Media reports and assessments
by public and private financial institutions make
clear that India invites and enjoys global attention
as one of the high growth, emerging markets n the
world economy. Along with China, Brazil and Russia,
it is one of the countries captured in the BRIC acronym
coined by international financial firms keen on talking
up these economies so that they attract investors
and deliver large commissions and fees to firms that
broker or mediate such investments. In the resulting
transition from fact, to hype and fable, India is
being presented as an economy that not merely grows
much faster than other global contenders, but is populated
by firms that are aggressively buying into global
assets and workers who are eating into global jobs
by underwriting cheap exports or through real or digital
migration. In the new Asian century, while the erstwhile
tigers of East Asia have lost momentum, India and
China are presented as contenders for supremacy.
This perception of India as an uncaged tiger in the
global system derives whatever strength it has from
developments during the last four years when India,
like other emerging markets, has been the target of
a surge in capital flows from the centres of international
finance. And India has emerged as a leader among these
markets over the last one year or so, when India’s
integration with the global economy has intensified
considerably.
The recent intensification has implied a qualitative
change in India’s relationship with the world system.
Till the late 1990s, India relied on capital flows
to cover a deficit in foreign exchange needed to finance
its current transactions, because foreign exchange
earned through exports or received as remittances
fell short of payments for imports, interest and dividends.
More recently, however, capital inflows are forcing
India to export capital, not just because accumulated
foreign exchange reserves need to be invested, but
because it is seeking alternative ways of absorbing
the excess capital that flows into the country. New
evidence released by the Reserve Bank of India on
different aspects of India’s external payments point
to such a transition.
The most-touted and much-discussed aspect of India’s
external payments is the sharp increase in the rate
of accretion of foreign exchange reserves. During
the first six months (April to September) of financial
year 2007-08, the net addition to India’s stock of
foreign exchange reserves amounted to $40.4 billion
(ignoring the effects of changes in the relative values
of currencies). The comparable figure for the corresponding
period of the previous year was just $8.6 billion.
This surge in the pace of reserve accumulation had
by September 28, 2007 taken India’s foreign exchange
reserves to $248 billion. Being adequate to finance
more than 15 months of imports, these reserves were
clearly excessive when assessed relative to India’s
import requirements. More so because net receipts
from exports of software and other business services
and remittances from Indian’s working abroad had contributed
between $28-29 billion each during 2006-07, financing
much of India merchandise import surplus. Viewed in
terms of the need to finance current transactions,
which had in the past influenced policies regarding
foreign exchange use and allocation, India was now
forex rich and could afford to relax controls on the
use of foreign exchange. In fact, the difficulties
involved in managing the excess inflow of foreign
exchange required either restrictions on new inflows
or measures to increase foreign exchange use by residents.
The government has clearly opted for the latter.
Not surprisingly, the pace of reserve accumulation
has been accompanied by evidence that Indian firms
willing to exploit the opportunity offered by liberalized
rules regarding capital outflows from the country
are resorting to cross-border investments using the
“invasion currency” that India’s reserves provide.
Even though evidence is available only till the end
of June 2007, this trend (that has intensified since)
is already clear. Figures on India’s international
investment position as of end-June 2007 indicate that
direct investment abroad by firms resident in India,
which stood at $10.03 billion at the end of March
2005 and $12.96 billion at the end of March 2006,
had risen sharply to $23.97 billion by the end of
March 2007 and $29.39 billion at the end of March
2007 (Chart 1). The acceleration in capital outflows
in the form of direct investments from India to foreign
countries had begun, as suggested by the anecdotal
evidence on the acquisition spree embarked upon by
Indian firms in areas as diverse as information technology,
steel and aluminum.
Chart
1 >> Click
to Enlarge
Does this suggest that using the invasion currency
that India has accumulated, the country (or at least
its elite firms) is heading towards sharing in the
spoils of global dominance? The difficulty with this
argument is that it fails to take account of the kind
of liabilities that India is accumulating in order
to finance its still incipient global expansion. As
has been noted in these columns, unlike China which
earns a significant share of its reserves by exporting
more than it imports, India either borrows or depends
on foreign portfolio and direct investors to accumulate
reserves. China currently records trade and current
account surpluses of around $250 billion in a year.
On the other hand, India incurs a trade deficit of
around $65 billion and a current account deficit of
close to $10 billion. Its surplus foreign exchange
is not earned, but reflects a liability.
