Themes > Economic Briefs
There has been
a Substantial Increase in India's Dependence on Foreign Finance since
1990-91. Are we Slipping Deeper into the Debt Trap?
What are the chances of
India Avoiding a Balance of Payments Crisis as in 1991, in the Medium Term
Future?
When the current adjustment effort under the
auspices of the IMF began in 1991, the essential imbalance was the deficit
in the current account of the balance of payments, that had become unsustainable
because of India's loss of creditworthiness abroad. At that point of
time the deficit on the current account amounted to just less than 3
per cent of GDP, and the strategy of stabilisation adopted by the government
essentially involved a substantial cutback in the fiscal deficit on
its budget. In 1992/93 India's exports amounted to $18.5 billion against
$18.2 billion in 1990/91, while imports were $21.9 billion against $20.3
billion. That is, exports registered just a 1.6 per cent increase in
dollar terms during 1992/93, and despite the recession-induced sluggishness
in import growth, the current account deficit stood at 2.2 per cent
of GDP, as compared with 2.9 per cent in 1988/89, 2.5 per cent in 1989/90,
2.6 per cent in 1990/91 and 1.1 per cent in 1991/92 (when import compression
measures were adopted in the face of a BoP crisis). That is, with the
relaxation of import compression, imports increased and worsened the
trade deficit. These features the government argued had been transformed
completely in 1993/94 when exports rose by 20 per cent in dollar terms
to $22.2 billion, while imports rose by just 5.9 per cent to $23.2 billion.
Three years of recession appeared to be showing up in a reduction in
the trade deficit and an improvement in the current account balance.
However, evidence in the first six months of 1994/95 shows that while
export growth is running at 11.5 per cent, import growth has touched
16.1 per cent. Thus the trade, and in all probability the current account,
deficit is returning to levels close to the crisis year.
That is, the principal target of the adjustment effort, namely a reduction in the deficit on the current account of the balance of payments had not been achieved at all. To finance this deficit, India has had to rely on substantial inflows of debt. Going by the government's estimates, India's external debt rose by $4.8 billion from a total of $85.3 billion at the end of March 1992 to $90.1 billion at the end of March 1993. This comes in the wake of an average increase of $4.5 billion a year between end- March 1989 and end-March 1992, which is expected to result in a peaking of repayments next year. The threat of another crisis is more than real.
This is true even when we consider some recent changes in India's access to international finance. With Indian firms having mopped up large sums of dollars through Euro-issues over the last 2 years, and foreign institutional investors having pumped in additional volumes of capital into Indian secondary markets during the last year, India is being presented as one more of the world's "emerging markets". That term is now the buzzword in international financial markets, where mainstream investors are finding risk-discounted returns in the developing countries much better than in the developed. As a result out of a total of $2.4 billion of foreign capital that came into India between April 1992 and December 1993, $1.6 billion was in the form of portfolio capital.
A number of factors explain the interest in these emerging markets. The recession in the developed countries, where growth averaged just 1.5 per cent over the first 3 years of the 1990s, has increased risk and reduced returns in their product and share markets substantially. Many shares are seen to be overpriced relative to corporate performance. At the same time growth in some of the more successful developing countries amounted to a creditable 6 per cent, providing investment opportunities and rendering their stockmarkets buoyant. The fact that movements in stock markets in the developed and some of the developing countries were contrary, provides the classic basis for hedging against risk through portfolio, as opposed to fixed, investment. Second, most developing countries, including good and poor growth performers, were opting for more open economic regimes that affected foreign investment regulations, on the one hand, and financial and foreign exchange markets, on the other. In fact fiscal caution, deregulation, privatisation, trade liberalisation, financial reform and currency convertibility are the pillars of policy in most developing countries. This, independent of returns, has opened up markets that were earlier closed to the mainstream investor. Finally, financial innovations in investor countries are helping financial institutions to hold a larger share of foreign paper. One such innovation is the American depository receipt (ADR), which under provision 144A of the rules governing disclosure and registration of equities, makes it possible for a company from a developing country, to issue shares in America. To quote The Economist: "ADRs are tradable instruments, quoted in dollars and paying dividends in dollars. They are issued by American banks, which certify that the receipts are backed by a corresponding amount of equities, held abroad on behalf of the bank." ADRs which are launched simultaneously in several markets are known as GDRs (global depository receipts).
