FM promises action on capital inflows when it is needed

Indira Kannan / New York October 12, 2010, 1:09 IST

Ministry is closely monitoring situation, he says.

Finance Minister Pranab Mukherjee said here on Monday that rising capital flows into India had not yet reached an alarming level, but
appropriate action would be taken as and when it was considered necessary.

“As far as our economy is concerned, I am not unnecessarily worried. Reserve Bank is watching the situation, the ministry is also
watching the situation, and we have not reached a stage where the panic button needs to be pressed,” the minister said, adding that
“as and when action is called for, appropriate action will be taken”.

Mukherjee’s statement, made during a brief interaction with Business Standard, is significant in the light of global concerns over rising
capital inflows posing fresh risks to financial stability and Reserve Bank of India Governor Duvvuri Subbarao’s statement a day earlier in
Washington that the central bank would intervene if capital inflows were lumpy or volatile.

The finance minister was in New York on his way back to India after attending the autumn meeting of the World Bank and International
Monetary Fund in Washington, where increasing capital inflows was identified as a “policy challenge” that could “pose significant risks
to the financial stability” of Asia.

In his interaction, Mukherjee touched upon a wide range of issues, including the contentious demand made by developing countries for
a higher quota in the IMF and the ongoing US-China talks on exchange rate adjustments.

The finance minister said he was optimistic that the quota revision in IMF would be achieved soon, leading to a greater voting share for
emerging markets and developing countries in the Fund. “They will have to do it quickly, shortly,” he said. India has argued for a 5-6 per
cent shift in quota share from advanced economies to developing countries, and Mukherjee had reiterated this position in Washington.

On the current controversy over the revaluation of the Chinese yuan under US pressure, Mukherjee said India had no desire to take
sides between the two countries. The US is expected to raise the issue of the yuan’s valuation at the G-20 Summit in South Korea next
month. “We have suggested that this should be discussed and a solution must be found through dialogue,” he said.

US Treasury Secretary Tim Geithner had announced in September that the US would try to mobilise support from G-20 members
during the Seoul Summit in an effort to press China for further and faster appreciation of its currency.

Mukherjee also said the controversy over the yuan was not a major issue at the meetings. He also said he did not know if it would be
discussed at the G-20 finance ministers’ meeting preceding the summit. The subject was not discussed at the bilateral meeting with his
South Korean counterpart, according to officials.

While in Washington, the finance minister also met US Secretary of State Hillary Clinton, and they talked about US President Barack
Obama’s upcoming visit to India. But Mukherjee said the agenda for the visit was still under discussion and declined to identify any
areas where decisions or progress could be expected during the visit.

According to sources, during the Mukherjee-Clinton meeting, the US repeated its long-standing demand for India to open up its
domestic market to American dairy exports. Meanwhile, India conveyed its position that it had fulfilled all its commitments regarding the
Indo-US civilian nuclear agreement, and urged the US to complete the remaining formalities on its side quickly.

Subbarao’s policy dilemma

The 2 November policy review will probably be governor D. Subbarao’s most difficult since he
took over in September 2008

Some interesting things have happened in the Indian financial system in the past few weeks. The local currency recently rose to a 25-
month high against the dollar on sustained capital inflows. The Reserve Bank of India (RBI), which had last intervened in the foreign
exchange market in June 2009, was seen buying dollars to stem the rupee’s runaway appreciation. The Indian central bank also
announced a Rs 12,000 crore buyback of government bonds from the market to infuse money into a liquidity-starved banking system.
Finally, the State Bank of India, the nation’s largest lender, has raised its minimum lending rate, or base rate, by 10 basis points. One
basis point is one-hundredth of a percentage point. The bank had for so long resisted a rate increase, but finally toed the line of other
banks as its cost of funds has gone up.

These apparently disparate developments weave a complex pattern and make the job of the RBI difficult as it approaches its mid-year
monetary policy review. Foreign exchange dealers believe that it must have bought about $1 billion (Rs 4,446 crore) from the foreign
exchange market. The rupee has appreciated about 4.5% this year against the dollar and the bulk of the appreciation has happened in
the past one month. Many analysts want the central bank to stay away from the market and allow the local currency to appreciate. An
appreciating rupee makes imports cheaper and that helps fight inflation, which continues to be very high. On the other hand, a rising
rupee affects exports; exporters’ income in rupee terms comes down. The only way to stem the rupee’s appreciation is by buying
dollars from the market. But for every dollar the RBI buys, an equivalent amount of rupees is infused into the system. It needs to flush
out this money as excess liquidity in the system will stoke inflation. In the past, the central bank had soaked up this liquidity through the
so-called MSS (monetary stabilization scheme) bonds. When the system needed liquidity, in the wake of the global credit crunch that
followed the collapse of US investment bank Lehman Brothers Holdings Inc., a part of the MSS bonds was redeemed to generate
money. The RBI has not been active in the foreign exchange market, and that is why its foreign currency assets have gone up by a
mere $13 billion since January to $296.43 billion.

The banking system has been running in a deficit mode and commercial banks have been raising between Rs 60,000 crore and Rs
80,000 crore daily from the RBI’s repo window to take care of their temporary asset-liability mismatches. The RBI infuses liquidity at 6%
and drains excess money from the system at 5%, its reverse repo rate. In a liquidity-flush situation, which was the scene last year, the
reverse repo rate is the policy rate. But currently, the repo rate is the policy rate. The RBI needs to keep the system in a deficit mode to
keep it effective. If it buys dollars from the market and releases rupees in the process, the system will no longer remain in a deficit
mode.

