over 2001-02 were stagnant, growing at a negligible 0.1 per cent over the previous year (which was substantially below even the downscaled target of 4 per cent set by the Commerce Ministry.) Meanwhile, imports actually increased slightly, by 1.1 per cent, leading to a slight increase in the trade deficit. It is true, of course, that the current account has still been kept in check, essentially because of invisible payment inflows in the form of large-scale remittances from Indian workers abroad.
The real factor behind the increase in reserves has been the large increase in various short-term and debt-creating flows, as well as a dubious category in the balance of payments data called "errors and omissions", which essentially represents extra-legal capital flows. Foreign direct investment inflows (which includes mergers and acquisitions as well as Greenfield investment) amounted to just above $3 billion. But more short-term portfolio inflows by Foreign Institutional Investors along with purchase of shares by non-residents amounted to nearly $ 3 billion as well.
Also, there has been a substantial increase in the inflows of what are classified as "banking capital", to the tune of $4.6 billion. These are debt-creating flows; indeed, most of this amount was in the form of NRI deposits, probably in the Indian Millenium Bonds and similar deposits. Since these deposits bear higher interest than available on domestic deposits or even many international bank deposits, they are really also part of the total external debt.
So what exactly is going on ? It appears that the Indian economy is now attracting capital inflows which are not being utilised productively for investment, but are simply going into piling up the external reserves held by the central bank. Of course this represent s significant fiscal loss, since the interest being paid on the various form of debt instruments which are part of the inflow is very much higher than the interest available on the deposits of foreign exchange reserves.
But even more than that, it should be borne in mind that, just as is true in the case of the excess food stocks, excess foreign currency holdings reflect an excess of ex ante savings over ex ante investment. This suggests an economy operating well below potential, and an enormous slack in terms of the use of resources. It is both a reflection of the current economic recession and a contributor to it. Also, insofar as this process is associated with rising real exchange rates (the real exchange rate of the rupee has appreciated by about 16 per cent over the past two years) it can become a further factor in domestic recession.
While the government could certainly lift the economy out of its current recession through increased productive spending which would also generate more employment and reduce the other evidence of slack (the large foodgrain stocks) so far it has proved to be remarkably inactive on this front. It is not clear whether this reflects lack of enthusiasm for such expansion, or simply incompetence.
It can be argued that in the more open capital account regime, such high levels of reserves are necessary as a precautionary measure against possible capital flight and currency crisis. This is certainly an important consideration, especially given the current political developments in the sub-continent and the likelihood that investors will turn and stay shy of the region at least in the short term. While the level of reserves is enormous by conventional standards, amounting to around ten months' value of imports, it is still substantially below (less than two-thirds) the stock of short-term capital in the country. Therefore some could even argue that the level of reserves should be even higher in order to protect against possible capital flight.
Unfortunately, however, the experience of numerous crises in emerging markets has made one unpleasant fact quite clear : no level of foreign exchange reserves is enough to ward off a determined speculative capital attack. Most of the countries that have experienced currency crises over the past decade had levels of reserves which were considered comfortable if not excessive, and in all these cases these reserves proved to be totally inadequate to deal with the situation and prevent bleeding outflows of capital.
Indeed, the conclusion is inescapable that large foreign exchange reserves are no substitute for capital account controls in terms of regulating both inflows and outflows and preventing destabilising movements of capital and volatility in exchange rate movements. Therefore, the currently high level of reserves should not lead to complacency with respect to averting future crises : the likelihood of these reserves being enough to protect the economy in the event of a genuine collapse in investor confidence and capital flight is extremely small.
In fact, quite an opposite conclusion can be drawn. The current pattern in the Indian economy, of large inflows of relatively "hot" money, accompanied by domestic economic recession or stagnation, may appear paradoxical but it is not particularly new. Exactly such a combination has been experienced by quite a few emerging markets over the past decade : Mexico in the early 1990s, Russia, Thailand and other Southeast Asian countries in the mid-1990s, Argentina, Brazil and Turkey thereafter.
It should be obvious from this list that this process has usually been a prelude to the balance of payments and currency crisis, as the inflows dry up because of perceived threats to future currency stability. Indeed, it is the very fact of large capital inflows, which push up real exchange rates and shift domestic incentives away from tradeable to non-tradeable sectors and re-orient domestic investment and consumption patterns, which leads eventually to current account problems. These then ultimately cause the reversal of capital flows and create the conditions for a balance of payments crisis.
Since so many developing countries have experienced this very process quite recently, all this ought to be quite well-known to our policy makers. The government – and the Finance Ministry in particular – really will have no excuse, if they choose to ignore these danger signals and do nothing at the present time, and if this eventually leads to financial stress.
© MACROSCAN 2002