These developments have had a noticeable effect on international financial flows to India. Even as early as 1990 external financial flows into India were shifting away from the official sector. That sector - comprising the government and the RBI - accounted for an overwhelming 80 per cent of the foreign liabilities in the 1970s, but found its contribution touching a low of 52 per cent at the end of March 1990. On the other hand, the share of the non-official sector, consisting of corporate enterprises, commercial banks and insurance companies, in the country's net foreign liabilities rose from 27 per cent in March- end 1980 to 48 per cent at the end of March 1990. That shift, however, reflected India's growing reliance on external commercial borrowing and non-resident bank deposits during the 1980s as compared with the 1970s, when the country was still largely dependent on concessional external finance. Matters are beginning to change more recently, with India attracting international attention because of its IMF-financed structural adjustment programme, resulting in the large inflows of portfolio capital noted earlier.
The causes for this flurry of interest are not hard to find. Trade liberalisation, deregulation, changed foreign investment rules and financial reform, have all played their part. But so have high rates of return. Returns to foreign direct investors in India are known to be lucrative by international standards, as are stockmarket returns according to the International Finance Corporation's assessment for 1992. Seen in terms of the price index, India registered a return of 22.1 per cent, which put her at ninth place among the newly emerging markets. In terms of total return, India was sixth with 22.89 per cent. Not surprisingly, in the growing secondary market for Indian GDRs, almost all issues are reportedly trading at a premium and Reliance is now entering the market with a convertible bond issue of $125 million at a premium of around 10 per cent.
The euphoria about future inflows that these developments have encouraged has resulted (as in the 1980s with regard to commercial borrowing) in an almost total loss of caution. In the months to come, it is the quantum of external finance that can be mobilised by the private sector, rather than its implications for economic performance in the medium and long term, that would dominate the discussion. The question however remains: Is the new trend indeed something positive from the point of view of balance of payments finance and growth?
At present, FDI inflows are hardly of a kind that promise a net inflow in the medium term. They are aimed at expanding the profit repatriation base in firms already controlled by transnationals or at purchasing shares of the domestic market, rather than increasing export competitiveness and revenues. That is, direct investment inflows are of a kind that increase vulnerability. Unfortunately, the same appears to be true of portfolio inflows among which we must distinguish between capital flowing in through new issues and that being invested in secondary markets by foreign institutional investors.
As far as new issues of equity and bonds are concerned, they reflect the desire of Indian corporate organisations to mobilise foreign exchange resources, partly because of their need for foreign currency and partly because interest rates on international borrowing are competitive even after allowing for the higher costs of mobilising such finance. This implies that a significant part of the foreign resources mobilised would be directly spent on imports, and the rest would join the pool of reserves with the Reserve Bank of India. Once the resources are mobilised, however, the responsibility of the unit concerned ends. Any foreign exchange required to finance dividend repatriation, interest payments, amortisation and payments for shares sold has to be met by the RBI whenever necessary.
In the case of shares purchased by institutional investors in the secondary market there is no connection between such 'mobilisation' of foreign exchange and imports. Hence the whole of the sum involved enters the pool of reserves, but as is true of the primary market, that reserve has also to meet all payments on account of dividends or capital repatriation after sale of shares.
These features of the new form of portfolio finance have two major implications. First, since it is impossible to link foreign exchange access to foreign exchange earning capacity, there is a real possibility that expenditure of foreign exchange today may exceed that warranted by the future ability to pay out foreign exchange, unless the trend of additional inflows remains more than adequate to meet these requirements. Second, since a part of the inflow is not directly linked to imports, mobilisation of finance through these means can lead to a build up of reserves that strengthens the domestic currency and undermines export competitiveness, unless of course the underlying process of growth in the economy raises the demand for imports and exhausts a part of these reserves.
Thus portfolio inflows can represent a "no-win" situation if everything else remains constant. If they are used to finance imports directly, they are encouraging foreign exchange profligacy by delinking expenditure of foreign currency from the ability to earn it. On the other hand, if they are not used to finance imports, they result in an accumulation of reserves, a consequent appreciation of the domestic currency, a decline in export competitiveness and a worsening of the current account of the balance of payments. To boot, an increase in reserves by leading to an increase in money supply reduces the government's influence over monetary trends and its macroeconomic control through monetary policy.
