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dimensions and Policy framework
Sustainable Current Account Deficit and External Resources
2.35 The rapid build-up of external debt during the 1980s, culminating in the crisis of 1991, has created some apprehension regarding the maximum sustainable level of external inflows that can be absorbed by the economy. Since one major element of the development strategy for the Ninth Plan is to augment domestic resource generation through enhanced inflows of external savings in order to accelerate the rate of growth, this issue needs to be elaborated in some detail. There is no single objective criterion for determining the level of current account deficit that can be run by a country on a sustained basis. It is determined by the perception of the viability of the economy in servicing its external obligations by the international financial system, which in turn may be dependent upon a number of summary measures of external liability of the nation.
2.36 One of the standard yardsticks for evaluating the sustainability of a nations debt position is the external debt (ED) to GDP ratio (ED/GDP). This had reached an unsustainably high figure of about 41 per cent in 1991. Since then it has declined more or less steadily, and stands at about 26 per cent at present. While this is reassuring, in the sense that if present trends continue, the ratio could be reduced to about 18 per cent by the end of the Ninth Plan, it should be treated with caution. The reason for caution arises from the fact that the reduction in the external debt to GDP ratio has been achieved to a large extent by substituting foreign investment flows for external debt flows. Thus the ED/GDP ratio is today an incomplete measure of the total outstanding external liabilities of the nation. Since foreign investment also needs to be serviced and in theory is also repayable, it constitutes just as much a claim on the current income of the nation as debt repayment. Therefore, the proper measure of external indebtedness should include all foreign liabilities, which would include both external debt and all foreign investment inflows. If such a measure is used, the external liabilities to GDP ratio is substantially higher, and stands at about 32 per cent. On this count, therefore, the country continues to be quite heavily indebted, which is reflected in the fairly low ratings that are being presently given to India by the international credit rating agencies.
2.37 There is a point of view which holds that the current account deficit need not per se be a matter of policy concern, and attention should be restricted only to the public component of external debt. The argument is that the private sector can be expected to fully take into account the inter-temporal viability of its liabilities, both internal and external, and hence the private component of the current account deficit would necessarily be self-correcting. This is, however, not a tenable position, particularly at the present juncture. International experience shows that debt crises can occur even when the bulk of the external liabilities are privately held. The reason for this, apart from normal failure and default risk inherent in any commercial activity, is that the individual private sector firm normally evaluates its inter-temporal budget constraint in terms of the domestic currency and not on the basis of the currency in which the liabilities are denominated. Thus the possibility exists that private viability can coexist with a running down of the nations foreign exchange reserves. Therefore, the aggregate level of current account deficit is and will continue to be a matter of policy concern until such time as the foreign exchange reserves of the country are large enough to meet such contingencies.
2.38 The standard methodology (e.g. Joshi and Little) to determine the sustainable level of current account deficit (CAD) for India defines the critical indicator as the external debt to exports (ED/E) ratio on the ground that this indicator is more relevant to a large and relatively less open economy like India than the external debt to GDP ratio. The analysis indicates that the increase in external debt as a proportion of exports can be broken down into two components. The first is the primary, or the non-interest component of current account deficit. The second is the interest payment on external debt; but since the denominator of the ED/E ratio is the value of real exports, the increase in the debt ratio depends upon the difference between the real interest rate on external debt and the growth rate of real exports. If the latter component is positive, i.e. the rate of growth of exports is less than the rate of interest on external debt, then there is no level of primary current account deficit that is sustainable since the ED/E ratio follows an explosive path. On the other hand, if this component is negative, then it is theoretically possible to run a primary CAD provided that in the long run the ED/E ratio converges to a sustainable figure. The sustainable value of the ratio is of course a matter of judgement; but as has been pointed out, since there are indications that the international capital markets regard Indias external debt as being on the margin of the danger zone, it may be sensible not to allow this ratio to rise above the current level.
2.39 From the point of view of macro-management of an economy with a low initial level of foreign exchange reserves, the standard exercise needs to be modified in one important respect. The requirement of external capital inflows is given not only by the current account deficit (CAD), which represents the inflow of foreign savings, as assumed by Joshi and Little, but it also needs to cover the desired increase in the foreign exchange reserves, which provides the precautionary cushion against sudden disruptions. If this latter component is not taken into account in determining the sustainable level of CAD, then either the terminal value of the ED/E ratio will be higher than the sustainable or the foreign exchange reserves will be lower than dictated by prudence. Therefore, the Joshi and Little formulation needs to be modified by inclusion of a term which captures the requirement of maintaining the desired level of foreign exchange reserves. If the desired level of foreign exchange reserves (FER) is defined, as is normally done, in terms of months of imports, its future trajectory can be specified as being a function of the expected growth rate of imports.