Then, why has the RBI decided to infuse liquidity into the system through its Rs 12,000 crore bond buying programme? Technically
known as an open market operation, such a programme was floated by the central bank in June 2010 when the system ran dry after a
Rs 1 trillion outflow on account of the telecom licence auctions. Besides, the advance tax outflow also affected liquidity in June. Indian
companies pay income tax every quarter on their projected quarterly profit. There will be advance tax outflow in mid-December again,
and the system will be in deficit mode till the end of December. The RBI is buying bonds possibly to avoid any spike in interest rates as
too much of tightening will lead to a sudden rise in short-term rates. The yield on 10-year government paper has already crossed 8%,
and that of short-term treasury bills and commercial paper are quite high. If there is a sudden spike in rates, that will impact the
investment cycle and the central bank will be blamed for derailing growth. Besides, it also needs to oversee the smooth passage of the
government’s hefty borrowing programme. The government plans to borrow Rs 4.57 trillion this year. Since 63% of this has been
completed in the first half of the year, Rs 1.59 trillion will be raised from the market in the second half. Too much of tightness in the
system will jack up the yield on government paper and raise the cost of borrowing.

Incidentally, the spread, or the gap, between the 10-year US treasury and Indian sovereign paper has widened considerably and is the
highest among all emerging markets. If this is any indication to go by, foreign funds will continue to flow here to take advantage of the
yield differential. The US Federal Reserve is expected to announce another round of quantitative easing in November after RBI’s review
of monetary policy, flooding the global markets with money. So, if RBI decides to raise its policy rates to fight inflation, it runs the risk of
attracting more foreign capital.

There has been talk of capital controls. In fact, quite a few countries, including Thailand, Brazil and Indonesia, have taken recourse to
capital controls in some form or the other, and South Korea will follow soon. But both the RBI governor and finance minister have so far
not given any indication of such restrictions being contemplated. In fact, just about a month ago, India raised the foreign investment limit
in both corporate and sovereign bonds by $10 billion. The 2 November policy review will probably be governor D. Subbarao’s most
difficult since he took over in September 2008 at the height of the global credit crisis. More about this next week.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor
in Mumbai.

Inflation & deficit may rise if capital inflows

spike up
Low rates in the developed world and quantitative easing increase the possibility of spike in capital inflows to India. Morgan Stanley’s
global economics team expects interest rates in the G3 to remain low for a longer period. Indeed, our team expects average policy
rates in G3 — comprising the US, eurozone and Japan — to remain close to 0.6% until end-2011 . Moreover, the team thinks the Fed
could announce additional quantitative easing, which would involve about $1.2 trillion of asset purchases . Over the last few weeks,
there has been a significant increase in capital inflows into the region, and this has raised the debate on managing capital inflows to
ensure that it does not add to inflation and asset bubble risks.

So far, capital inflows have not been a concern. Capital inflows into India have been well below the peak in F2008. In the previous
cycle, 12-month trailing sum of capital inflows had reached a peak of $106 billion as of March 2008. Based on trends in forex reserves
and our estimate of current account deficit and revaluation in non-dollar currencies in forex reserves, we believe that during the last 12
months, capital inflows would have been about $65-70 billion. Moreover, high current account deficit is absorbing bulk of the capital
inflows. We believe that during the 12 months ending September 2010, the current account deficit would have been about $50 billion,
largely offsetting the capital inflows. We believe that the recent appreciation of the rupee against the dollar seems to be creating a
notion that the balance of payment surplus has risen sharply. We believe this trend was a reflection of the weakening of the dollar
rather than an appreciation of rupee. On tradeweighted basis, the rupee has not appreciated much during this period. For example ,
since July 1, while the rupee has appreciated against the US dollar by 4.8%, it has depreciated against the euro by 6.1%.

While so far capital inflows have been manageable, there is a risk that capital inflows into India may rise further from the current levels if
US Fed implements additional quantitative easing in early November. If capital inflows do rise sharply toward $100 billion or more, the
complexities of policy management will increase in the context of current macro environment with strong GDP, high inflation and rising
current account deficit.

What will be the policy response going forward if capital inflows rise sharply?

The RBI will hesitate in allowing currency appreciation :

On the real effective exchange rate (REER, trade-weighted basis adjusted for inflation differentials) basis, the currency is already close
to the 2007 peak. Considering that the current account deficit is already high, the RBI may hesitate in allowing a major appreciation in
nominal trade-weighted exchange rate. If capital inflows rise sharply in the first stage, the RBI may intervene more in the forex market.

Currently, interbank liquidity is already tight and the RBI has been injecting funds on a daily basis. Hence, initially the RBI may not even
need to sterilise the liquidity arising on account of forex intervention. In case the magnitude of capital inflows is large, the central bank
can start issuing market stabilisation scheme bonds and reverse repos to sterilise the increase in liquidity arising from forex intervention
(buying dollars, selling rupees). In the second stage, as capital inflows continue to rise above $100 billion, there is a chance the
government may initiate some soft measures to discourage debt-related inflows.

