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- India’s dependence on foreign fund inflows is cause for worry

The sensitive index of the Bombay Stock Exchange has risen from 5591 at the end of 2003-2004 to 6493 in 2005, 11280 in 2006, a range of 8929 to 14652 in 2007 and in the year 2007-8 so far between 12455 and 18814. Most Indian investors must now believe that there is a Santa Claus after all. Even the small fall last week was followed by another large rise. But is this likely to be sustained' Conditions have become much more difficult, markets have probably reached their peak range, the only direction for the next few months is erratically downwards, and that may be true for gross domestic product growth as well.

Indian economic growth rates stimulated the stock markets. Average growth in the last three years was 8.6 per cent while the investment rate rose by 30 per cent, financed largely by domestic savings, not by savings of others overseas (unlike the United States of America that uses savings of others by a high current account deficit). Our current account deficit — highest among comparable countries despite the rise in the balance of trade deficit (imports in relation to exports) — is lower than before. Expansion in domestic demand accounts for all the growth. The result of this rising demand is that supply constraints rule today in every sphere — tradable manufactured goods, physical infrastructure and social infrastructure.

The last time this happened was in the late Nineties when there were substantial capacity additions as a result of capacity shortages. These capacities became surplus when demand fell and overall growth declined. It was 2003 before new investments took place and additional capacities were created.

That may not be repeated. This time there is substantial and growing public as well as private investment in infrastructure, and a consumption boom. Interest rates came down sharply towards the late Nineties and despite rate increases since, are far lower than in earlier years. However they remain higher than in developed economies. With relaxations in external commercial borrowings, overseas borrowings have surged. Borrowings have been invested in new capacities and domestic and overseas acquisitions. Overseas acquisitions obviously add to the risks of default if the acquisitions fail to produce early rewards or are not serviced on schedule. Defaults will hurt India’s credit ratings.

Equity investments by overseas investors have risen sharply and they have added a continuing and substantial inflow of foreign funds into stock markets. The low interest rates in the US and Japan, the India growth story, relatively lower price/earnings (almost half) ratios in India as compared to China, the perceived security of Indian investments, the easy repatriation of funds, have all combined to produce this inflow. In addition there are the ECBs which have added to liquidity.

The Reserve Bank of India has tried to soften the inflationary impact of this liquidity by hesitant raising of interest rates, and more often by raising the cash reserve ratio. The surge in liquidity continues, with its inflationary potential.

So far, despite the expansion of liquidity (21 per cent in money supply over the year), inflation has been contained. This is largely due to declining import costs, but chiefly due to subsidized fuel and power prices despite rising imported crude prices. Fuel subsidies alone add about Rs 80,000 crore to oil company losses. By leaving them out of the deficit calculation, the government is able to show a fictitiously lower fiscal deficit which is yet higher than that in comparable developing countries.

Apart from concealing inflation numbers by subsidizing consumer prices for fuels, prices of primary products (food and so on) are rising. Hence the claimed inflation in the wholesale price index hides the reality. The wholesale price index shows a much lower rise in price than what most consumers actually pay.

The RBI is obviously concerned by this fictitiously low inflation rate. It has already restrained ECBs and further RBI actions can be expected soon to restrain liquidity. The RBI is unlikely to easily raise interest rates because that will attract further foreign fund inflows, add to liquidity and, also, adversely affect industrial growth.

The question is whether rising stock prices, large foreign fund inflows, apparently low inflation, high levels of GDP growth are sustainable for long. The astonishing rise in equity prices (by 50 per cent in one year) could turn negative because of many factors — a decline in domestic and export demand, rising rupee exchange value reducing export margins, swamping of the domestic market with cheap imports, a monsoon failure, collapse in foreign economies and rise in oil prices. Brazil and China have had much higher rises in stock prices but may not be as vulnerable.

China has for many years managed to hold its currency values at stable levels despite much larger inflows of funds. This is perhaps because a greater part of Chinese inflows are in more stable direct investments and also because of substantial export surpluses. If the inflows into financial markets increase as they are now doing, the volatility of such funds might make currency stability more difficult to maintain.

Export surpluses might fall if the American economy declines, as it shows signs of doing. China may have to impose higher interest rates to contain the adverse impact of decline in the dollar. China also cannot switch to the euro as other countries can, because of its huge dollar holdings, whose value will be hit if it makes such a switch. However, a decline in exports may not hurt the Chinese economy too adversely because the value added within China by exports is relatively small.

In India, the easy availability of cheap foreign funds, the boom in equity markets, and substantially increased government investment in physical infrastructure, social spending and agriculture have stimulated industrial investment, domestic demand and not exports. Hence a decline in the US economy will not have too much of an adverse effect on India. What will hurt us however, is a decline in foreign funds inflows. This can happen if interest rates rise in the US, Japan and Europe; if domestic demand declines; if the monsoon fails (unlikely since it has been quite good till late in the season); if the RBI constrains liquidity by too much or raises interest rates to contain inflation; and if there is political instability.

Equity prices have risen too fast, too quickly. Unlike in the past, Indian shares are responding more to future expectations than current performance. Slowing down of industrial production, rising crude prices — adding to already high government deficits if correctly calculated, rising rupee values, rising imports, falling exports are worrying signs. If fuel subsidies are cut, inflation will rise. If subsidized prices continue, government spending on other sectors must inevitably be reduced. This will hurt growth. Rating agencies might downgrade India into a higher risk category. This will also hit Indian company borrowings and foreign fund inflows. If the US raises interest rates to moderate inflation and improves the exchange value of the dollar, fund inflows will be hit again. If American demand for imports declines, we might not be as badly affected, but will face increased competition from cascading Chinese imports into India.

Thus, while we are insulated to some extent from an American economic downturn, our dilemma is our heavy dependence on volatile foreign fund inflows, and the sharp increase in crude prices. We may exult about our foreign exchange reserves. But reining them in could hurt economic growth. Growth has vastly increased government tax revenues and stimulated public investment in physical and social infrastructure. These could significantly improve the human condition in India.

The Indian economic situation is not as good as it seems. Oil prices are very high and we will have to manage them without raising inflation. The government will have to restrain growth and reduce dependence on volatile foreign funds. Perhaps the next government will have to take this action. The stock markets are unlikely, until the world economy stabilizes, to show the spectacular increases of the last year.

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