2.40 The formulations for the sustainable current account deficit arising from the above two approaches have been worked out for the Ninth Plan period. As has already been mentioned, although the External Debt/Exports ratio in 1996-97 is likely to be 2.7, if the broader definition of total external liabilities is used, the applicable ratio works out to 3.2. These figures, however, include debt at concessional terms. In evaluating the future it cannot be assumed that the share of concessional debt will continue to remain at the past levels. Correcting for this, the ratio of discounted external liabilities to exports works out to 2.2, which is the relevant figure for the exercise. In so far as the real rate of interest on external borrowings is concerned, it would not be prudent to assume a rate lower than 5 per cent, which takes into account not only the long-term behaviour of international interest rates, but also premium which may have to be paid on account of the higher risk perception of the country and the possible future depreciation in the real exchange rate. Import growth is assumed to take place at the 10.8 per cent per annum for the Ninth Plan. On this basis, the sustainable values of CAD for the Ninth Plan period at different rates of growth of real exports by the two methods are presented in Table 2-12. As can be seen, the modified methodology yields a consistently lower value of the sustainable CAD/GDP ratio than the standard by about 0.3 percentage points. The two estimates are, however, not unrelated. The proper interpretation would be to treat the modified estimates as the sustainable level of the CAD/GDP ratio, and the standard estimates as the sustainable level of external inflows/GDP ratio. The difference between the two yields the level of inflows necessary to increase the foreign exchange reserves at the desired rate.
2.41 The calculations of sustainable CAD given in Table 2-12 implicitly assume that all future external inflows will be in the form of commercial debt, and ignore the possibilities of concessional debt, on the one hand, and foreign investments, on the other. In so far as concessional debt is concerned, the trend behaviour suggests that it will steadily decline as a proportion of total external inflows into the country. This view is supported by the overall trend in the international availability of concessional funds. However, to the extent that concessional debt does become available to the country, thereby reducing the average interest rate on foreign borrowings from the assumed figure, the CAD limits specified above can be pierced. This, however, would have to be done in a flexible manner keeping in view the commitments that are received by the country in this regard.
Table 2-12 : Sustainable Current Account Deficits --------------------------------------------------------- Export Growth Sustainable CAD(% of GDP) Standard Modified --------------------------------------------------------- 8.0% 1.70% 1.40% 10.0% 2.00% 1.70% 12.0% 2.35% 2.05% 14.0% 2.75% 2.45% --------------------------------------------------------- NOTES : (1) The standard formula for sustainable non- interest CAD is : z = d.(gx - r*); where z = non-interest CAD/Export ratio; d = External Debt/Export ratio; gx = growth rate of real exports; r* = real interest rate on external borrowings. (2) The corresponding modified formula is : z = [d.(gx - r*) - m.gm]/[1 + m.gm]; where m = FER/Import ratio; gm = growth rate of real imports. (3) The sustainable total CAD (ie. including interest payments) to GDP ratio (c) as reported in the table is given by the relation : c = e.(z + d.r*); where e = Export/GDP ratio
2.42 On the positive side, the economic reforms have created the enabling conditions for inflows of foreign investment, both direct (FDI) and portfolio (FPI), which were practically nonexistent earlier. The basic advantage of foreign investment lies in that its risk sharing characteristics are superior to that of debt. In other words, unlike debt, these inflows generally need to be serviced only to the extent that they yield positive returns. The only form of external investment which does not have this characteristic is external portfolio investment in domestic debt instruments, which are substantially no different from external debt except to the extent that, on the one hand, they command the domestic rate of interest as against the international interest rate but, on the other hand, the exchange rate risk is borne by the foreign investor rather than by the domestic borrower. While caution needs to be exercised with regard to this particular form of foreign investment, the greater inflow of foreign investment, particularly FDI, may permit a somewhat higher level of sustainable CAD, subject to certain conditions.
2.43 Prior to the economic reforms, when foreign investment was virtually non-existent and the import elasticity was constrained by various import controls, the sustainable CAD was about 1.4 per cent of GDP and the required inflow of external capital was 1.6 per cent of GDP. The difference was for keeping the foreign exchange reserves at a desirable level. The external debt trap situation that occurred was mainly on account of the CAD being consistently around 2 per cent of GDP over an extended period during the 1980s which was financed primarily by higher recourse to external commercial debt. With the liberalisation of external trade and investment that has occurred since 1991, foreign investment inflows have begun to grow steadily and the import elasticity has also gone up quite sharply from about 1.5, which is the historical average, to 1.7. These two factors operate in opposite directions in so far as the sustainable level of CAD is concerned, the former to increase it and the latter to reduce it. Although the computations regarding the sustainable CAD capture the latter effect, the former has not been incorporated. The reason for this lies in the fact that foreign investments are supply-driven in the sense that although the country can create the conditions for making such investment attractive, the decision as to whether and how much to invest is made by the foreign investor. It is preferable to base the resource estimates for Plan investment upon the assumption that if necessary the entire amount of external capital inflows required for meeting the Plan targets can be made in the form of debt without jeopardising balance of payments sustainability. To the extent it is possible to attract non-debt creating flows of equity investment from abroad, it would give larger elbow room to the financing of the Plan.
