India’s Obsession with Foreign Capital “Good or Bad”

The Indian economy is facing a macroeconomic crisis. The external imbalance (whether measured by the trade balance or the current account) is well beyond what can be called normal. The nominal value of the rupee has fallen more than the currencies of other emerging market economies this year. Our finance minister has come under lots of criticism for his ignorance about the definition of current account. He (and many others) defines it as dollar payments minus dollar receipts. Truly speaking his ignorance is the main reason for ill-designed policies and obsession with foreign exchange inflows. He based on his understanding is doing everything possible to attract foreign inflows through foreign direct investment, foreign institutional investment, external commercial borrowings or ECBs (which are capital account items). India has received over nine billion dollars from two foreign schemes, which were announced in September to attract foreign funds and help the country to bridge the widening current account deficit (CAD).

Recently one of the senior bureaucrats in finance ministry said, “We have done our arithmetic to get some additional flows, including through quasi-sovereign bonds issued by public sector finance institutions…..They are preparing for a programme and according to that it will be decided”. Instead of tackling the current account deficit in strategically this government is targeting the foreign capital. In the short-run we can use foreign capital to manage current account deficit but certainly we can’t rely on foreign inflows for sustaining the whatsoever amount of deficit. The obsession with foreign capital has other detrimental effects for the economy. With foreign currency inflows, our currency gets appreciated and export gets hurt. So reliance on foreign capital doesn’t allow the current account deficit problem to be solved by the exchange rate fluctuations. Foreign inflows are fickle everywhere there is no surprise in sudden stops and reversal of inflows.

Their volatile nature leads to unwarranted volatility in the foreign exchange market and Central Banks find it difficult to achieve other targets and it interferes with the independent monetary policy of the central bank. Recently in a Jackson Hole Symposium one of the presenter argued that the Trilemma ( A central Bank Can’t have all three, Independent Monetary Policy, Free flow of Capital and Flexible exchange rate) has reduced to Dilemma, with flexible and fixed both types of exchange rate regime restricted capital flow is required for Independent Monetary Policy.

Foreign inflows increase the domestic money supply and to prevent that central banks have to do sterilisation. Central Bank has to issue bonds to suck the liquidity by issuing bonds and more and more issue of fresh bonds raises domestic interest rates. Rising domestic interest rates lead to the decline in investments by the firms dependent on the domestic market for borrowing. The large firms go abroad to raise the funds at a cheap rate and they fall in the trap of the debt in foreign currency. In last few year Indian firms have borrowed a lot because of government reliance on foreign capital for managing the current account deficit and have become quite vulnerable. Depreciation of currency beyond a certain level can be devastating for the firms having foreign currency debt. Therefore, obsession with foreign inflows is subsidising foreign investment in comparison to domestic investments and making our firms more vulnerable.

Foreign reserves with Central Bank has to be invested mostly in US treasury that give a low return and the bonds issued by Central Banks for the sterilisation has to be paid a higher interest rate leading to unnecessary cost. Foreign inflows matter for investing as developing countries need capital, but certainly not for consumption as our government is doing.

India’s growth story has been largely driven by domestic saving and so the government is oblivious and is obsessed with foreign inflows for managing Sensex. It looks like that our finance ministry is doing Sensex targeting instead of targeting inflation or unemployment. Instead of focusing on foreign capital for managing current account deficit by foreign inflows, our government must act on the manufacturing sector, that will solve the current account deficit problem and at the same time will lead to the generation of employment opportunities and economic growth. China has done that, why can’t we?

Originally published at on October 31, 2013.

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