Will more foreign financing be required?

Business Standard, 20 April 2020

The capital inflow into India is the gap between investment and savings. In the coming one to two years, large changes in both investment and savings are likely. There is a reasonable probability of a large increase in the current account deficit. It would be prudent to remove the policy thicket that hinders Indian financial engagement with the world.

The accounting identity from macroeconomics

The current account deficit ("CAD"), i.e. the capital inflow into India, is the gap between domestic investment and domestic savings. If we invest Rs.35 in India, and we save Rs.30, the gap of Rs.5 comes from abroad. The neat formula is CAD=I-S. This is not a theory, it is an accounting identity.

Financing from abroad does not require any central planning or action by the government. The capital account is the highway through which persons in India obtain financing abroad based on market forces. These add up to a net financing flow into India, which tallies up exactly with the gap between I and S.

Envisioning the CAD of the next year or two

It is now interesting to ask: How might I and S, and thus the CAD, evolve over 2020 and 2021? Let's start at the savings, S.

Household savings are likely to go down, as many households dis-save to stabilise consumption in these difficult times.

Corporate earnings will go down, and thus corporate retained earnings will also go down.

The fiscal deficit is likely to expand sharply, through the working of automatic stabilisers. When household income is reduced, income tax payments go down. When corporations have reduced revenue, GST payments go down. And when corporations have reduced profit, corporation tax payments go down. All the three components of taxation are likely to drop sharply. In addition, a well designed government program such as the NREGS has flexibility built in: usage of NREGS will spontaneously go up in bad times. These factors will come together and give a large expansion of the deficit.

There is a clamour in India today, asking the government to enlarge the deficit. Leaving aside anything that discretionary fiscal policy might choose to do, automatic stabilisers are already in action, and a large expansion of the fiscal deficit is baked in.

Putting these three together (reduced savings of households, of corporations and of government), the overall savings will decline. What about investment?

Conventional fixed investment will decline. Private gross fixed capital formation has achieved a value like 16% of GDP in the past. But it had already declined to about 5% of GDP, prior to the pandemic, and there is not much room for it to decline further. Working capital requirements in firms will surge, as supply chain uncertainty will demand higher inventories, and firms finance a period of operating losses. The government led infrastructure investment process will experience a more limited decline. Putting these together, the decline of I may prove to be lower than the decline in S.

In this scenario, the current account deficit will rise.

For a while now, India has been in a comfortable zone, where slow investment in India meant that the current account deficit was small, and external financing was hence not large. We now face a changed environment, which calls for new kinds of thinking by policy makers, by financial firms and by non-financial firms.

Implications for macro policy

In 1981 and 1991, India came to grief when facing enlarged foreign financing requirements. The key to doing this right is to have a large number of different markets, asset classes, financial instruments, and financial firms in the play. This yields gains from diversification. Any one channel (e.g. ECB) might flounder, but when there are numerous channels in play, the overall highway is more stable. Conversely, when policy makers try to narrow down or central-plan the instruments, asset classes or intermediaries which can ride on the capital account highway, this induces difficulties.

India has established a thicket of barriers on the capital account. Financial regulation, taxation, capital controls and enforcement agencies have come together to create a "home bias" against India in the world. Reforming this license/permit/raid raj is now prudent.

The gap between investment and savings will be financed from abroad. This is an accounting identity and nothing can change that. The thicket of restrictions achieves higher transactions costs and higher risk. There will be greater exchange rate depreciation, in order to make Indian assets more attractive, and pay the foreign investor for these frictions.

Implications for financial firms

For finance practitioners, it is important to work on financial intermediation, on connecting up the infinite capital of the global financial system to end-users in India. Across a diverse array of assets, there will be large opportunities where there are good rates of return available in India, which require human relationships and information transmission to the large pools of capital abroad. The coming two years will be an ideal time to have dry powder which can be invested in India.

The simplest connections are those where debt and equity capital from abroad reaches the top 200 firms with liquid securities trading, and these firms in turn act as financial intermediaries and send this capital into their ecosystem of millions of suppliers, distributors and retailers. Financial market reform can enhance this number beyond 200.

Financial innovation is required to connect foreign capital to others in India. Failures of financial economic policy have frustrated the fintech revolution in India. Securitisation is a key tool through which a large number of innovative originators, across the country, can be linked to the bond market in Bombay, where non-residents investors can participate.

Implications for non-financial firms

Non-financial firms should see that access to capital in the domestic financial system is limited, prioritise the time and effort of working with financial intermediaries, and growing trust in the ultimate non-resident investors. For users of capital, the license/permit/raid raj hampers rational transactions. There is merit in undertaking the fixed cost of establishing the more complex structures that are required to do rational things.

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