In India, Not All Capital Inflows Are Welcome

Op-ed in the Business Standard, New Delhi

June 27, 2012

Monday's policy announcements—in the form of further significant opening of the capital account—to restore investor confidence deserve a failing grade. The response of most analysts is that the policy changes will at best succeed in attracting capital and at worst will fail to do so. Wrong. The policy changes are bad on substance. They are possibly also troubling for what they signal about the independence of one of the few competent institutions left—the Reserve Bank of India (RBI). Consider each. Foreign capital has headed for the exit because of fundamental doubts about this government's fiscal and growth policies. To open the capital account in response will either be effective and dangerous today, or ineffective today and dangerous tomorrow. How so?

Suppose in the first scenario that the measures are effective in inducing capital to return soon. When there is a combination of high fiscal deficits, high inflation and decelerating growth, it is probably the worst time to open the capital account. The capital that returns is almost by definition going to be of the speculative sort, chasing high yields rather than long-term opportunities. This capital is, therefore, more susceptible to "sudden stops" and will contribute to the boom-bust cycle that has been the bane of the international economy these last few years, and to which Indian policy makers seem oblivious.

Furthermore, the exchange rate's decline is an unambiguously good development for India, and a necessary part of the adjustment towards faster growth. From now on, the exchange rate should only strengthen, and only be allowed to strengthen, in response to improvements in underlying productivity and growth, and not in response to speculative and reversible capital inflows. Put differently, having suffered the costs of a decline of the rupee to about 58 to the dollar, India should keep the rupee close to that level and leverage the benefits of a cheap exchange rate in the form of greater manufacturing exports without allowing those benefits to be undermined by speculative inflows. That has been the Chinese formula for keeping its export juggernaut going.

Suppose, in the alternative scenario, the measures are ineffective in attracting capital back because investors' concerns are elsewhere and remain unaddressed. Essentially, the bite of these measures will be felt later, when policies have improved and the economy has recovered. Then, capital will come pouring in because of better fundamentals, but the opening today will lead to more capital than India will want or be able to handle. At that stage, India will have further lost its ability to control inflows, and the problem will be that if the country then reverses course, Indian policies will be seen as retrograde and market-unfriendly. In other words, the opening today will lead to an unnecessary loss of policy options in the future.

And finally, even if the objective of attracting foreign capital were desirable, the policy measures were compositionally perverse because they failed to attract good capital and favored less good or even bad capital.

All the evidence suggests that foreign direct investment (FDI) is the best form of foreign capital because it brings in scarce technology and links to global markets. And the opportunity was there to liberalize restrictions on FDI in multi-brand retail, or better still to remedy the regulatory uncertainty that has affected foreign direct investors. That opportunity was spurned.

Instead, the two worst forms of foreign capital were liberalized: external commercial borrowings (ECBs) and flows into government securities. ECBs, because they are foreign-currency denominated debt, cause balance-sheet problems when capital exits and the currency plummets (dollar liabilities of companies and banks balloon in rupee terms). And at this juncture, attracting flows into the government securities market is perverse. Rather than putting pressure on the government to mend its profligate ways, facilitating easier government debt financing feeds its populist addiction. In sum, the manner in which the government is opening up to foreign capital is egregiously sinful in omission and commission.

Turn next to the independence of the RBI. For some time now, India has been witnessing the unfortunate spectacle of very senior government officials expressing opinions on monetary policies in advance of key RBI meetings. The magnitude of the interest rate cut in April as well as the advance verbal emanations from Delhi smacked of government pressure on the RBI, provoking the question whether this government believed in the independence of the RBI. Or whether it considered that that invaluable social capital could be sacrificed at the altar of short-term political expediency.

It was, therefore, heartening that earlier this month the RBI did not reduce interest rates. Most analysts applauded that decision on the merits. But that decision was also a welcome sign, actually a relief, that the RBI had maintained its independence in the face of severe political pressures. Not just the Indian economy but the Indian policymaking apparatus as a whole was better off as a result.

But Monday's policy announcements once again muddy the waters. Outsiders will never know whether the decision to further open the capital account was taken by the RBI because the government prevailed upon it or because the central bank genuinely believed in it. The latter is possible but two factors hint at government influence. First, the timing suspiciously coincided with the departure of the finance minister and his desire to make a dramatic exit. Second, it seems unlikely that the RBI, which has repeatedly criticized the government for adding to inflationary pressures through reckless fiscal policy, would have deviated from that view by allowing easier foreign financing of government deficits.

It is tragic that a whole range of policies that need to be changed are ignored and the few that are sensible are changed. It is tragically ironic that this government has not grasped that India is not savings constrained, that the accumulating international evidence suggests that all forms of foreign capital are not worthy of equal embrace, and that some are particularly unworthy of embrace at this juncture. One risk is this government's inability to meet even the minimal Hippocratic objective of doing no harm to the economy or, perhaps even more consequentially, to India's institutions.