Aggressive tightening in monetary policy will be a challenge:

Although inflation has been moderating, it remains high. So far, the burden of managing inflation risks has been on monetary policy.
After cutting the repo rate by 425 bps from the peak of 9% between September 2008 and April 2009, the RBI has lifted it up by 125 bps.
Short-term markets rate has risen by 225 bps. However, real interest rates still remain negative and will likely remain very low even as
the short-term rates rise further and inflation moderates over the next six months. Although so far the debt-related capital inflows have
been manageable, there is an increased risk that these inflows may start rising if the RBI tightens monetary policy aggressively.
Moreover, as the corporate sector is able to fund itself more easily from the capital market, the ability of the monetary policy to influence
aggregate demand will be limited.

Fiscal policy needs to play more active role, going forward:

We believe that fiscal stimulus has probably played a bigger role in growth recovery since the credit crisis compared to monetary policy.
In F2008, the consolidated fiscal deficit (including off-Budget expenditure) stood at 5.8% of GDP, the lowest since F1983. However,
pre-election spending , a wage hike for government employees and stimulus related to the credit crisis meant that consolidated national
expenditure to GDP shot up by close to 4 percentage points between F2008 and F2010. Moreover, the government had also provided
support through a cut in indirect taxes, which has not been fully reversed as yet. The consolidated fiscal deficit (including off-Budget
expenditure) increased to 10.8% of GDP in F2009 and remained high at 10.3% of GDP in F2010 compared to 5.8% of GDP in F2008.

Although the central government will report a reduction in fiscal deficit in F2011, this has been largely supported by one-off items like
collection in 3G and broadband wireless access (BWA) licence fees and higher collections from divestment in SOEs. The expenditure
to GDP (including off-Budget oil subsidy) will remain closer to the peak in F2011 and the aggregate demand push remains intact.
Indeed, in the first five months of the current financial year, the central government’s expenditure has increased by 30% year-on-year .

We believe the time has come for the government to tighten the fiscal policy swiftly to manage the aggregate demand as the private
sector spending is rising quickly. In the absence of this move from the government, we believe inflation and current account deficit
could only rise if capital inflows spike up.

(The author is Asia-Pacific economist and managing director with Morgan Stanley in Singapore)

Rajeev Malik: Monetary policy: Time for a pause

RBI is better off taking a breather on policy rates while maintaining its hawkish tone.

The upcoming policy review of the Reserve Bank of India (RBI) on November 2 is the first time since the central bank began its exit late
last year that there is a strong case for it to pause. At the very outset, a pause does not mean the end of the tightening cycle or that the
central bank is taking its eyes off inflation. It essentially offers a breather to take stock of the emerging domestic and external trends, as
the incoming data are becoming more two-directional after being unidirectional over the last year or so. A pause also allows the RBI to
buy time for its recent aggressive moves to be effective, and to avoid accidental over-tightening relative to the incoming indications
about economic activity.

In its last policy statement, the RBI indicated that it was near the neutral rate and that future actions will be affected less by the need to
normalise and more by the evolving growth-inflation trade-off. Given the lack of consensus or clarity on what the correct — or even an
appropriate — level of the neutral rate is for India, the RBI could be either at the neutral rate now (with the repo rate at six per cent) or
25-50 basis points away from it. Given that the RBI now announces monetary policy approximately every six weeks, it surely cannot be
raising rates at each review.

More important for the upcoming policy are issues such as the outlook for inflation and growth and whether the monetary actions so far
are already beginning to pay dividend. Monetary policy changes deliver results with lags, hence central banks have to be mindful of not
overdoing the tightening.

The RBI has cumulatively raised policy rates 275 basis points beginning with the first increase in March, as it moved to normalise the
monetary setting following a successful and aggressive easing to soften the hit from the global credit crisis. With the exception of a 25
basis point increase each in March and April, the remaining increase in rates was packed in the July-September quarter, as the RBI
also shifted its operational policy rate to the repo rate from the reverse repo rate.(Click for graph)

The change in the operational policy rate is an aggressive tightening by “stealth”. Also, the recent rate hikes were complemented with a
sizeable deficit in the liquidity adjustment facility (LAF), and with currency appreciation. The bottom line is that monetary conditions
tightened significantly in the July-September quarter, and the full effect of these moves has not yet played out.

But real economic activity is already rolling over, even if the industrial production data exaggerate that moderation. Also, the strength of
the upturn in private investment is not yet what it should be. In any case, banks are poised to raise their rates further after Diwali, which
will in turn affect economic activity, as it is expected to. Indeed, banks have yet to fully transmit the effect of the RBI’s moves, but it is
coming. However, the RBI should focus more on the worrying speculative trend in the real estate market that is partly being fuelled by
innovative borrowing plans.

The RBI’s monetary tightening is yielding positive result in fighting inflation. Indeed, seasonally-adjusted data unambiguously show that
inflation, including that in non-food manufactured goods (or core, which is what the RBI can really affect), is coming off. This trend will
begin to be captured to a bigger degree in the year-over-year (YoY) comparison in the coming months.

