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THE REVENGE OF THE TWIN DEFICITS OR ALL THE MACRO LIGHTS ARE FLASHING RED

If you thought they had gone away for ever, think again. With the fiscal deficit touching 6% for several years and the current account deficit inching its way over 3% we must necessarily examine whether we are moving into dangerous macro territory in a time of great global uncertainty, and what if anything can be done.

The fiscal deficit is not a new story. However, what is new is the government’s front loaded borrowing program which envisages borrowing Rs 3.7 trillion ($75 billion) in the first half. Ten year bond yields are moving up alarmingly and for those who argue that we can fund our deficit easily, these higher government bond yields just raise the cost of borrowing for everybody else. So even if the RBI cuts rates, the lack of liquidity in the market will ensure that actual interest rates do not decline proportionately and the benefits will be dampened. Second, the ability of the market to absorb so much debt is in question and the RBI will no doubt have to work hard to inject further liquidity into the economy through CRR cuts or open market operations. At the most recent auction, a considerable amount of government paper devolved to the primary dealers – a warning sign that we are approaching a liquidity crunch which will simply make it harder for corporates and consumers to borrow.

Sticky interest rates have further deleterious impacts on the economy. A recent CRISIL report on borrower quality states that overall credit quality of borrowers has declined from an average of AA in March 2008, to BBB a year later, to an average of BB now. In addition, default rates at 3.4% are at ten year highs, and NPA’s have almost doubled since 2006. All this indicates that the credit quality of corporates is not moving in a healthy direction, and as the internal stresses within the economy stay high on the back of decreased liquidity and higher interest rates, this will not change. On the contrary, credit quality will likely continue to decline.

Let’s examine the current account deficit. Our exports have been increasing by an average 20% a year, but our imports have been increasing at 30% on oil and gold. Some might argue that gold imports represent a stock of value and should be treated as a capital item, but that is a spurious argument – people consume gold in India as they would any other consumable, and the government has no recourse to this stock in times of trouble. In recognition of this problem the FM increased the customs duty on gold imports. While we can hope for a reduction in the flow, it appears unlikely given Indians’ hunger for the yellow metal. Regardless, our trade deficit is now over 10% of GDP and shows no signs of abating. Our positive balance on account of services and remittances cuts this deficit but we are increasingly dependent on capital inflows to support our balance of payments position. Again some would argue that a developing country like India has to necessarily run a current account deficit to account for capital inflows. But that would be out of a choice we do not have right now.

Our current dollar reserves which have declined from a high of $322 billion in August 2011, to $294 billion now, partly to defend a rupee decline, would account for at most 7 months of imports. Take out short term debt and FII flows from our FX reserves and we are in a much less comfortable position. Our twin deficits therefore make us vulnerable to global shocks in a volatile global environment. Our margin for error is increasingly shrinking.

In this context, one sees with increasing trepidation India’s handling of its investment environment. First, we had the supreme mismanagement of the telecom sector leading to the Supreme Court cancelling 122 licenses issued by the government. The loss on account of this to bona fide international investors such as Telenor, Etisalat, Sistema and Bahrain Telecom is to the tune of more than a billion dollars. The loss to Indian companies is probably of a similar magnitude. Let’s remember that not all companies paid bribes to get their licences. Some gamely followed what was a highly public but flawed process meant to favour a few, and in doing so, lost a lot of money. Some of these foreign companies are now threatening to take India to international arbitration under bilateral treaties. The reputational damage to India as a result of this fiasco has been considerable.

Separately, Posco was announced as the largest foreign investment into India with an investment plan of over ten billion dollars. Many years after the plans were announced, it is still mired in the infamous Indian approval process. In another example, a hedge fund has threatened to take Coal India to court over the FSA’s it has been asked to sign under a Presidential Directive. Vodafone won its tax case in the Supreme Court and the government decided to change its laws with retrospective effect to bring it under its tax net. Vodafone is now contemplating legal action. By also extending the period for investigations into tax claims, it has brought a number of other transactions into play, including probably unintentionally, the P-Note structure and PE investments through GAAR. In doing so, it has shaken the very foundations of one of the few advantages that India possessed – a rule of law and some stability in policy making.

Such legal action by so many corporates against the Indian government is unprecedented and at a time when we need it most, is severely testing foreign investor sentiment. Our BOP is now very sensitive to declining inflows – whether FDI (strategic and PE), FII, or ECB – and this will have significant negative consequences for the rupee, reduce liquidity even further, increase interest rates, impact corporates’ access to funds, and weaken our already rapidly deteriorating macroeconomic fundamentals. The government therefore needs to work hard to re-burnish India’s rapidly eroding image as an attractive investment destination.

Source: Economic Times