From The Wire
The opening up of the Indian economy in 1991 under Finance Minister Manmohan Singh heralded the coming of age of what the world called an “ambling elephant”. The forces of liberalisation, privatisation, and globalisation were expected to activate the potential of a previously untapped economy. However, a socialist past and cautious economic policy led to the tempered introduction of neoliberal policies into the country. Today, under Prime Minister Narendra Modi, India is being praised the world over for its rapid acceleration of the process that began 25 years ago, but do we have any idea of what we’ve gotten ourselves into?
Modi is being guided by Reserve Bank of India governor Raghuram Rajan, who comes from a strong ordo-liberal tradition of the kind that inspired the politically neutral German Bundesbank. Armed with an ideology of establishing similar central bank independence and utilising interest rate-based monetary policy to tinker with the economy, Rajan has served as one of the key elements driving investor confidence in the Indian economy. His emphasis on deregulation, combined with Modi’s focus on attracting foreign investment, however, have primed India for a ruinous crisis should global macroeconomic forces suddenly shift directions.
The dominant narrative in India in recent years has been its ability to steer clear of the financial crisis that affected markets across the world in 2007. Pundits used this as a tool to cheer on the confidence the world had in the Indian economy, and urged greater foreign investment into the country. In doing so, however, they forgot that one of the key reasons for the absence of an impact of the global financial crisis on Indian was precisely its relative isolation from the rest of the world. Like China, India had stringent capital controls on foreign investments (especially within the financial sector) and regulated capital flows to give the government the ability to steer the economy in its desired direction.
Today, however, caps on foreign direct investment have been completely dismantled for agricultural and broadcasting sectors in the last few months, with FDI up to 49% being permitted in the insurance sector and up to 73% being permitted in the banking sector. This easing of regulation has borne fruit: India emerged as the largest foreign investment destination in the first half of 2015, attracting inflows of $31 billion that surpassed the $28 billion attracted by China and $27 billion by the United States.
Yet, inflows tell only one half of the story. In February 2014, India saw a $60 million net outflow amidst investor fears of an economically unfriendly political climate during an election year characterised by populist promises. This volatility in foreign investment flows suggests that the Indian economy is slowly slipping out of Indian control. Increased foreign investment in key sectors like agriculture and banking, moreover, now suggests that India may be more vulnerable than ever to international influences, dismantling the “India is different” narrative that has been swallowed as gospel truth so far.
The recent anxiety amongst analysts in emerging economies about a possible interest rate hike by the American Fed is a telling sign of how dependent countries like India are today on global indicators working in their favour. This anxiety triggered the selling of equities worth over $3000 million by foreign investors in August 2015, causing a sharp fall in Indian markets and raising fears that there could be an equity outflow of up to $5 billion in less than a month should interest rates rise in the US.
Such a dependence upon macroeconomic frameworks in the rest of the world, combined with a high current account deficit and double-digit inflation, has now put India at a substantial risk of suffering from a “sudden-stop crisis”. Like Mexico in 1994 and Thailand in 1997, India too is vulnerable to massive capital outflows triggered by poor investor sentiment that can throw the economy into tumultuous waters and lead to periods of large-scale unemployment and repression of domestic demand. The magnitude of such a crisis in a country of 1.2 billion people will be unprecedented and will certainly upset the fragile equilibrium of the current world economic order.
It is increasingly evident, then, that control of capital flows is one of the key components in maintaining Indian monetary policy independence and thus ensuring Indian economy stability. This is supported by Hélène Rey’s research, which shows how global financial inter-connectedness has led to the transformation of the international macroeconomic trilemma – a choice of any two out of three policies (stable foreign exchange rates, free capital movement, and independent monetary policy) – into a dilemma, or a choice simply between independent monetary policy and completely free capital movement.
Dealing with the risks
This dilemma puts emerging economies at risk of massive volatility in the face of large disturbances to gross capital flows. The greatest impact of such volatility is excessive credit growth. The largest risk is that of excessive leveraging by financial intermediaries when credit is easily available that can lead to large scale economic instability in the face of capital outflows. The failure of capital outflow restrictions in the past therefore suggests that minimising this impact and its associated risk requires the introduction of prudential capital controls (like raising of average reserve requirements on foreign exchange deposits and of marginal reserve requirements on foreign currency liabilities of banks) on new inflows, similar to those seen in Peru, that will prevent a destabilisation of the economy in the face of loss of investor confidence.
The current economic crisis in Brazil must serve as a warning bell for India. The Brazilian economy’s dramatic collapse has shown that modern crises can strike rapidly and cripple even stable economies because of the dependence of emerging markets on “hot money” capital flows from developed nations. Latin America’s experience with stagnation in the recent past has demonstrated the destabilising impact of capital exoduses on indigenous businesses, something Prime Minister Modi should keep in mind given the government’s recent emphasis upon “Make in India”. Most importantly, however, the austerity measures thrust upon developing nations by international lenders have outlined the disastrous effects of a slowdown on wealth inequality and social security provisions.
Raghuram Rajan’s recent critique of American monetary policy suggests an attempt to prevent such a crisis in India, but his selective targeting of mechanisms like quantitative easing reveals a belief in American generosity favouring the interests of emerging markets that simply does not exist. The recent interest rate hike by Fed chair Janet Yellen, with forward guidance suggesting continued hikes in the near future, have made it clear that American unilateral action is now the norm rather than the exception, and Rajan must go against conventional macroeconomic wisdom to embrace concrete measures like capital controls to prevent a Brazil-like exodus of hot money from India.
In 1991, a balance of payments crisis threatened the ability of the Indian government to sustain itself. Today, the risk of dwindling investor confidence in India threatens to take down the entire economic system because of its reliance on foreign capital. Therefore, Raghuram Rajan and Modi’s pursuit of economic growth via foreign capital must be complemented by rigorous prudential capital control regulations to ensure that even in the face of a crisis, India has control over its own economy.