The seasonally-adjusted pattern is remarkable enough that the RBI should not ignore it. Also, the rolling over in economic activity
already visible will further ease demand pressures at the margin. Admittedly, the YoY WPI inflation rate remains high at 8.6 per cent,
but even this has eased from 11 per cent in April. The core WPI inflation has eased to five per cent YoY from close to six per cent in
April, and the RBI appears on track to meet its WPI inflation forecast of six per cent for March 2011. While the current level of inflation
rate is relevant, the expected inflation trajectory should be an important input in deciding the next step.

India’s food inflation has two different dynamics at play. One, an increase in food items rich in protein (such as meat, fish, eggs) that
has partly been driven by the government’s own active policy of improving the disposable income of the poor. There is little monetary
policy can do to correct this structural increase. In fact, it would be counter-productive for the RBI to target this as it is an intended result
of the government’s policy. The correct approach would be for the government to enhance supplies.

Two, the rise in the prices of food items that is dependent on the monsoon. Given that the monsoon rainfall has been good, the prices
of many of these items should ease as the harvests hit the markets. In the final tally, the food inflation rate, which has already halved, is
likely to ease more meaningfully over the next two months.

What about the impact on inflation of rising global commodity prices? This is a legitimate risk. However, these prices are rising not
because of improving global growth but because of the same reason that is causing a surge in capital inflows in emerging economies:
the weakening US dollar and easy global liquidity. Several emerging economies are talking about restricting capital inflows, but seem
unclear about how to deal with rising commodity prices. In the current setting, they are more effectively tackled by currency appreciation
rather than by interest rate increases, as the latter will hurt domestic-driven growth and attract even more capital inflows. Currency
realignment (read appreciation) in emerging economies is an important part of fixing the broader global imbalance. Restricting capital
inflows does not do anything to the transmission of that rebalancing via higher commodity prices.

Unfortunately, there continues to be a severe lack of full appreciation about the fact that the actual monetary conditions now are much
tighter than what the repo rate of six per cent indicates. Market rates are much higher than what would normally be hinted by the
current level of repo rate. The current combination of the repo rate and the LAF deficit makes for a much more aggressive policy setting
than was the case when the repo rate was at six per cent, say, in early 2005. Further, raising rates a day after Bernanke formally begins
QE2 only increases the risk of attracting even more volatile foreign capital into India.

Thus, there is a strong case for the RBI to pause now but maintain a hawkish stance rather than raise rates by another 25 basis points
and then go on hold. There is little to gain from another rate hike at this point but potentially more to lose. Remember that winning the
inflation battle by crippling growth is not on the agenda.

The author is senior economist at CLSA, Singapore.

T N Ninan: Temptations of power
T N Ninan / New Delhi October 23, 2010, 0:31 IST

China is not only on the path to Great Power status, it also means to exercise its newfound muscle. What is difficult to understand is
why it wants to behave like a rogue power when the world would want it to be a responsible force in global affairs. Consider the
evidence, starting with its choice of friends — including two countries whom you would consider as a part of the “axis of evil”, Pakistan
and North Korea. China has not only ignored its own treaty obligations and nuclear-enabled a known proliferator like Pakistan, it has
also lent its tacit support to North Korea even as that country has been busy violating its obligations under the Nuclear Non-Proliferation
Treaty, to which China is a signatory.

In the economic sphere, few will quibble with the argument that China’s skewed (export-oriented) growth pattern has added to a global
payments imbalance that is exacerbated by its mercantilist currency policy. In the technical field, it repeatedly tries to hack into other
countries’ government and strategic computer systems. And in the commodities sphere, it has only recently been reported that it forced
Japan to back down in the two countries’ most recent confrontation by signalling an informal blacklisting of Japan in the supply of rare
metals (in which China has a virtual monopoly, and rare metals are crucial to many industries). Finally, in the geographic sphere, its
claim to the Spratly Islands in the South China Sea as a “core interest” is about as unilateralist as it gets.

It is, of course, inherent in the nature of power that you want to use it to either change the rules, or break them when convenient. Nor
can it be argued that other great powers have not behaved in exactly the same way in the past. China itself has bitter memories of
gunboat “diplomacy”, the opium wars, the Boxer uprising, and unequal treaties being forced on it by the great powers of the 19th
century. The United States, as the pre-eminent power of the past century, was not particularly choosy about the rogue rulers whom it
supported when it found that convenient (remember Pol Pot, and sundry puppet regimes in three continents). Indeed, President Bush’s
unprovoked war on Iraq could be cited as a good example of power gone rogue. So, China is not charting untrodden paths.

Still, Beijing must ask itself whether it serves its own interest well by creating hostility or wariness in its spread-out neighbourhood,
taking in countries all the way from Japan to India, with South Korea in between and Australia off on the side, and not to mention at
least some members of the Association of Southeast Asian Nations (notably Vietnam). Of course, if you really have power on your side,
you don’t have to spare too much concern for those whom you are shoving aside, but even in international affairs what goes round
does come round.

It is not that there is no alternative course available. For all the unilateralist action that can and should be laid at Washington’s door, the
US as a superpower has frequently worked in the interest of protecting the global commons — defending free trade, protecting open
sea lanes, acting as a global policeman when no one else was willing to take on the role (Serbia, Somalia, etc.), and working even if
selectively to protect human rights. Such stances create a soft power that is a useful corollary to hard power, because it encourages
willing compliance by other countries and helps create and sustain alliances. And it cannot be that China, with its strong civilisational
strengths, would not see any self-interest in exercising some soft power.