2.44 Although, by and large, non-debt creating external capital inflows permit a somewhat higher sustainable CAD than under pure debt finance, two factors need to be taken into account. First, such inflows tend to require a higher rate of return than the interest rate on debt over the longer run. Therefore it would not be prudent to raise the CAD target too much unless there is sufficient confidence in being able to maintain high growth rates of exports over an extended period. This would be so even if these foreign capital flows are productively deployed, unless they raise net exports directly or by releasing resources indirectly from the competing sectors. Second, a distinction has to be drawn between FDI and FPI in terms of their effects on the economy. In general, FDI is to be preferred over FPI flows, partly because its returns are closely linked to the performance of the real economy and partly because it tends to be less volatile than FPI. Besides, the most important disadvantage is that FPI flows tend to be pro-cyclical, in the sense that it comes in when the balance of payments (BOP) position is seen to be strong and goes out when the BOP position is expected to weaken. Thus, it accentuates the direction of movement of the BOP, which can cause problems in macroeconomic management. In the case of countries like India, where the foreign exchange markets are very thin compared to the international financial market, a free FPI regime carries a danger of speculative movements which can lead to serious disruption in the economy.
2.45 On balance, while FPI flows can play a major role and should be welcome, our basic objective should be to promote larger volumes of FDI inflows. In certain years in the recent past, inflows of FPI have been relatively high and this has created difficulties in exchange rate and monetary management. In fact, the need to sterilise the large FPI inflows has led to a situation where public holding of government debt has had to increase beyond desirable levels and has restricted money finance of the fiscal deficit to very low levels. This situation has arisen due to the fact that there are still considerable controls and other barriers on the inflow of FDI and external debt, which are respectively the most desirable forms of external capital, but virtually none on FPI. The policy directions in the future should be to focus on creating a more liberal enabling framework for FDI with FPI flows being left to be determined in the market.
2.46 Keeping in view the above discussion, it is felt that the limits on sustainable CAD given in Table 2-12 may be adhered to as a matter of prudence until such time as there is greater confidence in the ability of the economy to attract higher FDI inflows. It may further be seen that the estimates are extremely sensitive to the assumed growth rate of exports. In planning for the Ninth Plan, although the targetted growth rate of exports has been taken to be 11.8 per cent per annum, it is felt that some relaxation may be permitted while specifying the sustainable current account deficit in order to provide necessary resources for growth. Such a relaxation is contingent on higher FDI inflows and on the fact that the current level of foreign exchange reserves is fairly comfortable, at least for the near future. Over the longer run, however, it is imperative that the growth rate of exports be raised to over 14% per annum. Therefore, the Ninth Plan has been based on a current account deficit of 2.2 per cent of GDP, which corresponds to an export growth rate of about 13 per cent per annum in real terms. The detailed figures for the Ninth Plan are presented in Table 2-13, where the sustainable figures are on the basis of 11.8 per cent growth rate of exports.
Table 2-13 : External Capital Requirements and Inflows ------------------------------------------------------------ Sustainable Planned ------------------- ---------------- % of GDP $ bill. % of GDP $ bill ----------------------------------------------------------- Current Account Deficit 2.0 41 2.1 43 Increase in Foreign Exchange Reserves 0.3 6 0.2 4 Total External Inflow 2.3 47 2.3 47 Of which : (1) FDI 1.2 24 1.2 24 (2) Debt + FPI 1.1 23 1.1 23 ------------------------------------------------------------
2.47 It should first be noted that the external financial inflows (Debt + FPI) given in Table 2-13 are specified in net terms, i.e. after taking into account the outflow of principal payments. Thus, the gross inflows would have to be significantly higher. Secondly, it may be noted from Table 2-11, that the public sector investment requirement will absorb about 0.6 per cent of GDP in the form of external resources, over and above the amount needed for maintaining the foreign exchange reserves. This will be almost entirely in external debt, with a minor component of external grants. Thus the resources available to the private sector will stand reduced by this amount. Third, export performance would need to be tracked with great care in order to determine whether or not the limits specified above can be allowed to be breached. If the growth rate of exports exceeds the target of 11.8 per cent, pari passu adjustment in the limits can be made.
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