The events surrounding Cyprus signals that the worst is not over. The free capital mobility model is almost certainly not a panacea for all economic woes. Otherwise, why else should Cyprus agree to a bailout package in exchange for its promise to restrict capital mobility itself? The restrictions include the requirement that a distressed bank convert its deposits into its own shares. In other words, quite apart from a bank’s client losing his right to withdraw his money, his net worth, as the shareholder of an ailing bank, will fall. The story of course does not end here. The fate of Cyprus depositors has begun to raise doubts in Spain, Italy and other economies too which are themselves hovering in the vicinity of ventilators. Panicky depositors are expected to line up in these countries to withdraw their money before it is possibly frozen Cyprus style and head towards what appears to them as a safe haven for the moment. The chain reaction so generated could well snowball into yet another crisis.
A recent observation by Nobel Laureate Paul Krugman therefore contains great wisdom: (T)he truth, hard as it may be for ideologues to accept, is that unrestricted movement of capital is looking more and more like a failed experiment. (The New York Times and Business Line, March 25, 2013.) To drive home the point as clearly as possible, it is worth recalling the golden era of the South East Asian miracle. During 1960-1992, Hong Kong, Malaysia, Singapore, South Korea, Thailand and Taiwan maintained consistently high growth rates ranging from 4.5 per cent to 6.9 per cent. Economic reforms, involving export led growth in favour of import-substituting development strategies, surely had a role to play in bringing about the transformation. However, what distinguished a large part of this period was a dependence on the economies’ domestic saving to support investment (in addition to the building up of a skilled labour force.) During the nineties, however, these emerging economies caught the imagination of lenders and investors from developed countries. The result was that the domestic investment of these countries began to be financed by foreign savings or capital as well and when things turned sour on account of incorrect moves (involving in particular the real estate sector), the foreigners fled, leaving the banks in these countries to bleed to death.
To quote Professor Krugman once more: (T)he best predictor of crisis is large inflows of foreign money: in all but a couple of … cases …, the foundation for crisis was laid by a rush of foreign investors into a country, followed by a sudden rush out.
It is against this backdrop that the Indian Finance Minister’s recent assertions need to be judged afresh. In his budget speech for 2013-14, the FM expressed serious concern about our current account deficit (CAD).
To quote the minister: The CAD continues to be high mainly because of our excessive dependence on oil imports, the high volume of coal imports, our passion for gold, and the slowdown in exports. This year, and perhaps next year too, we have to find over USD 75 billion to finance the CAD. There are only three ways before us: FDI, FII or External Commercial Borrowing … India… does not have the choice between welcoming and spurning foreign investment. If I may be frank, foreign investment is an imperative.
Borrowing a word from the FM, this author considers it even more imperative to clarify the notion of a CAD. We need to begin with two important lessons from John Maynard Keynes’ General Theory of Employment, Interest and Money, the classic that addressed the Great Depression of the 1930’s.
First, while the GDP of an economy represents the total flow of goods and services produced, its market value must equal the payments (wages and profits primarily) made to the producers and suppliers of GDP. Hence, the total value of output of an economy must equal the total incomes generated. Second, and as a corollary of the first lesson, the part of total income not spent on private and public consumption, i.e. savings, must represent a slice of real GDP (goods and services) available to meet the demand for domestic investment and export.
What happens, however, if the aggregate of export and domestic investment exceeds the available savings? In India’s open economy, domestic savings can be augmented by savings flowing in from the rest of the world, goods and services foreigners did not use for their domestic needs. These are our imports. Consequently, in value terms, our domestic investment (I) and exports (X) sum up to our savings (S) and imports (M), so that I+X = S+M, or, S-I = X-M.
A trade deficit, i.e. a negative value of X-M, indicates then that domestic investment has exceeded domestic savings and that this excess represents imported commodities. (The observation is comparable to the East Asian case mentioned earlier.) Since imports are paid for in foreign money, the trade deficit stands for a net demand for foreign exchange also. As opposed to this, the CAD equals a net demand (or supply) in the foreign exchange market arising from (X-M) as well as other cross border transactions. The “non-(X-M)” items involve
It is important to note that the emergence of a CAD implies that the “non-(X-M)” items, even if they happen to be net positive inflows of foreign exchange, have been unable to reverse the negative trade deficit. For example, RBI data reveals that in 2011-12, (X-M) equaled (-) Rs. 9,121 bn, while the CAD was (-) Rs. 3,760 bn. The non-(X-M) items were helping therefore, though only partially, to wipe out the trade deficit.
(1) foreign exchange inflows associated with foreign investments (incomes to Indians from their foreign investments net of payments to foreigners for their investments in India),
(2) net invisible inflows (such as tourist expenditures) and
(3) net transfers (which are purely in the nature of foreigners’ gifts to India net of India’s gifts to foreigners).
The FDI’s and FII’s generate a net supply in the foreign exchange market to meet the CAD without reducing our foreign exchange reserves (as far as possible). Apart from covering the deficit, the interaction of demand for and supply of foreign exchange determines the exchange rate too.
The FM considers a positive net inflow of FDI and FII to be a sine qua non as far as countering a CAD induced demand for foreign exchange is concerned. What he appears to have missed is that this is only the proximate cause for opening the doors to foreign investors. The ultimate cause lies in the necessity for correcting the domestic saving investment mismatch, for it is the latter that gave rise to the excess demand for foreign exchange in the first place.
If the domestic investment plans the foreign capital flows help to fulfill consist of real asset building for future income generation, there need be little reason for alarm, leaving out of course the normal uncertainties surrounding any investment project. However, examples abound where investments were wrongly conceived and foreigners ended up with insufficient returns. These inevitably constitute the “ rush of foreign investors into a country, followed by a sudden rush out ” cases. The rush outs are painful, since they are accompanied by demand for foreign currency by investors from the rest of the world. To satisfy such demand, the home country’s exchange rate needs to depreciate and exports rise relative to imports. The Keynesian identity would then predict an increase in savings and fall in investment. The latter reduces the growth rate of GDP and poses possible threats of recession.
The scenario may not be entirely bleak of course. But one tends to worry nonetheless, for the FM has also observed that we shall “encourage foreign investment that is consistent with our economic objectives.”
Experiences of other countries suggest that such consistency is rare to come by.
Published in The Telegraph, Calcutta on April 5, 2013 under the title "The Worst is not Over".