Bimal Jalan: Policy options for capital flows

Bimal Jalan /  October 23, 2010, 0:03 IST

There has been a fair amount of discussion in the media on whether India needs to control, tax or otherwise discourage excessive
foreign capital inflows. The policy dilemmas on whether such flows need to be reduced and, if so, how to do so without affecting growth
have become more intense in view of high inflation. If the Reserve Bank of India (RBI) intervenes in the market to buy excess dollars,
rupee liquidity increases, which, in turn, contributes to inflationary pressures. If the RBI does not intervene, the rupee appreciates
making exports uncompetitive.

There is no easy answer to what has come to be known as the impossible trinity, i.e. it is simply not feasible to have capital mobility,
exchange rate stability, and an independent monetary policy to check liquidity or reduce credit growth.

So far as India is concerned, different views have been expressed by experts and policy makers on the policy objective that should be
given priority. Some assign the highest priority to growth and capital inflows, some to inflation and liquidity control, and some to a
competitive exchange rate to promote exports.

Interestingly, the government’s policy for capital flows also came up for discussion in the media’s “in-flight” interaction with the prime
minister when he was returning from Toronto after the last G20 meeting. As reported by this newspaper on June 30, the prime minister
then pointed out, “As far as India is concerned, we have not reached a stage where capital flows have become a problem.”

Whether capital flows into India are “excessive” or not is, of course, a matter of judgement. And so is the choice of instruments to
control capital flows even if they are considered excessive. However, what is beyond dispute is that India was saved from the full
impact of the global financial and economic crisis in 2008 because it did not make its capital account fully convertible or its exchange
rate fully flexible.
The relative insulation of India, China and some other emerging markets from the global crisis has also had a profound effect on
academic thinking as well as the policy stance of international financial institutions, particularly the International Monetary Fund (IMF).
As is well known, over the past several decades, the IMF was strongly in favour of full capital account convertibility. However, in a well-
publicised Staff Position Note on February 10, 2010, the IMF declared that there are “circumstances in which capital controls can be a
legitimate component of the policy response to surges in capital flows”.

So far as capital flows into India are concerned, we certainly do not need additional quantitative controls or taxes on inflows. India
already has far-reaching controls on certain types of inflows, particularly foreign direct investment, short-term debt and external
commercial borrowings. India also has a substantial current account deficit in its balance of payments, and capital inflows are important
sources of bridging this deficit.

At the same time, from a policy point of view, it needs to be recognised that certain types of capital flows, particularly portfolio or foreign
institutional investments in financial markets, can be highly volatile and reversible. When times are good and the country is growing fast
with high rates of return on investments, such inflows can multiply within a short period. However, these can also be reversed sharply if
the global environment and country’s prospects change or if an “asset bubble” emerges in the capital markets. Sudden reversals like
this can lead to a crisis of confidence and destabilise the economy.

This is precisely what happened in a number of emerging market countries in recent years — Malaysia in 1997, Thailand in 2006,
Columbia in 2007 and Brazil in 2009. Faced with a financial crisis, these countries had to reverse their policies and introduce either
direct controls or impose taxes on transactions. The impact of such measures on financial stability and growth was highly adverse, and
could have been prevented if “over-exuberance” was avoided and timely measures taken.

India, too, has faced volatility in capital flows in the past three years. Total capital flows were $108 billion in 2007-08, falling to a mere
$8 billion in 2008-09 and increasing to $54 billion in 2009-10. It is also significant that the sharpest volatility was recorded in portfolio
investments. These were +$27 billion in 2007-08, -$14 billion in 2008-09 and rising to +$25 billion in 2009-10. Foreign direct investment
(FDI) inflows, on the other hand, were generally stable and fluctuated in the range of $15 billion to $20 billion during this period. High
volatility in portfolio flows was also reflected in India’s stock market indices. The Nifty recorded a sharp increase of 55 per cent in 2007;
fell to -52 per cent in 2008 and again increased to +76 per cent in 2009.

Paradoxically, at present India’s policy for foreign direct investment. which contributes to manufacturing or services output, is subject to
widespread and diversified controls. It varies from sector to sector and there are as many as five overlapping — and sometimes
confusing — press notes on the subject. However, portfolio investments are entirely free, fully reversible, and also relatively tax free.

I leave it to readers to judge, and our policy makers to decide, whether something should be done to regulate tax-free portfolio
investments and at the same time, simplify rules for foreign direct investment when economy is doing well and aggregate capital flows
are not considered “excessive”. Or should we wait until these become excessive and unmanageable, resulting in financial instability or,
worse, a crisis?

N Chandra Mohan: 'Remitting' economic development

The sustainability of remittances surging into India is questionable
N Chandra Mohan /  October 22, 2010, 0:40 IST

While “hot” capital inflows, especially portfolio investments surging into India’s economy, have triggered serious concerns of late,
remittances or private transfers from the vast diaspora are still welcome. For starters, the latter inflows are more stable than portfolio
investments that are pro-cyclical in nature, rising in good times and falling in bad times. “They are less likely to suffer the sharp
withdrawal or euphoric surges that characterise portfolio flows to emerging economies,” argues Dilip Ratha, lead economist and
manager of the migration and remittances team at the World Bank.

