India’s external imbalance – hiding one’s head in the sand doesn’t help

Rabindranath Tagore – India’s poet laureate’s prescription for healthy thinking was to open the doors and windows.  The Union governments did quite the opposite, yesterday when it stuck its head into sand and came up with a desultory five-point plan to deal with the growing current account deficit (CAD) – the difference between our imports and our exports of goods and services plus net current inflows (like helpful NRI remittances).

India’s creditors and the rating agencies have praised the restrained CAD below 1.9 per cent of GDP since 2013-14. This achievement came easy as oil prices declined and remained low during this period. Persistent CAD is financed by net capital inflows (the difference between inflow of foreign loans and investment and outflows of loan repayments). The International Monetary Fund expects CAD to slip from 1.9 last year to 2.6 per cent of GDP in 2018-19.

But we have been there before. In 2008 CAD was 2.6 per cent of GDP and oil price (India crude basket) was at $96 per barrel. We have also seen worse in 2012-13 with CAD at 4.8 per cent of GDP and oil price (India basket of crude) at $110 per barrel. This illustrates that no strategic structural change has been devised or seriously pursued to balance and derisk our external account. Post the 2019 elections would be a good time to start.  

A flaky five point program to combat external imbalance

The five-point program envisaged by the government includes (1) Mandatory requirements for hedging exchange risk for infra borrowers of foreign loans are to be diluted. (2) Manufacturing companies to be allowed $50 million in one-year external loans versus a minimum tenure of three years presently. (3) Maximum limits (20 per cent as a group) for Foreign Portfolio Investors and foreign corporate bondholders (50 per cent as a group) are to be removed. (4) Masala Bonds to be exempted from levying 5 per cent withholding tax on foreign bondholder income. (5) Indian banks to be allowed to underwrite the issue of Masala Bonds.

The gap between breaking news and reality

The objective of all five initiatives is to mask the real cost of incremental foreign capital inflows to finance the CAD by diluting prudential norms. None of these will actually reduce the CAD. There is a mismatch between the breaking news headline today and the reality.

Back to the future- import control

The measures announced to reduce the underlying CAD were very regressive and paltry. Consider – controlling unnecessary imports – what is that? High end German, British and Japanese cars – but what about the linked exports? Aircraft fuel? Gucci handbags? Are we seriously keen to slip back so casually into the “license raj” again? Isn’t a more realistic exchange rate the best hands-off option to balance external flows?

 Export pessimism is dominant

The prevailing export pessimism, within the government, is breathtaking.  It was Mr Jaitley, who as Finance Minister proposed last year, liberalised intrastate movement and exports of agricultural products with export facilitation infrastructure at the point of production (state of the art warehousing) and at ports. These proposals lie moribund, even as we are back to bean counting.

Strong Rupee remains an emotive slogan

Financing the CAD by creating an artificially high supply of dollars seems to have gained prominence as a measure to contain the depreciation of the INR. But doing so by relaxing prudential controls on foreign debt inflows, particularly of short tenure or by encouraging the inflow of hot money inflow into equity markets are poor short-term options.

Are we creating new NPAs – this time in foreign denominations

The class of business which will be attracted to foreign loans rather than domestic financing are the very same who are “impaired” from using local refinance since the friendly Indian banks have turned righteously prudent over-night. These very same Indian Banks are also being encouraged to underwrite the proposed Masala Bonds – bonds floated overseas but denominated in INR so the foreign lender takes the exchange risk. This is a sexy, niche product.

Masala Bonds – a sexy but niche product

The International Finance Corporation – a World Bank affiliate tickled India’s ego by issuing the first such bond in 2014 for Rs 10 billion for its India based investments followed by another in 2015 for Rs 3.2 billion. HDFC (India’s primary private housing loan company) raised Rs 30 billion in 2016 and NTPC (India’s premier publicly owned power generator) raised Rs 20 billion – all in the London Stock Exchange. Once the new International Financial Centre is up and running in GIFT City, Gujarat it could become the home of Masala Bonds. But for now, the dollar inflow from such Bonds is likely to be minimal at US$ 500 million even if NTPC were to issue a second series during this fiscal.

The government and Mr Jaitley should not be stampeded into doing something, anything, to show that it is in control on the CAD issue. No foundational reform is possible at this late stage. What we should be looking at are the least harmful bandaids.

Use big data to prune “hawala” transactions from export-import statistics

First, is it possible in the short term to use big data to prise open cases of under-invoicing of exports and over-invoicing of imports. These tactics overestimate CAD and facilitate cross-border illicit capital flows. Are we using big data to monitor the 100 top potential fraudsters? Can such statistical diligence prune CAD by 10 per cent?

Green light corridors for painless export transit

Second, what about removing export pain points by reducing transaction costs for export? Creating “green transit” channels for export from factory to exports, in the manner vital organs are transported, can help.

Get buy-in on export orientation from state governments

Determine fiscal incentives for states which boost their exports above the mean national growth in exports.

Competitive interest rates, capital controls and market determined exchange rate are good short term policy objectives

The RBI, rightly so, will not let go of managing interest rates strategically to contain inflation. This is sound politics too. Increasing interest rates to remain competitive is also imperative for avoiding capital flight. The RBI has the reserves to fend off a speculative attack on the exchange rate of the INR. But a gradual adjustment to the real value of the INR is inevitable. We should be ready to use $20 billion of the RBI’s reserves for this purpose till the elections are over, rather than look for hot foreign capital.

FM can correct awry market expectations

Markets move on expectations. Mr Jaitley must convince participants that he is not focused on keeping the Sensex over-valued or the INR at mythically high levels as markers of economic strength. The government is doing what it can to make the most of a bad externally driven situation. We are not alone in this quandary.

Keep economic ambitions low and your powder dry

Decent growth at around 7 per cent in 2018-19 and sticking to the fiscal deficit target of around 3 per cent of GDP whilst ensuring that state-level fiscal deficits remain within an aggregate 3 per cent of state GDP can burnish the India, growth with stability.

Also available at Times Blogs September 15, 2018 https://blogs.timesofindia.indiatimes.com/opinion-india/indias-current-account-deficit-sticking-ones-head-in-the-sand-wont-help/