To take the most recent period for which data is available,
India had recorded a current account deficit of $10.7
billion on its balance of payments during April-September
2007. Despite earning $15.4 billion from net exports
of software and business services and receiving net
remittances of $18.4 billion during those six months,
India had an overall deficit in its current account
because of a large negative merchandise trade balance.
This deficit had to be financed with capital imports.
But this is where the change in India’s external engagement
is occurring. The $10.7 billion current account deficit
recorded during April-September 2007, was not very
much higher than the $10.3 billion deficit relating
to the corresponding months of 2006. However, while
during April-September 2006 India received capital
flows amounting to just $18.9 billion to finance the
deficit and leave a small capital surplus, it received
a massive $51.1 billion during April-September 2007
resulting in the acceleration of reserve accumulation.
Chart
2 >> Click
to Enlarge
The implication is that excess capital flows account
for all of the accretion of foreign exchange reserves
(excluding valuation changes) in India. The composition
of such accretion needs examining (Chart 2). Of the
$51.1 billion net inflow of capital during April-September
2007, net inward foreign investment ($22.2 billion)
and external commercial borrowing ($10.6 billion)
account for an overwhelming share. What is more, within
foreign investment, it is not direct investment but
portfolio investment that dominates. According to
the Reserve Bank of India’s Balance of Payments statistics,
during the first six months of financial year 2007-08
(April-September), net direct investment by foreigners
in India amounted to $9.86 billion. However, this
was the period when Indian firms were increasing their
investments abroad. As a result, net direct investment
from India to foreign countries amounted to $5.97
billion. This, implies that the net inflow into the
country on account of direct investment amounted to
just $3.89 billion. The bulk of the inflow on the
investment side was on account of portfolio flows.
Net inflows of portfolio investments by foreigners
amounted to $18.3 billion, whereas net outflows on
account of Indian investments abroad were a meagre
35 million. In addition, aiming to benefit from the
much lower interest rates abroad, the Indian corporate
sector has increased its borrowing from abroad. Once
we take account of the resulting large inflows of
external debt being incurred by private players in
India, much of India's foreign exchange reserve accumulation
is explained.
Thus, the acceleration in the pace of reserve accumulation
in India is not due to India’s prowess but to investor
and lender confidence in the country. But the more
that confidence results in capital flows in excess
of India’s current account financing needs, the greater
is the possibility that such confidence can erode.
This could happen for two reasons. First, the build
up of debt and short-term portfolio inflows that imply
interest, dividend and capital outflow commitments,
also implies that the volume of such commitments rises
relative to India's ability to earn foreign exchange
from exports of goods and services and access foreign
exchange through remittances from migrant workers.
As the cost of debt and investment servicing rises
relative to current foreign exchange earnings, concerns
about India's “real” ability to sustain this trajectory
are bound to arise.
Further, there are signs that India’s capacity to
earn foreign exchange from exports may be diminishing
because of the appreciation in the value of the rupee
that capital inflows result in. During April-September
2006, merchandise exports (on a balance of payments
basis) rose by 22.9 per cent relative to the corresponding
months of the previous year and exports of software
and business services by 38.3 per cent. On the other
hand, the corresponding figures for April-September
2007 were 19.9 and 4.6 per cent respectively. In the
case of services, this is a sharp slowdown indeed.
If this continues, India may have to use capital inflows
to meet commitments related to past inflows.
A second reason why investor confidence may wane is
that much of the inflows into India are in the form
of portfolio flows. This implies that, unlike in the
case of China, the contribution of foreign capital
inflows to India’s export earnings is small. It also
means that these flows are more easily repatriated
and the probability of a quick exit is significant.
Therefore, a rising capital liability of this kind
could erode foreign investor confidence, and the reserves
and investments that give India its current "strength"
can shrink.
The difficulty is that the misplaced domestic confidence
that rising reserves create and the difficulties and
costs associated with managing those reserves, is
encouraging the government to favour profligate foreign
exchange use by both firms and individuals. The obsession
with acquisitions abroad, the full benefits of which
for the country are yet to be assessed, is one element
of this new attitude. The decision to allow resident
individuals to transfer sums up to $200,000 a year
for use in any form, is another. That is, capital
import rather than export success is leading to a
resurgence of foreign exchange profligacy in a form
very different from that witnessed during the second
half of the 1980s, when borrowed foreign exchange
was used to finance non-essential imports. The 1980s
episode led to the foreign exchange crisis of 1991.
What this episode would deliver is yet to be seen.
