Financial debacles in emerging markets: Why the surprise?

Emerging economies such as India and Indonesia which have experienced the destabilising effects of the US policy of quantitative easing should not ignore the fact that this whole problem has arisen only because of their flawed approach to economic strategy, says Jayati Ghosh.

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FOR a while now, the BRICS seem to have lost their sheen. Global investors and financial media that could not say enough good things about them and their huge potential appear to have decided that the party is over for now and they should move on to find action somewhere else. The relatively guarded statements about the possible tightening of US quantitative easing policies have been the trigger for this, but the outlook had already turned darker because of decelerating exports in all of the BRICS - Brazil, Russia, India, China and South Africa -  in the past year.

India is the latest casualty among emerging economies, with its currency sliding more than 20% over half a year against the US dollar before recovering just a tiny bit on the appointment of a new governor of the central bank. While some have argued that the damage has been contained for now, that is far from the truth. In fact, the Indian economy may well be on the verge of a full-blown currency crisis.

In this febrile situation, it is open season for rumours and pessimistic predictions, which then become self-fulfilling. So even if there is a slight market rally, investors quickly work themselves into even more gloom. Each hurriedly announced policy measure (raising duties on gold imports, some controls on capital outflows, liberalising rules for capital inflows and so on) has had the opposite of the desired effect. Everything the government does seems to be too little, too late - or even counterproductive.

These are all classic features of the panic phase of a financial market cycle. This doesn't mean that a crash is inevitable, but clearly it is possible. But the real surprise in all this is that investors and Indian policy makers are surprised. For some reason, they apparently did not foresee this turn of events, even though the story of every financial crisis of the past and many in the very recent past should have caused some nostrils to twitch at least a year or two ago.

The Indian economy has been in trouble for quite a while already, and only wilful blindness could have led to ignorance on this. Output growth has been decelerating for several years now, and private investment has fallen for 10 consecutive quarters. Industrial production declined over the last year. But consumer price inflation is still in double digits, providing all the essential elements of stagflation (rising prices with slowing income growth).

At the moment the external sector is the weakest link. Exports are limping along but imports have ballooned (including all kinds of non-essential imports like gold), so both trade and current account deficits are at historically high levels. They are largely financed by volatile short-term capital. This has already started leaving the country: since June more than $12 billion has been withdrawn by portfolio investors alone.

This situation is the result of internal and external imbalances that have been building up for years. The Indian economic boom was based on a debt-driven consumption and investment spree that mainly relied on short-term capital inflows. This generated asset booms in areas like construction and real estate, rather than in traded goods. And it created a sense of financial euphoria that led to massive over-extension of credit to both companies and households, to further compound the problem. Sadly, this boom was also 'wasted' in that it did not lead to significant improvements in the lives of the majority, as public expenditure on basic infrastructure, as well as nutrition, health, sanitation and education did not rise adequately.

We should know by now that such a debt-driven bubble is an unsustainable process that must end in tears, but those who pointed this out were derided as killjoys with no understanding of India's potential.

Something similar is occurring in a number of other Asian economies that are also feeling the pain at present, like Indonesia, while Brazil in the other part of the world shows some similar features. The current Indian problems may be extreme, but they reflect what should now be a familiar process in all major regions of the world.

The typical story, which was elaborated half a century ago by Charles Kindleberger, goes something like this: A country is 'discovered' by international investors and therefore receives substantial capital inflows. These contribute to a domestic boom, and also push up the real exchange rate. This reduces the incentives for exporters and producers of import substitutes, so investors look for avenues in the non-tradable sectors, like construction and real estate. So the boom is marked by rising asset values, of real estate and of stocks. The counterpart of all this is a rising current account deficit, which no one pays much attention to as long as the money keeps flowing in and the economy keeps growing.

