India’s Balance of Payments: Time for a New Paradigm

There has been a great deal of consternation in the media about India’s recent capital account deficit caused by net outflows of both Foreign Direct Investment and Foreign Portfolio Investment. The government has also taken a variety of measures to allay concerns about how India will finance its balance of payments. My view is that it is not the capital account that needs to be addressed, but the current account. In fact, the capital account deficit is a great opportunity to correct the imbalances that have developed over many decades.

The economic reforms of 1991 successfully solved the balance of payments crisis of 1990-1991, but this very success contained within it the seeds of a Dutch disease that has become salient only now. The Dutch disease is a phenomenon first modelled more than four decades ago in which a boom in one sector of the economy causes other sectors of the economy to atrophy, leading in extreme cases to de-industrialisation (Corden, W.M. and Neary, J.P., 1982. Booming sector and de-industrialisation in a small open economy. The Economic Journal, 92(368), pp.825-848).

India’s balance of payments has benefited from not one but three booms over the last three decades: (a) large capital inflows, (b) huge remittance flows, and (c) massive exports of Information Technology services.

All of these have contributed to a loss of global competitiveness in merchandise exports and a yawning deficit in the balance of trade (trade in goods rather than services). Historically, each of these booms served a useful purpose, but as circumstances changed, their ill effects have become more pronounced, and there is a need for a paradigm shift that reorients our foreign trade towards our long-term national interests.

Large Capital Inflows
During the quarter century from the early 1990s till the mid-2010s, foreign portfolio investors were absolutely critical for the Indian economy because of the pattern of Indian household savings at that time. In the era of the planned economy from the 1950s to the early 1990s, the government had been the main engine of economic growth and the principal risk taker in the economy. The task of the financial system was essentially to mobilise household savings and channel it to the coffers of the government. An extensive bank branch network, a vast army of insurance agents, and the wide reach of post office savings products enabled the financial system to mobilise financial savings from every nook and corner of the country.

The government preempted a huge fraction of these savings through regulatory mechanisms. For example, the cash reserve ratio and statutory liquidity ratio required banks to lend more than 40% of their deposits to the government.

A consequence of this entire system was that household savings were almost entirely in the form of “risk-free” fixed-income products.

A core element of the Indian economic reforms in the early 1990s was that the government shifted the investment burden to the private sector. An immediate problem was the availability of risk capital since Indian household savings were almost entirely in safe bank deposits and other fixed-income products, which could provide only debt capital.

The solution that emerged almost by accident was to tap foreign risk capital by allowing foreign portfolio investors to buy non-controlling minority stakes in Indian companies. While necessary for economic growth at that time, large capital inflows do lead to a Dutch disease, because a capital account surplus has to be offset by a current account deficit, as reserve accumulation does not completely neutralise the capital inflow.

This quarter century of dependence on foreign portfolio capital was also a period of sweeping capital market reforms, but these took decades to bear fruit. First, it was the complete overhaul of the stock market with modern technology and strong regulation. Second, it was the creation of investment institutions, including private sector mutual funds, insurance companies and retirement savings vehicles. The third and fourth factors, generational change and demographic transition, were not really “reforms” and are perhaps not adequately appreciated, but were critical.

The fading away of the old generation and the coming of age of a new generation created an investor pool willing to look beyond bank deposits and adopt newer products if they offered better returns. Reinforcing this trend is the demographic dividend that is providing a significant net addition to the workforce that increases the savings pool.

As a result of this multi-decadal process, India now has a large pool of domestic risk capital. Reflecting this, the ownership share of foreign portfolio investors in Indian companies listed at the National Stock Exchange peaked just before the COVID pandemic and has declined steadily since then. Domestic institutions, including mutual funds, banks, and insurance companies, now hold a larger ownership (nearly 19%) than foreign portfolio investors (17%).

Domestic risk capital is now ready to supplant foreign risk capital. FPIs will not go away because of the need for global diversification, but FPI outflows should be larger than FPI inflows. The net flow of portfolio capital should become mildly negative in the long run. Similarly, net FDI should also be mildly negative in the long run. In other words, India’s capital account should be in modest deficit. The unavoidable implication of this is a modest surplus on the current account.