One situation in which this need not hold is when the government resorts to deficit-financed expenditure to boost growth and uses the excess foreign exchange to meet the import requirements of that strategy. And such a strategy can prove virtuous if the autonomous growth in exports that accompanies growth is adequate to meet the service payments on the implied foreign exchange expenditure. In practice, however, portfolio capital favours those countries with "stable macroeconomic policies", which include an unwillingness of the government to resort to large budgets deficits. Nor is there any guarantee that portfolio inflows would be coincidentally accompanied by an 'autonomous' export boom. That is, the preconditions for portfolio inflows to be positive from the point of view of the balance of payments and growth are either difficult to realise or entirely fortuitous.
That is, the principal target of the adjustment effort, namely a reduction in the deficit on the current account of the balance of payments had not been achieved at all. To finance this deficit, India has had to rely on substantial inflows of debt. Going by the government's estimates, India's external debt rose by $4.8 billion from a total of $85.3 billion at the end of March 1992 to $90.1 billion at the end of March 1993. This comes in the wake of an average increase of $4.5 billion a year between end- March 1989 and end-March 1992, which is expected to result in a peaking of repayments next year. The threat of another crisis is more than real.
This is true even when we consider some recent changes in India's access to international finance. With Indian firms having mopped up large sums of dollars through Euro-issues over the last 2 years, and foreign institutional investors having pumped in additional volumes of capital into Indian secondary markets during the last year, India is being presented as one more of the world's "emerging markets". That term is now the buzzword in international financial markets, where mainstream investors are finding risk-discounted returns in the developing countries much better than in the developed. As a result out of a total of $2.4 billion of foreign capital that came into India between April 1992 and December 1993, $1.6 billion was in the form of portfolio capital.
A number of factors explain the interest in these emerging markets. The recession in the developed countries, where growth averaged just 1.5 per cent over the first 3 years of the 1990s, has increased risk and reduced returns in their product and share markets substantially. Many shares are seen to be overpriced relative to corporate performance. At the same time growth in some of the more successful developing countries amounted to a creditable 6 per cent, providing investment opportunities and rendering their stockmarkets buoyant. The fact that movements in stock markets in the developed and some of the developing countries were contrary, provides the classic basis for hedging against risk through portfolio, as opposed to fixed, investment. Second, most developing countries, including good and poor growth performers, were opting for more open economic regimes that affected foreign investment regulations, on the one hand, and financial and foreign exchange markets, on the other. In fact fiscal caution, deregulation, privatisation, trade liberalisation, financial reform and currency convertibility are the pillars of policy in most developing countries. This, independent of returns, has opened up markets that were earlier closed to the mainstream investor. Finally, financial innovations in investor countries are helping financial institutions to hold a larger share of foreign paper. One such innovation is the American depository receipt (ADR), which under provision 144A of the rules governing disclosure and registration of equities, makes it possible for a company from a developing country, to issue shares in America. To quote The Economist: "ADRs are tradable instruments, quoted in dollars and paying dividends in dollars. They are issued by American banks, which certify that the receipts are backed by a corresponding amount of equities, held abroad on behalf of the bank." ADRs which are launched simultaneously in several markets are known as GDRs (global depository receipts).
These developments have had a noticeable effect on international financial flows to India. Even as early as 1990 external financial flows into India were shifting away from the official sector. That sector - comprising the government and the RBI - accounted for an overwhelming 80 per cent of the foreign liabilities in the 1970s, but found its contribution touching a low of 52 per cent at the end of March 1990. On the other hand, the share of the non-official sector, consisting of corporate enterprises, commercial banks and insurance companies, in the country's net foreign liabilities rose from 27 per cent in March- end 1980 to 48 per cent at the end of March 1990. That shift, however, reflected India's growing reliance on external commercial borrowing and non-resident bank deposits during the 1980s as compared with the 1970s, when the country was still largely dependent on concessional external finance. Matters are beginning to change more recently, with India attracting international attention because of its IMF-financed structural adjustment programme, resulting in the large inflows of portfolio capital noted earlier.