But all bubbles must eventually burst. All it takes is some change in perception for the entire process to unravel, and then it can unravel very quickly. The trigger can be a change in global conditions, or a sharp slowdown in domestic income growth, or political instability, or even economic problems in a neighbouring country. In India, Mr Bernanke of the US Federal Reserve is being blamed for bringing this on, but it could easily have been some other factor. Once the 'revulsion' in markets sets in, the very features that were celebrated during the boom are excoriated by both investors and the public, as examples of crony capitalism, inefficiency and such like. The resulting financial crisis hits those who did not really benefit so much from the boom, by affecting employment and workers' incomes.

This is what has just started to happen in India, and is also likely to happen in several other emerging markets. But essentially the same process has already unfolded many times before in different parts of the world: Latin America in the 1980s, Mexico in 1994-95, South-East Asia in 1997-98, Russia in 1999-2000, Argentina in 2001-02, the US in 2008, Ireland and Greece in 2009 and so on.

Wrong-headed response

 

So it should have been quite obvious to the Indian government and to external observers that this was an outcome only to be expected. Instead, surprise and even shock among policy makers seem to be the order of the day. The panic-stricken government has been throwing what it can at the problem - to little avail, since each hurriedly announced measure seems to be followed by further capital outflow and further depreciation of the rupee. But given the loss of policy imagination that comes after two decades of manifestly open market policies, that is perhaps not so surprising.

There are at least four problems with the nature of the central government's economic responses to the current crisis. The first is the tendency in official circles to blame most of the problem on external forces, rather than on the internal mess of the large imbalances within the economy and the lack of sustainability of private sector expansion in particular. Government representatives regularly appear before the public to blame everything on Mr Bernanke of the US Federal Reserve for threatening to raise US interest rates, or on the global economic slowdown for causing our exports to decelerate. But the truth is that the recent boom was a bubble waiting to burst - the external forces have influenced the timing rather than the unfolding of the process.

The second problem is the inability to recognise what should be obvious: that a crisis associated with hot money flows cannot be resolved by begging for further hot money flows. It should have been evident that running large and growing current account deficits financed with essentially short-term capital flows could never be a sustained strategy, and essentially characterised a temporary bubble that is now bursting. Instead of dealing with the source of the problem, the government is desperately trying to stem the crisis by somehow attracting the same capital back in by offering yet more concessions.

But such concessions can never be enough to compensate for expected capital losses, if expectations of the value of the rupee and other domestic assets like stocks are on the downswing. The Prime Minister Dr Manmohan Singh actually went as far as to declare the government's subservience to global capital: 'It is absolutely not on the table to put any limits on the ability of FIIs [foreign institutional investors] who have put money into India to take it out whenever they want. In fact we are taking measures to make it more attractive for them to invest more.'

This in turn leads to the third problem, which is that the proposed remedies actually make for an even bigger problem in the near future. The current approach looks too much like what it is: a series of nervous and jerky responses that try to apply quick-fix bandages without being part of a cohesive medium-term economic strategy. So various different measures are tried out: rules for foreign direct investment are further liberalised; new bond issues are launched for non-resident Indian investors; public sector undertakings are encouraged (even pushed) to engage in more external commercial borrowing, even when this may turn out to be very costly for the country later; there is a bit of half-hearted intervention in the foreign exchange market by the central bank; gold import duties are raised slightly (though they are still far too low). None of this adds up to a clear plan that is likely to instil confidence - not just in the rupee, but in the wisdom of those at the helm of affairs, and therefore the economic future of the country.

The fourth, and possibly most significant, problem stems from the refusal to look seriously at the necessary counterpart of the capital inflows that were so celebrated during the boom years: the current account deficit. The true source of India's current balance-of-payments concerns is the burgeoning trade deficit, which has now turned so large that the current account deficit also could not be kept in check even with the largest inflows of workers' remittances in the world. And the critical matter with respect to the trade deficit is not simply the slowing down of exports, but the fact that imports have continued to increase even as the Indian economy slowed down.

Tackling the import influx

This makes it quite evident what the crisis resolution must necessarily entail: systematic steps to reduce the import bill. Indeed, this is not only a temporary emergency measure, since it has implications for the pattern of output and employment growth in the economy as a whole. But how exactly is this to be done?