Huge Remittance Flows
India currently receives remittances of more than 3% of GDP from Indians who have migrated (temporarily or permanently) to foreign countries. In the early days, this was dominated by relatively low-skilled Indian workers in the Middle East, but more recently, the bigger source of remittances has been highly skilled Indian professionals in the advanced economies of North America and Europe. These remittances are a testimony to India’s macroeconomic stability, as otherwise non-resident Indians with access to global investment opportunities would not choose to invest in Indian assets.

But there is a flip side as well.

When India runs an almost balanced current account with a deficit of, say, 0.5% of GDP, it is actually running a deficit in goods and services of nearly 4% of GDP. The global standard in balance of payments accounting regards worker remittances as current account transactions rather than the capital account transactions that they arguably are. The result of this statistical quirk is that we fail to realise that we are running a big current account deficit that is hollowing out our own economy.

A useful way of looking at migrant remittances is that these are somewhat analogous to exporting iron ore instead of building steel plants. The difference is that instead of exporting natural resources (iron ore), we are exporting human resources (migrant workers). This export might appear to make sense when the country is not generating enough jobs for its people, but by reducing pressure to adopt employment-friendly macroeconomic policies, it also helps perpetuate a low employment trap.

Information Technology Services Exports
India’s IT services sector has produced large current account surpluses on services that have masked big deficits in the foreign trade in goods. This boom was very important, but it was somewhat benign because it did not reduce India’s global competitiveness. The IT boom only redirected our global competitiveness from goods to services.

In recent months, however, with Artificial Intelligence models posing a threat to traditional IT services, there is a worry that relying so heavily on IT services exports might have created an unacceptably large concentration risk. There is an urgent need to diversify our export basket, both of goods and of services.

A New Paradigm
In short, all three booms have not only outlived their original purpose but have become hindrances to the next stage of India’s economic development. These booms (at least the first two) contributed to a structurally misaligned exchange rate and a loss of global competitiveness. They have helped create a situation where we import far more than we export. I think the time is now opportune for a paradigm shift in the management of our external sector that reverses the Dutch disease, makes Indian businesses globally competitive, and strengthens our strategic economic resilience. Several factors make this shift particularly attractive and urgent:

• India is going through the peak phase of its demographic dividend that provides a narrow window of opportunity for rapid growth. In another decade, demographics will turn unfavourable, and growth will be much harder.
• Stable flows of domestic savings into the equity market now enable risk capital to be raised without help from foreigners.
• Geo-economic instability and fragmentation make it dangerous to rely excessively on foreign capital, and also make it imperative to build and nurture strong domestic suppliers of goods and services.
• Substantial public investment in infrastructure and other industrial support services during the last decade has created the preconditions for a significant step up in exports of goods and services.

The path that I envision is that remittance inflows are roughly matched by net capital outflows led by reserve accumulation, sovereign investments, private portfolio capital outflows and outward foreign direct investments. This would cause the balance of payments deficit to reflect the actual foreign trade in goods and services. The currency would then find its natural level in order to bring the adjusted current account (excluding remittances) to balance or a slight surplus.

Some analysts worry about bridging the savings-investment gap if capital flows dry up or reverse.

I am sanguine about this for several reasons.

First, the savings-investment gap has historically been quite small, and so we need only a very small bridge. Second, the rate of savings out of incremental income tends to be higher than the average savings rate, and so if we boost the economic growth rate, savings can be expected to increase. Third, as East Asia demonstrated in its growth phase, fiscal incentives and other measures can be used to stimulate greater savings. Fourth, as businesses shift from rent-seeking pursuits in a protected home market to succeeding in global competition, they would be forced to become more efficient, and would allocate capital more carefully, leading to a decline in the incremental capital output ratio, and this would reduce the savings-investment gap. Finally, the transition to this path would be a multi-decade process that gives enough time to all economic agents to adapt to the new environment.

On the political-economy side, a big barrier to a sensible exchange rate policy has historically been that big businesses had large debt in foreign currency, and therefore had a vested interest in a strong rupee. As the Indian corporate bond market matures and rupee-denominated debt becomes more attractive, this political hindrance would be attenuated, and it would become easier to let the exchange rate reflect global competitiveness rather than the preferences of some vested interests.