The calculus of liberalisation

Liberalisation was born out of a balance of payments crisis in 1991. As non-resident Indians withdrew foreign currency deposits and international banks cut their lending lines, India sought help from the international community. Emergency funding was granted contingent on reforms that would make the economy more market-oriented and externally competitive. Almost three decades later, these external sector imbalances remain. Worse still, the liberalisation of trade and investment has left us with an economy that is fundamentally weakened and structurally fragile.

Over the past five years, our current account deficit has averaged 1.9 per cent (versus 2 per cent in 1990), with a merchandise trade deficit of 7.4 per cent somewhat offset by an invisibles surplus of 5.5 per cent. Sectoral analysis explains why this deficit persists. Our primary sector, agriculture and mining, has minimal competitive advantages given our scarcity of natural resources and the many challenges facing agriculture. Our secondary sector, industry, is a bigger issue. Manufacturing's share of GDP is the same as it was in 1990, and the expectation of export-driven growth has not materialised. China, with whom we have our largest trade deficit, is the reason. Opening our markets has subjected us to a competitor, driven not by market forces but economic and geopolitical ambitions. Our domestic industry, meanwhile, remains stifled by lack of reform in labour laws, regulation and taxation, and antiquated infrastructure. The net result is deindustrialisation as Chinese goods have flooded Indian markets. Our third sector, services (which along with remittances and investment income constitute invisibles), has become the growth engine of the Indian economy. However, services (construction being a prime example) are largely untradeable. In addition, growth in service income has only added to consumer demand for oil and other imported goods, notably electronics.

Despite a booming global economy, our share of world exports has, in fact, declined over the past five years. One reason for this is the appreciation of our real effective exchange rate (REER), i.e., the rupee has not weakened enough to compensate for inflation. On the import side, inflation fears contribute to the persistent demand for gold while oil (our largest import) is largely price inelastic.

The seeming silver lining in this story is net capital inflows, which (as per the last Economic Survey) “was more than sufficient to finance the current account deficit leading to accretion in foreign exchange reserves”. Since the turn of the century, $600 billion of cumulative investment (FDI and FII) inflows have, along with remittances, paid for our deficits, and helped us accumulate foreign currency reserves of almost $400 billion today (from $5 billion in 1991). Should this alleviate concerns about persistent external sector imbalances?

The answer is no. First, recognise that we are effectively selling off assets to pay for current consumption. Central depository data show that foreign investors (both FDI and FII) own a combined 56 per cent of the value of all shares outstanding. Loosely speaking, more than half of all profits generated by the organised private sector now accrue to foreign investors. Apart from strategic considerations, this loss of ownership severely diminishes our ability to fund new investments domestically and makes us ever dependent on foreign capital.

Second, the rupee is always at perpetual risk of a run. We saw this in 2013 when the rupee fell by 15 per cent. This year there has been a fall of 8 per cent, thanks to oil prices rising and modest outflows by FIIs — who can, in theory, literally leave tomorrow — seeking higher returns elsewhere. Our $400 billion of reserves pale in the face of $1 trillion of foreign liabilities (FDI, FII and $530 billion of external borrowings), and a deficit of $50 billion every year.

Third, the surge of capital inflows in the 20042008 period has had material adverse impacts on the broad economy. As the World Bank has pointed out, the partially unsterilised buildup of reserves likely led to a significant increase in money supply. The consequences of this — the run-up in inflation, and a credit bubble leading to the NPA problem facing the financial sector — are being felt today.

Last, policy options to deal with these imbalances are restricted. The RBI’s ability to restore competitiveness by weakening the rupee is hampered by the fear that international investors might then run for the door, or at the very least stage a ‘buyer’s strike’ and not bring in fresh funds. The recent collapse in Turkey’s currency is a stunning, real-time testament to this fear.

In summary, the effects of liberalisation have been the very opposite of what was intended by the Washington Consensus. Deindustrialisation has decreased our productive capacity, and the growth of a services-based consumer society has led to an insatiable demand for imports. We depend on the kindness of strangers to finance these consumption excesses. These strangers now control our capital stock and financial markets and may look to sell and leave overnight. Serious thought must be given not just how to correct these long-term imbalances, but also to figure out what to do when — and not if — the next crisis occurs.