It perhaps is a little too early
to predict the coming death of "neoliberalism",
or the economic philosophy that governments should
facilitate the functioning of "free" economic
agents rather than regulate them. More crudely put,
the idea is that markets should be left free to work
so long as they deliver profits. But globally evidence
has been growing that markets are just not working,
precipitating crises that requires bringing the state
back in. Oil prices have risen to levels close to
their inflation-adjusted historic highs and there
are no signs of quick adjustment. Governments, therefore,
need to ensure that prices in the areas they govern
are not left to the market. Financial markets that
had convinced some policy makers of their ability
to govern themselves are facing their worst crisis.
The sub-prime problem, everybody admits, is merely
a symptom of a deeper malaise which calls for a return
to intensive regulation. And the crisis in global
food markets, that has triggered food riots which
threaten to spread globally, has made clear that nations
cannot expect markets to deliver crucial public goods
like food security.
These, however, are the starkest and most critical
failures of neoliberal policy. But there have for
some time now been many areas where outcomes that
were initially considered signs of the success of
neoliberalism have turned out to be more of a problem
that an economic gain. In the Indian case, consider,
for example, the increase in foreign exchange reserves
because of a more liberal policy with regard to foreign
direct and portfolio investment and foreign borrowing.
During the 1990s the resulting accumulation of reserves,
though gradual, was quoted as evidence of the success
of neoliberal policy. In 1991, India had faced a foreign
exchange crisis. The change in policy that followed,
it is argued, ensured that we have enough and more
reserves to prevent the recurrence of any such crisis.
More recently, however, the perspective on reserves
has changed. The problem now is that we have too much.
Foreign currency assets accumulated by the Reserve
Bank of India crossed the $300 billion mark in early
April, having risen by more than $100 billion over
the previous year. Much has been written about the
difficulties this rapid accumulation creates for the
central bank in terms of both exchange rate and monetary
management. Rising reserves have as their counterpart
increases in money supply, which the RBI wants to
rein in given the inflationary conditions prevailing
in the economy. But, large and persistent inflows
of foreign currency imply that unless the RBI mops
up these dollars through its purchases, the rupee
would appreciate with adverse consequences for India’s
already beleaguered exporters. In practice, the RBI
has intervened substantially in forex markets, even
if it has not been completely successful in stalling
rupee appreciation.
Caught in this quandary, the RBI and, more recently,
the government, have been contemplating the possibility
of limiting inflows. But the efficacy of any measures
adopted towards that end would depend on the kind
of inflows that predominantly account for such accumulation.
Detailed figures on the sources of accretion of foreign
exchange reserves over the period April to December
2007 (Table 1), recently released by the RBI, permit
an assessment of the room for manoeuvre the government
has to adopt policies that can realise its goals.
The figures show that, after allowing for valuation
changes, foreign currency reserves with the RBI rose
by $76.1 billion between the beginning of April and
the end of December of 2007.
Table
1: Sources of Accretion to Foreign Exchange
Reserves |
|
April-December
2007 |
April-December
2006 |
Current
Account Balance |
-16 |
-14 |
Capital
Account (net) (a to f) |
83.2 |
30.2 |
Foreign
Investment (i+ii) |
41.4 |
12.8 |
(i)
Foreign Direct Investment |
8.4 |
7.6 |
(ii) Portfolio Investment |
33 |
5.2 |
Banking
Capital |
5.8 |
0.2 |
of
which: NRI Deposits |
-0.9 |
3.7 |
Short-Term
Credit |
10.8 |
5.7 |
| External
Assistance |
1.3 |
1 |
| External
Commercial Borrowings |
16.3 |
9.8 |
| Other
items in capital account |
7.6 |
0.7 |
| Valuation
change |
8.9 |
9.4 |
| Total
(I+II+III) |
76.1 |
27.8 |
Source:
Reserve Bank of India. |
Table
1 >> Click
to Enlarge
Among the factors underlying this rise in reserves,
are invisible receipts that helped cover a substantial
share of the deficit on the merchandise trade account
recorded during April to December 2007. According
to balance of payments figures from the RBI, gross
invisibles receipts comprising current transfers (that
include remittances from Indians overseas), revenues
from services exports, and income amounted to $100.2
billion during April to December of 2007. The increase
in invisibles receipts was mainly led by remittances
from overseas Indians ($13.8 billion) and software
services ($27.5 billion). After accounting for outflows
net invisible receipts stood at $50.5 billion.
