Friday, October 5, 2012

FIIS: JEOPARDISING INDIAN ECONOMY

Heavy Inflows of FII Money, Falling Exports due to Rising Rupee, And Widening Current Account Deficit! India is now walking on the same lane that Once Brought in the Asian Financial Crisis in 1997.

The RBI is currently increasing its base rates by around 25 to 50 basis points in almost every fiscal policy meeting to absorb the excess liquidity that was injected by the government to the economy earlier to lift the country’s GDP growth rate to over 8%. But in the process, it is drawing a higher inflow of foreign funds to the country’s economic system. As of now, the spread between India’s 10-year bonds and the US 10-year treasuries is standing at a record high of 5.7%, making India a hot destination for the overseas investors. In fact, considering the fact that RBI is still to reach to a peak in terms of interest rate hikes, India even stands as a better destination for FIIs as compared to other developing Asian markets where inflation is well under control (see chart) and hence chances of rate hike is lesser than India.

On the other hand, such a rush of FIIs to invest in the Indian market has created another hassle for the apex bank. As Bodhi Ganguli, Economist, Moody’s Economy points out, “All foreign-currency purchases by the RBI will have to be fully sterilised now to prevent from adding excess liquidity to the domestic economy.” But then, considering that India’s foreign currency reserve has grown over 5% from $256 billion to $269 billion between August 27 and October 29, the job in the hands of RBI does not seem to be an easy one. And if the country’s Broad Money (M3) is an indicator to be considered, then RBI is certainly struggling on this front as India’s M3 has grown by nearly 4.1% during that period to Rs.60.68 trillion (as on October 22) from Rs.58.30 trillion (as on August 27).

Many economists believe that the Asian crisis was more due to faulty policies than by market psychology. Taking a lesson from that, today, when global investors have become opportunists, Asian and Latin American developing nations have already imposed capital or currency controls to safeguard themselves against the unholy day. However, the Indian regulators have so far avoided such measures stating that they will act only if the inflows are “lumpy and volatile” or disruptive to the economy. But the billion dollar question remains, when was the last time we saw non-volatile hot money that was non-disruptive for an economy?

Add another paradoxical situation and one starts realising the gravity of the monetary side of our economy. Previously, the gold market and the real estate market together were negatively correlated to the stock market (that is, money would flow either to stock markets or to safer options like gold/houses). As things stand today, the correlation is positive. One of these will have to give pretty soon.

However, for the time being, the country can be in solace as the Planning Commission is still confident that these inflows can be absorbed by the country’s huge current account deficit. Interestingly, this was one of the reasons that in their race to attract foreign capital inflows, in 1997, the East Asian countries doomed their exports, which deteriorated their current account position and finally brought in the crisis by almost killing the value of their domestic currencies. India, at present, if not close to that position, is headed in the same direction. As noted economist Paul Krugman has argued, only growth in total factor productivity, and not capital investment, can lead to long-term prosperity. Thus, for a long term benefit of the country’s economy, today, Indian regulators must let go of the short term market benefits and put a check on the hot money flow. Else, sooner or later, India will end up being the epicentre of yet another Asian financial crisis.


Source : IIPM Editorial, 2012.
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