No sudden stops here
India is unlikely to be hit hard by any sudden capital ouflow thanks to the nature of the economy and dependence on long-term debt.
By Pravin Palande & Shishir Prasad, TNN |
Financial market regulators and the Reserve Bank of India have been worried over capital inflows, of late. Many experts say such worries are justified because India doesn’t want to be in a situation where capital inflows dry up, or worse take flight. A situation which economists call “sudden stops”. Sudden stops, as with most things in life, are usually unpleasant. But how justified are regulators in entertaining thoughts of an untimely cessation of things as pleasurable as capital inflows?
To be fair, over the past few months, capital inflows, especially through portfolio investments, have been large enough to demand some thought. But it is highly probable that a reversal of capital inflows will have a muted effect on India compared with what happened in East Asian countries — Thailand, Malaysia, Philippines, and Indonesia — in 1997 and earlier in Mexico in 1994. This can be attributed to three key factors: size and diversity of Indian economy, lack of dependence on exports and their nature and financing of economy through long-term debt and equity rather than short-term debt.
Sceptics always point a finger to Thailand, Indonesia and other Southeast economies, which were unable to absorb capital inflows in a proper way, — think of wasteful golf courses and crony capitalism. When there was capital flight, there was trouble. It took almost 10 years for these Tiger economies to cripple back to normalcy after passing through hyper-inflation and economic slowdown.
Is the same fate so obvious to India if things go wrong and there is a capital outflow?
India’s balance sheet doesn’t point in that direction. For starters, India is a much bigger economy than these Asian economies or for that matter even Mexico, when these countries hit a sudden stop. The average size of these economies (GDP) was $137 billion, while India is a trillion-dollar economy at current exchange rate.
Thus, the amount of capital inflows that India can absorb is much larger. Structurally, India is a very diversified economy. It has export-oriented services like software, domestic services like retail, and a strong manufacturing sector. Hence, India’s economy is not heavily dependent on exports as much of the growth comes from domestic consumption.
This wasn’t true of the East Asian economies. India’s export to GDP ratio works out to 15%, which is low when we compare the same to that of export-driven economies where this ratio was well above 50%. This is not to suggest in any way that exports do not matter: they are very important.
It is just that India isn’t overly dependent on exports. Now consider the nature of exports of East Asian economies. Most of these countries were engaged in the export of semi-conductors, a hugely cyclical and price-cut prone category. Thus, these economies were heavily dependent on the export of a particular product.
When the demand-supply cycle for these products got affected these economies became vulnerable. For India, the largest items are software and gems and jewellery and in both we do a large amount of labour-intensive, ‘maintenance’ work. So, while new spends may dry up, maintenance work will have to go on.
To be fair, over the past few months, capital inflows, especially through portfolio investments, have been large enough to demand some thought. But it is highly probable that a reversal of capital inflows will have a muted effect on India compared with what happened in East Asian countries — Thailand, Malaysia, Philippines, and Indonesia — in 1997 and earlier in Mexico in 1994. This can be attributed to three key factors: size and diversity of Indian economy, lack of dependence on exports and their nature and financing of economy through long-term debt and equity rather than short-term debt.
Sceptics always point a finger to Thailand, Indonesia and other Southeast economies, which were unable to absorb capital inflows in a proper way, — think of wasteful golf courses and crony capitalism. When there was capital flight, there was trouble. It took almost 10 years for these Tiger economies to cripple back to normalcy after passing through hyper-inflation and economic slowdown.
Is the same fate so obvious to India if things go wrong and there is a capital outflow?
India’s balance sheet doesn’t point in that direction. For starters, India is a much bigger economy than these Asian economies or for that matter even Mexico, when these countries hit a sudden stop. The average size of these economies (GDP) was $137 billion, while India is a trillion-dollar economy at current exchange rate.
Thus, the amount of capital inflows that India can absorb is much larger. Structurally, India is a very diversified economy. It has export-oriented services like software, domestic services like retail, and a strong manufacturing sector. Hence, India’s economy is not heavily dependent on exports as much of the growth comes from domestic consumption.
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This wasn’t true of the East Asian economies. India’s export to GDP ratio works out to 15%, which is low when we compare the same to that of export-driven economies where this ratio was well above 50%. This is not to suggest in any way that exports do not matter: they are very important.
It is just that India isn’t overly dependent on exports. Now consider the nature of exports of East Asian economies. Most of these countries were engaged in the export of semi-conductors, a hugely cyclical and price-cut prone category. Thus, these economies were heavily dependent on the export of a particular product.
When the demand-supply cycle for these products got affected these economies became vulnerable. For India, the largest items are software and gems and jewellery and in both we do a large amount of labour-intensive, ‘maintenance’ work. So, while new spends may dry up, maintenance work will have to go on.
In the event of a capital flight, the import cover of forex reserves becomes very critical. Most of the countries, which went through crisis or periods of capital outflows, have shown this particular number at dismally low proportions.
The Tiger economies of Southeast Asia had this ratio of import cover barely at 2 to 4 months; Mexico had a cover of just a month. India has a cover of more than 15 months.
Exports account for around 17-18% if software exports are taken into consideration. But our domestic sector is bigger and it is interesting to see how that has been funded. “It is mostly through internal accruals, FDI (including private equity) and long-term debt like external commercial borrowings (ECBs),” says the chief economist at a US-based brokerage.
So one hand we have long-term dollars like FDI or private equity and this is largely risk capital. Then there are ECBs, which usually have a duration of 5-7 years. So even if there is an adverse situation, this money cannot be taken out easily and in any case such money is usually quite “patient”.
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Now compare this with economies that faced a problem in the past. Countries that have shown volatility in capital inflows have funded their growth through large amount of short-term debt. India’s short-term debt to total debt is at 7.7%. Countries, which have gone through capital outflow crisis, have shown this number to be very high. Thailand’s short-term debt was at 42%, Malaysia’s 28% and Indonesia at 25%. India clearly doesn’t fit in this trend. But what happens if capital — largely equity — actually leaves the country? Though markets are final arbiters of price, according to economists, even if the capital flows were to decline 20% next year the impact would be muted. Why? For one, the stock markets capture only 12% of India’s economy, corporate sector profits that is. Large enterprises as Coal India and LIC — valued at $50 billion — aren’t even listed. So, while stock market is an indicator, it is just that.
The real economy is far bigger. And if this sector faces a capital shortage, ie a ‘sudden stop’, the central bank can simply cut the SLR and release liquidity into the system. Almost $45 billion worth of rupees have been taken out of the system by RBI in the past one year; all that can be released back into the system.
For all practical purposes, the Indian economy is well-covered from a capital point of view for the next 3-4 years. Since the global fund managers already know this, they are unlikely to get off the gravy train in a hurry. The party is not about to come to a sudden stop, though there could be minor disturbances.
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