Handling the dollar deluge
Diverging fiscal responses to the crisis can create serious macroeconomic challenges for countries globally
The Reserve Bank of India’s (RBI’S) balance sheet size has grown sharply to 27 per cent of gross domestic product (GDP) in early July, a level last seen in 2006-08, from just 22 per cent at the end of February. In absolute terms it has expanded by ~8.3 trillion, a growth of 18 per cent in just four months. Developed economy central bank balance sheets have also grown during this period, but that has been to fund government borrowing. The RBI’S balance sheet growth, on the other hand, is involuntary, its hand forced by the “impossible trinity”. That is, as India’s balance of payments (BOP) surplus has expanded sharply, the RBI is forced to buy dollars to prevent the rupee from appreciating, and it may be taking monetary measures it does not want to. This problem may not go away for at least a few quarters, and may even intensify going forward.
In the last fiscal year, which ended in March, India had a BOP surplus of $59 billion, about 2 per cent of GDP. Dollars kept coming in through capital flows, even as the trade deficit, which normally absorbs these inflows, shrank to $159 billion, because imports declined due to weakness in the domestic economy and low oil prices. The current deluge of dollars, which has driven up RBI’S foreign currency reserves by $48 billion in four months, has been exacerbated by some large one-off capital transactions, and weakness in the trade-weighted dollar, but even without these, the BOP surplus would be large.
The rare monthly goods trade surplus that India reported in June is unlikely to sustain, but the trade deficit in the next year may not cross $80 billion, nearly half what was seen last year. Despite remittances likely to be significantly lower, given the relative stability of software exports, this means a rare substantial current account surplus. Add to that the capital inflows, and the BOP surplus could be considerably larger than what was seen last year or at any time in the past. Unlike the capital flow driven surges in BOP surpluses in the past, a significant part of the recent surge is due to a fall in the trade deficit: A collapse in gold imports — likely temporary — and low oil prices are driving it, but so is weak domestic demand for non-oil/gold goods.
This phenomenon is not limited to India: Countries where Covid-19 cases are surging, hurting domestic demand and imports, and the government has not given a large demand stimulus, have seen a drop in trade deficit or a rise in trade surplus. This is because exports have done better, as demand in most large global economies has either already recovered (like China), or is rebounding (like the US and the UK, where retail sales are now near pre-crisis levels), courtesy of substantial fiscal intervention by governments. However, in terms of the size of BOP surplus as a share of GDP, India appears to be an outlier.
Given the longstanding concerns over India’s stability on the external account (including the hard to understand but often discussed fears of a “rating downgrade”), a BOP surplus would normally be a good problem to have. But the size of this surplus is problematic: It has already disrupted the RBI’S usually calibrated approach to increasing the quantity of money in the economy. After several years of money supply growth lagging nominal GDP growth, and contributing to the slowdown in the run up to this crisis, it has been forced to increase this pace even as nominal GDP growth has slipped to zero. “Excess money supply growth”, measured as the difference between growth in money supply and nominal GDP growth, has now surged to an all-time high.
In an economy with weak demand this may not drive consumer price inflation, but is likely to inflate prices of financial assets. The resultant reduction in cost of funds can be helpful, particularly at a time like now when balance sheets of firms need help. High price- to-earnings ratios in stock markets mean low cost of equity capital. Low cost of funds for firms and consumers would help domestic demand and thus grow imports faster, helping absorb the surplus dollars.
However, this helps the real economy only if companies issue shares and raise funds. So far, only a few firms, particularly private financial firms, are doing so. For debt, higher bond prices mean lower interest rates for borrowers. However, this has occurred only for a handful of firms, and not only is the gap between bond yields and the RBI’S repo rate at very high levels, the gap between the weighted average lending rate of banks and the repo rate is at a record high.
This reflects broken plumbing in the financial system, and has to be addressed urgently. However, while the reduction in cost of capital is necessary, even that may not suffice, given impaired confidence of consumers and private enterprises.
Other steps that can drive the BOP adjustment: Rupee appreciation (cheaper imports, more expensive exports), and restrictions on capital inflows (of the type that the RBI tried in 2007), would not be advisable at this stage. The current surplus is mainly a reflection of weak local demand that one hopes is temporary. The RBI buying gold in order to absorb dollars without adding to domestic money supply, even if only to act as a hedge for the government’s gold bonds, may not be large enough to absorb the surplus.
Thus, only a temporary but significant fiscal stimulus may work. This would stimulate domestic activity, improve domestic demand and thus imports, helping adjust the BOP. If the surfeit of capital is not channeled properly so that it stimulates investment or consumption demand, it would instead end up creating asset bubbles that do not add value when they are forming, but hurt when they deflate, or worse, burst.
These challenges may exist even over the medium term. Foreign direct investment inflows are expected to be steady, and the government is opening up the capital account (like in the issue of special category government bonds which will not have any limits on foreign ownership, or a possible further relaxation in external commercial borrowings as the domestic financial system lacks capacity). At a time when import substitution and export growth are focus areas, this may need a new strategy to maintain macroeconomic stability and currency management.