India Story Looks Ever So Strong - Really?

According to Indian central bank, Reserve Bank of India (RBI), foreign direct investments for the period April-July 2008 stood at $12.32 billion. This compares with foreign direct investments of just $5.70 billion recorded for the same period last year. Clearly, structural reforms undertaken by the incumbent government, coupled with increased confidence in the India Story has contributed to this incredible y-o-y growth of over 100% in foreign direct investments. If the run-rate sustains, we may well end up experiencing the highest inflow of foreign direct investments ever. Last year was a record $32.43 billion. However, the more volatile foreign portfolio investments have been a sadly negative $4.67 billion for the period April-July 2008. This compares with a record year set last year, when foreign portfolio investments were $14.3 billion for the period April-July 2008. RBI records indicate that while fiscal deficit has improved, revenue deficit has slightly worsened, when compared to last year. The data also indicates that trade deficit may well widen this year, and this may potentially cause weaker balance of payments position.

Ofcourse, oil is a major import item for India, and the continuing high price of oil is a major reason for the widening trade deficit. This is interesting, because since the reforms undertaken in the early 1990's, India's road to economic prosperity has been built around the central theme of 'devalue and export' mantra. The current prime minister was then at the helm of affairs, when that reform theory was designed. Is it time for India to revisit this core economic policy? - If we go by Dani Rodrik, professor of political economy at Harvard University, the answer may well be to rely less on exports to achieve economic prosperity. He points out to an imminent threat of slowdown in advanced economies, and the almost certain unwinding of global current-account imbalances, as a clear threat to export-dependent economies. Dani argues that the economics and politics of protectionism in the West is likely to cause a slow-down in exports. If exporting does become a tough business, then economies like India will be forced to rely on domestic demand to sustain economic growth.

But domestic demand fueled only by easy money has its own problems. M3 data, the broader indicator of money supply, indicates that money supply growth in India has far exceeded the GDP growth since 2005 - due to the central bank's active intervention in the currency markets. While this 'sterilization' process was successful in containing currency appreciation that was to be caused due to strong forex inflows - and thus help exports; the process did very little to help solve the trade imbalance, particularly in light of high oil prices. In addition, weaker domestic currency also meant higher input costs (oil being a significant input constituent), and this helped the already fueling inflation, partly led by easy money, and partly by high food and commodity prices. The net result of a high-inflation expensive credit economy is a potential slowdown in growth.

Is it time for the Indian central bank to stop excessive intervention in the forex market, and let the domestic currency on a more free float? I would argue on the affirmative, especially because (direct) investments continue to be buoyant. The challenge is for the government to push the pedal on structural reforms in such a way that it fosters not only investments, but also creates a healthy competition.