Normally in times of uncertainty, funds will flow out rather than in. Presumably, election times are not exactly those intervals when things are crystal clear. Hence, one could assume that funds should not have flown into India the way it is happening currently.
Two questions rise in this context. Why are funds coming into India now/ And secondly can we really handle such inflows without creating some problems for ourselves. Some three years, one may recall we had gone through a similar phase. At that time when Quantitative Easing was being introducing without infusion of unprecedented amount of liquidity into the global system, funds were flowing gleefully into the emerging market economies. Some of the countries had witnessed assets price spiral and their exchange rates had also climbed up.
Select emerging market leaders, including the president of Brazil, had protested then about the consequential funds flow from the advanced economies into the emerging market ones. The common refrain was these flows were disrupting the normal rhythm of their economies and introducing instability in financial markets and as a spillover effect I the real economies. Thus, for example, when exchange rate was appreciating, they feared, exports would get hurt. Is something similar happening to India now. We are witnessing huge inward flows. Since September last year, no less than $12 billion have come into India. Maybe, this is good for the time being as we are having little problem meeting the deficits in trade account of the rupee is appreciating. Reserve Bank of India apparently getting a fresh window to build its foreign currency reserve and this growing muscles to tackle emergencies.
It should be noted that this time funds flows are not ubiquitous. These are coming in selectively into India; other emerging market economies are being bypassed. Why? Because many of them are not in the best of health and some have current account deficits that foreign investors see as source of potential crisis.
In contrast, India’s current account deficit has come down sharply. AT the present levels these are manageable. The budget deficits also look decently pared.
But then, as we are getting more funds, on expectations of a stable government after the election which can give a boost to overall growth, are we getting into a kind of bubble. The stock market has gone past 22,500 of the BSE Sensex. Rupee is also racing towards 58 to a dollar. As recently as last August the exchange rate was threatening to touch 70 to a dollar. India was included in the band of the Frail Five from the star group of the rising BRICS.
If outflow is bad, too much of inflows in too short a time is not good either. These are after all hot money and the funds come in as fast as they leave. The consequence is instability in the economy. Despite the US Fed’s tapering of the bond purchase programme under its new chairman, the funds flow into India proving to be overwhelming. We should now recognise that and start acting.
What are the actions possible in the current context?
RBI governor Rajan had taken the first initial step. He had forbidden FII investments in short term government securities, called the treasury bills. Instead, he had stipulated in yesterday’s credit statement that FIIs should invest only in longer dated securities of one-year and above. This he has done to stop too much funds flow – in and out – to take advantage of interest rate on shorter term money so that volatility in interest rates do not result in sharp fluctuations in exchange rate.
We had also seen that since last May when Fed had announced its decision to start tapering its bond purchase programme, that is gradually scrap Quantitative Easing, funds were p[primarily withdrawn from Indian debt markets and that has caused huge instability and erosion in rupee value.
Opening up the government of India debt market to overseas investors was the prime factor which had opened the gates of such short term debt investments. Maybe, taking RBI logic a little further, could be government securities market be further closed to FII investment. Do we really need overseas investment in GoI papers to fund budget deficit. Even for the sake of developing Indian debt market, is it not introducing too much incidental risks and instability?
Many other restrictive actions could be thought of. Even the talk of a lock-in period is the ultimate bear-bug for the institutional investor. But that is when we are trying to attract funds. When we should have a rethink on inward flows, some prospective lock-in in some categories could be mooted. That will act as a brake on too much inflow of hot money.
After all, why do we need such hot money. As finance minister Chidambaram had stated in his budget speech, we had to attract to funds from overseas to bridge the gap in our current account. That was the biggest mistake. Dependence on money flows from overseas had introduced helplessness in directing our own affairs ourselves. The ill effects of such a strategy had now been realised and subsequently the effort was to cut down such deficits. Today, in his latest press conference at the AICC office, he displayed with pride how current account deficit had narrowed drastically.
China never had any deficit on external account. For as long as one remembers, that country is running sur0pluses only. It was not ruffled even in the least al through the instability following Fed’s decision to pare bond purchase programme. Instead, of trying to attract portfolio investment, which has restrictions, China is ever attracting FDI. We can possibly learn some lessons there.
Maybe, this is the best time for a reboot when things are fine. A check could help us avoid too much instability later. IPA