Remittances have been estimated at $52 billion in 2009-10, according to the Reserve Bank of India. During the first quarter of 2010-11,
remittance inflows of $13 billion exceeded the net inflows of foreign direct and portfolio investments into the Indian economy. In sharp
contrast to the fair-weather portfolio investments, private transfers by Indians abroad are also more likely to be invested in the home
country despite adverse economic circumstances. Moreover, research has established that remittances augment savings and
investments of recipient households and help reduce poverty.

Though remittance flows are expected to keep rising, doubts are being raised about their sustainability in the future. After all, the west-
Asian oil-financed construction boom is over and there is less need for unskilled Indian workers who built the infrastructure. The
process of recovery from the global recession in the Gulf countries is also far from complete. Moreover, given the growing backlash
against migrants in the developed world, how much longer will the migration of Indian teachers, nurses and software techies to such
countries sustain private transfers?

In this context, Kerala’s experience is relevant since the state vitally depends on private transfers, which amount to one-fifth of its net
state domestic product. The Thiruvananthapuram-based Centre for Development Studies (CDS) has been doing interesting work on
emigration and the impact of remittances on Kerala’s economy. CDS has, in fact, completed four large-scale surveys on migration — in
1998, 2003, 2007 and 2008. Subsequently, a Return Migration Survey was done in 2009 to study the pre-recession (October-
December 2008) and recession (June-August 2009) experiences of emigrants from that state.

In recent CDS working papers by Professors K C Zachariah, S Irudaya Rajan and D Narayana, household cash remittances received
by sample households showed a modest overall increase of seven per cent despite the recession in 2009. Although a recession may
be expected to result in a decrease in remittances, the latter can paradoxically increase when emigrants who lose their jobs return
home permanently with their savings accumulated in more prosperous times. Also, the cash value of gifts received in 2009 was more or
less the same as in 2008.

The good news about Kerala’s remittances, however, conceals sharp variations since some households experienced large increases in
remittances while others suffered large decreases. Around six per cent of the households that received remittances in 2008 did not
receive any remittances during 2009. The number of households that received smaller amounts of remittances in 2009 vis-a-vis 2008 is
also substantial. Nevertheless, the overall rise appears plausible in the light of higher remittances during the recession period in south
Asian countries like Sri Lanka, Pakistan and Nepal.

Remittances have increased since the number of Keralite emigrants who returned home after losing their jobs due to the recession in
the Gulf was much less than popularly feared. The CDS working papers show that around 54,000 emigrants lost their jobs in 2008. But
since 32,000 unemployed emigrants in that year subsequently became employed, the net job loss was only 21,000. The number of
those who have returned home due to the recession also is not more than 63,000. Whether it is 54,000 or 63,000, these numbers are
marginal against the stock of 2.2 million emigrants from that state to the Gulf in 2008.

A major reason these job loss or return emigration figures are less alarming is that Keralite emigrants incur huge costs, including
borrowings, to work in the Gulf. So, even when they have lost their jobs, “they would prefer not to return home fearing inability to repay
the debt already contracted there. They would rather accept any job at a lower wage and try to continue to send home remittances to
repay their loans even during a crisis in the destination country,” argue Narayana and Rajan. Such emigrants also rely on social
networks to provide temporary support in the event of job loss.

The number of Keralites who have lost jobs in the Gulf and have not returned home has been estimated at 39,396 persons or only 1.8
per cent of the emigrant stock in 2008. Interestingly, such adverse developments have not prevented more people from the state from
heading to the Gulf. Around eight per cent of the return emigrants of 2008 have re-emigrated. Kerala also sent 142,000 new emigrants
during the recession. But as the recovery from the recession in the Gulf is somewhat fragile, the big question is how much longer will
the good times on the remittances front last?

Akash Prakash: Emerging markets and liquidity

Whichever way EM equities trade, there is very little doubt that this is a great environment for India
Akash Prakash /  October 22, 2010, 0:29 IST

Investors continue to pour money into the EM asset class. Weekly inflows into EM equity funds remain strong with no sign of let-up.
Just look at India, we have already received $23 billion of FII inflows, the highest level ever. Coal India has received a great response,
with the institutional portion subscribed 15x, FIIs are scrambling to get an allocation and the money continues to pour in. Investors are
rushing to raise weightings in EM stocks, before Fed chairman Ben Bernanke can fully unleash his plans to purchase possibly a trillion-
dollar worth of long-term debt instruments and lower long-term interest rates in the US. Given how weak the dollar has been, and this is
likely to continue, investors seem to be in a desperate hurry to move out of dollar-based assets. There is a strong intuitive appeal to this
trade, the Fed cuts rates and money rushes into EM equities. Investors chase growth, bid up these markets and it all ends ultimately in
one big bubble. This trade is the consensus view of how things will unfold, and most money managers are positioned to benefit from
and expect further EM outperformance. It looks like a very crowded and one-way trade at the moment.

In this context, a recent note by the EM strategy team at BCA is worth noting as it raises doubts on the inevitability of the above-
mentioned sequence of events. It asks the very pertinent question of whether a Fed easing always leads to an EM rally (BCA EMS
bulletin, October 19).

The note makes the point that in the early 1990s, emerging market share prices were negatively correlated with the Fed funds rate. Low
interest rates in the US drove capital into the emerging markets, where growth was stronger, much like today. The EM equity asset
class had a huge run, almost bubble-like conditions and a long-term secular peak were formed in EM equities in 1994-95.This is pretty
much what most investors expect to see going forward for EM equities over the coming months.