The causes for this flurry of interest are not hard to find. Trade liberalisation, deregulation, changed foreign investment rules and financial reform, have all played their part. But so have high rates of return. Returns to foreign direct investors in India are known to be lucrative by international standards, as are stockmarket returns according to the International Finance Corporation's assessment for 1992. Seen in terms of the price index, India registered a return of 22.1 per cent, which put her at ninth place among the newly emerging markets. In terms of total return, India was sixth with 22.89 per cent. Not surprisingly, in the growing secondary market for Indian GDRs, almost all issues are reportedly trading at a premium and Reliance is now entering the market with a convertible bond issue of $125 million at a premium of around 10 per cent.
The euphoria about future inflows that these developments have encouraged has resulted (as in the 1980s with regard to commercial borrowing) in an almost total loss of caution. In the months to come, it is the quantum of external finance that can be mobilised by the private sector, rather than its implications for economic performance in the medium and long term, that would dominate the discussion. The question however remains: Is the new trend indeed something positive from the point of view of balance of payments finance and growth?
At present, FDI inflows are hardly of a kind that promise a net inflow in the medium term. They are aimed at expanding the profit repatriation base in firms already controlled by transnationals or at purchasing shares of the domestic market, rather than increasing export competitiveness and revenues. That is, direct investment inflows are of a kind that increase vulnerability. Unfortunately, the same appears to be true of portfolio inflows among which we must distinguish between capital flowing in through new issues and that being invested in secondary markets by foreign institutional investors.
As far as new issues of equity and bonds are concerned, they reflect the desire of Indian corporate organisations to mobilise foreign exchange resources, partly because of their need for foreign currency and partly because interest rates on international borrowing are competitive even after allowing for the higher costs of mobilising such finance. This implies that a significant part of the foreign resources mobilised would be directly spent on imports, and the rest would join the pool of reserves with the Reserve Bank of India. Once the resources are mobilised, however, the responsibility of the unit concerned ends. Any foreign exchange required to finance dividend repatriation, interest payments, amortisation and payments for shares sold has to be met by the RBI whenever necessary.
In the case of shares purchased by institutional investors in the secondary market there is no connection between such 'mobilisation' of foreign exchange and imports. Hence the whole of the sum involved enters the pool of reserves, but as is true of the primary market, that reserve has also to meet all payments on account of dividends or capital repatriation after sale of shares.
These features of the new form of portfolio finance have two major implications. First, since it is impossible to link foreign exchange access to foreign exchange earning capacity, there is a real possibility that expenditure of foreign exchange today may exceed that warranted by the future ability to pay out foreign exchange, unless the trend of additional inflows remains more than adequate to meet these requirements. Second, since a part of the inflow is not directly linked to imports, mobilisation of finance through these means can lead to a build up of reserves that strengthens the domestic currency and undermines export competitiveness, unless of course the underlying process of growth in the economy raises the demand for imports and exhausts a part of these reserves.
Thus portfolio inflows can represent a "no-win" situation if everything else remains constant. If they are used to finance imports directly, they are encouraging foreign exchange profligacy by delinking expenditure of foreign currency from the ability to earn it. On the other hand, if they are not used to finance imports, they result in an accumulation of reserves, a consequent appreciation of the domestic currency, a decline in export competitiveness and a worsening of the current account of the balance of payments. To boot, an increase in reserves by leading to an increase in money supply reduces the government's influence over monetary trends and its macroeconomic control through monetary policy.
One situation in which this need not hold is when the government resorts to deficit-financed expenditure to boost growth and uses the excess foreign exchange to meet the import requirements of that strategy. And such a strategy can prove virtuous if the autonomous growth in exports that accompanies growth is adequate to meet the service payments on the implied foreign exchange expenditure. In practice, however, portfolio capital favours those countries with "stable macroeconomic policies", which include an unwillingness of the government to resort to large budgets deficits. Nor is there any guarantee that portfolio inflows would be coincidentally accompanied by an 'autonomous' export boom. That is, the preconditions for portfolio inflows to be positive from the point of view of the balance of payments and growth are either difficult to realise or entirely fortuitous.
© MACROSCAN 2002