One obvious offender is gold imports, which currently account for nearly one-fifth of the total import bill, second only to oil imports (around one-third). Clearly, these levels of gold imports are unjustifiable and must be curbed. But given the inelastic nature of gold demand in India generally and particularly now in a time of economic uncertainty when gold is still seen as a safe asset relative to volatile financial assets, small hikes in import duties are unlikely to do the trick. Much larger increases are called for, combined with much more stringent measures to clamp down on gold smuggling.

But this constitutes only part of the problem. There has been a huge increase not just in other 'non-essential' imports, but in imports that have dramatically attacked the productive capacities of the country and wiped out lots of employment. Since 1991 and over the past decade in particular, the nature of economic expansion in India has systematically eroded the capacities and competitiveness of huge swathes of producers in agriculture and manufacturing.

Small and medium producers coping with terrible infrastructure, erratic provision of basic utilities, next to no access to affordable institutional credit and constantly rising prices of fuel (the basic intermediate good that enters into all costs) have been forced to compete with global production. In many cases they have been unable to do so, to the point that many have been decimated and others survive only by the skin of their teeth. Informal enterprises (which still account for the bulk of national output) have been the worst hit by the rising tide of imports, which has adversely affected both employment and livelihoods.

As a result, many commodities that were previously produced in India have simply disappeared from markets in the country, to be replaced with imports coming not just from China but many other parts of the world. Of course it is well known that toys, decorations and similar things increasingly come from China, and electronic goods from various parts of Asia. The shopping malls sell garments made in Guatemala and Morocco even though similar garments are made in India; builders use marble from Italy rather than the stuff sold by small processors in Rajasthan and elsewhere; imports have replaced domestic production in the urban markets for many fairly standard goods that are very much part of mass consumption like pens, soaps, household goods and so on.

Of course all of this translates into employment losses. But it has possibly even more deadly implications for the future. The loss of some productive capacity does not just affect the producers involved in it: it means a social loss of knowledge, production capability and synergies that are absolutely necessary to build up manufacturing prowess. And surely by now it should have been understood that building up such manufacturing capability is essential, that India cannot simply leapfrog over to the next stage of service-led growth without first doing the hard work of industrialisation? The mindless pattern of import liberalisation has occurred without ensuring that Indian manufacturing producers have at least something like a level playing field in terms of access to infrastructure, credit and the like. Not surprisingly, they have suffered losses in terms of productive potential that may take years to reverse.

Similarly, the country is importing agricultural goods that it really need not do. This is certainly so for cereals and cereal products, where the imports indicate the poor management of the food economy in a sector in which the country should have a competitive advantage. In addition, the continuing import of pulses and oilseeds is a sad comment on the failure of agricultural strategy that has not addressed issues of viability of such production despite decades of government-sponsored 'Missions'.

Obviously much more public investment in basics like infrastructure and access to credit is required to move forward. But in the intervening period, some protection from imports is clearly necessary. India's current tariff levels for most commodities are well below the tariff bindings declared at the World Trade Organisation, and in any case the government could probably take advantage of the WTO balance-of-payments exceptions in the current situation. But the noodle bowl of free trade agreements that India has signed with ASEAN and other trading partners creates other constraints to import protection that need to be examined carefully.

What all this suggests is that, while the external sector is currently the weak link that has brought on the current crisis, it is precisely that - a link in a chain of economic policy that needs major reworking. Resolution of the crisis will not come from temporary measures to paper over the cracks and then hoping to proceed with business as usual. Current account balancing must be an essential focus - and if it can happen with the added advantage of reviving some domestic production, surely that is so much the better. But unfortunately this is unlikely to happen as long as the current approach to economic strategy in India remains the dominant one.    

Jayati Ghosh is an economics professor at Jawaharlal Nehru University in New Delhi.

*Third World Resurgence No. 276/277, August/September 2013, pp 31-33