The note also points out, however, that from this 1995 peak, till very recently, EM equities were actually positively correlated with US
interest rates. In this period, EM equities were seen as a call option on global growth and far more sensitive to global growth
expectations than interest rates. EM equities actually did better in an environment of rising US rates, as hikes in Fed fund rates
reflected strong global growth conditions. Any weakness in global growth actually impacted EM equities harder than any other asset
class, with serious consequences for EM relative performance.
In this period (1995 onwards), there were a few divergences between interest rates and the performance of EM equities (wherein the
correlation became negative again), but these divergences (in 2001 and 2007) were temporary and not lasting beyond a few months.

The note thus makes the point that investors need to make a judgment call as to whether the current rally in EM equities is a more
sustainable bull run like in the early 1990s, or something which will fizzle out soon, similar to 2001 or 2007 when EM equities faltered
despite continued declines in US interest rates as global growth weakened. Can EM equities outperform on the basis of liquidity and
flows alone, without a pick-up in global growth?

In trying to understand the different reaction function of EM equities to US interest rates pre- and post-1995, one clear difference
between the two periods is the external position of EM economies. Prior to 1995, most of the EM economies had current account
deficits and an externally leveraged corporate sector, and were thus very sensitive to both cost and availability of external capital.
Cheap and easily available credit made a huge difference to many of the larger EM economies and their companies. After the Asian
crisis, most of the larger EM countries have a current account surplus or very small deficits, and a corporate sector with little external
leverage, thus they do not benefit as much from cheap and easily available financial capital. They are more dependent today on global
growth to sustain their exports and current accounts, and maintain economic momentum.

Markets today, however, seem more likely to follow the pre-1995 template (where EMs did well with falling rates). Investors are
desperate to get out of dollar-based assets. Many believe that the “new normal” is for a decade or more of extremely low nominal
growth rates in the West and EM economies have demonstrated great resilience. Unlike the post-1995 period when global growth was
strong and EMs posted superior relative performance, today, except for the EM economies, there is just no signs of sustainable growth.
The financial metrics for most EM economies are far superior to the West, with many convinced that most economies in the West have
intractable fiscal sustainability and balance sheet issues. Trade within the EM countries themselves has also exploded, giving them
greater resilience to an OECD slowdown. Record low interest rates are also driving a mad scramble for yield and returns. If you wish to
remain invested in “safe” fixed-income instruments in the West, your returns are basically nothing. There also seems to be a secular
and long-term asset allocation shift towards EM assets, much like the early 1990’s when the asset class was first discovered.

Whichever way EM equities trade, there is very little doubt that this is a great environment for India. India has low export dependence
and needs global capital to finance its huge investment needs, running one of the larger current account deficits among the major EM
economies. This makes India one of the only beneficiaries of today’s environment of very subdued demand among the OECD
economies and record low interest rates. The tightening by China will once again put pressure on commodities, further enhancing
India’s appeal. India had begun to underperform as commodities began moving higher, but this underperformance should reverse as
commodities come off. As India has a genuine inflation problem, it also seems more willing to tolerate rupee appreciation than many
other EM central banks, further boosting returns for dollar-based investors. India is in a sweet spot, but just as the beta is high on the
way up, so is it on the way down as well. Any change in global risk appetite will impact India disproportionately. The only hope is that
given the funk the US finds itself in, liquidity conditions will not reverse in a hurry. Our more domestically oriented economic model and
strong entrepreneurship are in fashion. We must use this window of low-cost capital availability to suck in long-term capital, improve the
government balance sheet and build out productive assets.

T N Ninan: Tackle the inflows

T N Ninan / New Delhi September 18, 2010, 0:54 IST

An issue that has attracted surprisingly little notice is the size and growth of the trade deficit. Even more worrisome is the flat trajectory
for exports — which escapes notice because comparisons are with the corresponding month of a year earlier. But if one looks at the
variations month-on-month, the loss of all momentum becomes obvious because exports from April to August have stayed constant at
about $16 billion. Even the usual seasonal upswing after the summer slump is missing. In contrast, imports have been growing (hitting
$29 billion in August), and the trade deficit, therefore, has grown from $10 billion in April to $13 billion in August — which makes for 30
per cent growth in four months. The full year could register a trade deficit of $150 billion. At 10 per cent of GDP, that would be the
largest trade deficit in recent Indian history, and also the largest for any significant economy in the world.

These numbers have attracted next to no notice because remittances by Indians overseas and the surpluses on trade in services (IT
software, BPO and the like) neutralise a good part of the deficit in the goods trade. Even after accounting for this, the deficit on the
“current account” is more than 3 per cent of GDP — again, historically high for India. Even this has not rung any alarm bells because
there is a surplus inflow on the “capital account”, accentuated in recent weeks by the surge in portfolio money. Net capital flows are
more than the current account deficit, and the Reserve Bank, therefore, reports an addition to its foreign exchange reserves.