The result of these inflows was that while on a BoP
basis the merchandise trade deficit had increased
from $50.3 billion during April to December 2006 to
$66.5 billion during April to December 2007, or by
more than $16 billion, the current account deficit
had gone up by just $2 billion from $14 billion to
$16 billion.
Given its small size, financing that deficit with
capital inflows was not a problem. The problem in
fact has turned out to be exactly the opposite: capital
inflows have been too large. Net capital inflows during
the first nine months of financial year 2007-08 amounted
to $83.2 billion. The three major items accounting
for these inflows were portfolio investments ($33
billion), external commercial borrowings ($16.3 billion)
and short term credit ($10.8 billion). To accommodate
these and other flows of smaller magnitude, without
resulting in a substantial appreciation of the rupee,
the central bank had to purchase dollars and increase
its s reserve holdings (after adjusting for valuation
changes) by as much as $76 billion or by an average
of around $8.5 billion every month. This trend has
only intensified since then with reserves having risen
by $33.8 billion between the end of December 2007
and the end of Mach 2008 or by an average of more
than $11 billion a month.
Though inflation is now the focus of policy attention
in the country, the government cannot postpone any
further dealing with this problem. The first step
the government needs to take is to put a stop to borrowing
abroad by Indian corporates, much of which is to finance
rupee expenditures. This is a clear form of a carry
trade in which loans at lower than domestic interest
rates in foreign markets is used to finance domestic
investments, some of which may even be speculative,
in the hope that the investor concerned can not merely
benefit from differentials in the rates of return
but also from the appreciation of the rupee between
the time the loan is contracted and repaid. There
is no reason why the government and the central bank
should be left with a macroeconomic muddle just because
sections of the private sector are looking for quick
returns. A return to a more stringent external borrowing
regime with lower ceilings is the obvious option for
the government.
Controlling the second of the flows that are resulting
in large accretion of foreign exchange reserves, namely,
portfolio investment flows is more difficult. This
consists of flows in which the acquisition of shares
by a single foreign investor in an Indian company
is less than 10 per cent of the aggregate shareholding.
This could occur either through the FII route involving
purchases of shares in the stock market or the private
placement route where share acquisition is ensured
through negotiations with the promoters. Acquisitions
through private placements now far exceed acquisitions
through the stock market. Thus, while the SEBI reports
that net FII inflows in the form of equity and debt
during April to December 2007 was around $18 billion
(Chart 1), the RBI reports that net portfolio investment
during the period was $33 billion. Almost as much
portfolio investment seems to be coming through the
private placement route as is happening through the
FII route.
This suits foreign investors, investments by whom
would otherwise have been constrained by the volume
of free floating shares of listed companies that are
available for trading. This is known to be small.
Private placements suit Indian promoters as well because
they are in a position to sell, at a premium, a small
slice of shares, which would not threaten their control
over the company. If these are new shares issued for
the purpose and if the premium is large enough, the
company obtains a relatively large volume of resources
to finance expansion. In return for this investment
existing shareholders who now own a part of a larger
company need to reward the foreign investors with
dividends only when profits are made. If the promoters
had resorted to borrowing instead, interest and amortisation
payments would have to be paid irrespective of the
profit performance of the company. It is of course
true that foreign investors are resorting to such
investments in the hope of selling out these shares
at a later date at an appreciated price. If such expectations
are realised, the promoters gains because it increases
the market valuation of their own shares and therefore
their net worth. If these expectations are not realised
the promoters anyway benefit from the expansion of
the company financed with funds obtained at extremely
low cost. Here again, it is the search for significant
gains by domestic wealthholders that is partly driving
the large inflow.
Chart
1 >> Click
to Enlarge
As is known it is far easier for the government through
tax-based or quantitative measures to control capital
inflows through the stock market route. Controlling
inflows through directly negotiated purchases of equity
requires retracting some of the liberalisation of
foreign investment rules that has been adopted in
recent years. Thus far the government and the nation
have borne the costs associated with this form of
profit making by foreign and domestic wealth holders.
This may be defensible for some time. But with the
inflows persisting, exchange rate and macroeconomic
management proving increasingly difficult and instability
increasing, it is time to rethink at least some of
the liberalisation that has led up to this situation.
This is one more area where, the dangers of lightly
controlled or uncontrolled markets are being driven
home. It is better to learn the lessons early rather
than be burdened with a crisis whose dimensions are
unknown and solutions unclear – as is currently true
in the world of finance globally.