As A V Rajwade has been pointing out in his Monday columns in this newspaper, the issue when looking at the current account is not
the financial question of whether the deficit is bridged easily or with difficulty (with equity inflows, debt and remittances), but whether the
real economy is in balance. It is worth bearing in mind that the capital inflows push up the rupee’s value and so make life difficult for
exporters — thus adding to the already yawning trade deficit. It makes no sense at all for the rupee to be stronger against the dollar
than it was a decade ago, since Indian inflation has been greater than US inflation throughout the intervening period. On an inflation-
adjusted basis, the rupee has moved up quite substantially against the dollar — at a time when the Chinese have done the exact
opposite with the yuan, and improved the competitiveness of their exporters.

Second, as the world has realised in the wake of the financial crisis of 2008-09, financial flows are fickle; one day money can rush into a
country, the next it can flow out with the same rapidity. All it takes is for some analyst in the financial capitals of the world to point out
that India’s trade account does not look in great shape, and people who control money may start worrying about the rupee’s stability
and trigger a quick capital outflow.

This may not happen in the foreseeable future because the Indian economy happens to be in a sweet spot, but that is no reason to not
focus on the imbalances. In any trade-off between righting the real economy and paying heed to the financial sector, it should be
obvious post-financial crisis that the thing to look at is the real economy. If this means having to push the rupee down, and if the only
way to do that is to slow down capital inflows, then that is what has to be done — even if the stock market hates the idea.

A V Rajwade: Till the music stops...

A V Rajwade / New Delhi October 4, 2010, 0:19 IST

Chuck Prince’s statement that “we have to keep dancing till the music stops” should figure on any list of famous last words. Mr Prince
was the chairman and CEO of Citibank when he said this. The “music” was the market in mortgage-backed securities, and it collapsed
just a few days after his statement. Mr Prince was sacked and Citibank needed a government bailout to survive. Some of the other
“dancers” were wiser: J P Morgan stopped going long in these securities towards the end of 2006; Goldman Sachs went a step further
and started shorting the securities by buying credit default swaps, even as it was structuring and selling more mortgage-backed
securities to other players.

Looking at the stock and currency markets in India, one wonders when the music will stop. Our policy makers seem to be continuing
their benign neglect of the exchange rate even as it reaches highest-ever levels. In his speech at the High-level Conference on The
International Monetary System jointly organised by the Swiss National Bank and the International Monetary Fund in Zurich on May 11,
the RBI governor said: “Last fiscal (2009/10), the rupee appreciated by 13 per cent in nominal terms but by as much as 19 per cent in
real terms because of the inflation differential.” Considering the changes in the exchange rate and the domestic price level since then,
the rupee has appreciated 25 per cent in real terms against the dollar over the last 18 months.

No wonder the current account deficit, conventionally calculated (i.e. considering remittances as current account receipts) as a
percentage of GDP, has gone up from 1 per cent in 2006-07 to 2.5 per cent of GDP in 2009-10. (Incidentally, the figure 2.5 per cent
used in the governor’s speech seems questionable. The actual amount was $38.4 billion.) Data released last Thursday show that the
deficit has tripled from $4.5 billion in the first quarter of 2009-10 to $13.7 billion in that of 2010-11. At this rate, it could cross 4 per cent
of GDP in the current financial year. Our policy makers seem to be willing to keep dancing so long as financing the deficit is not a
problem.

I have used the expression “as conventionally calculated” to describe the current account number. Conventional accounting fails to give
a “true and fair” picture of the competitiveness of our economy. Though classified as receipts under “invisibles”, remittances are not
“earnings” of the domestic economy. For economic analysis, they need to be considered capital transfers, albeit of an irreversible
nature; they are a means of financing the gap between our current external earnings and expenditure. This gap was of the order of $90
billion last year, and may cross $100 billion in the current year. Its easy financeability through remittances and capital flows should not
blind us to its implications for output and jobs.

In fact, it seems our policy makers are still looking at the current account from a balance of payments perspective. If so, it is high time
this changed. Compared to a reasonable balance between current earnings and expenditure, we are currently missing out an output of
Rs 4,50,000 crore (equivalent to the gap between external earnings and expenditure). Wages constitute about 30 per cent of GDP. The
output loss then translates into lost wages of Rs 1,50,000 crore — far larger than UPA’s much trumpeted MGNREGS! Another way of
looking at the number is that it represents a loss of a crore of reasonably paying jobs. Can we afford such reckless neglect of job
creation in the external sector (whether in exports or in domestic industry competing with imports) when the extreme left keeps gaining
strength every year, in district after district, and the need for employment creation should be the paramount objective of policy makers?

Is the number of potential jobs resulting from a reasonable balance between current income and expenditure fanciful? Not really. In the
debate in the US Congress on the Bill authorising the imposition of up to 20 per cent duties on Chinese imports, the argument for it is
that it would create a million jobs. If a million jobs can be created by the devaluation of the dollar against the yuan alone, which is what
the 20 per cent duty amounts to, despite the huge gap in wages between the US and China, my estimate of the potential additional jobs
in the tradeables sector hardly seems unrealistic. What is needed is an exchange rate aimed at the domestic economy being
reasonably competitive globally.

Who are the biggest gainers from the not-so-benign neglect of the exchange rate? The FIIs and the Chinese exporters: our bilateral
trade deficit with China alone could well come to around $40 billion in the current year. It is high time we managed our exchange rate in
the interest of optimising growth, jobs and consumption, rather than being carried away by the efficiency and sanctity of markets, the
possible immediate impact on stock prices and so on.