[stop-imf] IMF official's call for Indian financial deregulation

[robert weissman]

http://www.imf.org/external/np/vc/2008/050408.htm

The 500 Billion Dollar Question
by Kalpana Kochhar
Senior Advisor, IMF Asia and Pacific Department
published in Business Standard (India)
May 4, 2008

Today, few question the need for substantial improvement in India's
infrastructure if the rapid growth is to be sustained. Recognizing this,
the Planning Commission has put front and center in its strategy to
sustain faster, more broad-based and inclusive growth, investment of
about $500 billion in infrastructure before the end of the 11th Five
Year Plan in March 2012.

Over the past three years, India has invested an average of 4=BD percent
of GDP each year in infrastructure. Getting to the Planning Commission's
target-which is estimated to be the equivalent of 9 percent of GDP in
2011/12-means that infrastructure investment will need to increase by
nearly 1 percent of GDP each year between 2007/08 and 20011/12 percent
of GDP. The question we ask here is: where will the resources to finance
this additional investment-nearly 5 percentage points of GDP by
2012-come from?

Let us look first at domestic sources. India's household sector saves
about 24 percent of GDP up from around 16 percent of GDP only a decade
ago. Over this same period, India's corporate sector's savings has also
increased from around 4 percent of GDP to close to 8 percent. Can we
expect such increases to continue? Perhaps but it is not likely.
Household savings, are already at the high end of broadly comparable
emerging markets. And corporate profitability-which has been remarkably
high-is likely to be buffeted by the slowing global economy, the
financial turmoil, and upward pressure on wages. Therefore, it may not
be realistic to expect much by way of additional savings from India's
private sector.

What about the public sector? From dissavings of around 1 percent of GDP
a decade ago, public sector savings shot up to an impressive 3 percent
of GDP in 2007/08. But given the pressures from the 6th Pay Commission,
the agricultural loan waiver, and continued commodity subsidies it will
likely be difficult to increase or even to maintain this level of
savings in the absence of substantial improvements in tax revenue
collection..

So, the 500 billion dollar question: Can India achieve the 11th Five
Year Plan's target for infrastructure investment without foreign
capital? We argue that it cannot.

In 2006/07, net capital inflows amounted to about 5 percent of GDP but
the residual gap between investment and domestic savings was only around
1 percent of GDP. This led to the view amongst analysts and some policy
makers that capital flows are "excessive" and should be curbed. There is
no denying that a major policy challenge is to maintain macroeconomic
stability in the face of capital inflows that may not match outflows in
timing. As investment is typically prefunded, capital will flow in
before it goes out as imports and profits. And this is true for FDI,
portfolio inflows, and fixed-income lending. Such asynchronized timing
makes life very difficult for macroeconomic policy makers.

Often and perhaps naturally, policymakers tend to give a much higher
weight to the short-term problems than to the longer view and this leads
to attempts to fine tune capital controls to manage the impact of the
inflows. But fine-tuning capital controls rarely works. To quote Glenn
Stevens, now Governor of the Reserve Bank of Australia, as he discussed
Australia's experience in the 1980s, "[Capital inflows] occurred in
spite of capital controls that were still in place, because the
distinction between current and capital transactions was blurring and
market participants were becoming more adept at circumventing the controls.=
"

Another rationale that is often provided for active capital account
management is the belief that by changing relative prices (through taxes
and other forms of transaction costs) policymakers can influence the
form of the inflows, i.e., foreign direct investment, or portfolio
investment, or borrowings. The choice of such taxes is derived from a
hierarchy of the relative desirability of different types of inflows.
There is little by way of evidence (even from the famed Chilean
experiments with controls) that government policy can do better than the
market in pricing different forms of capital. At the same time, there is
considerable evidence that controls do at least two things: they make
capital inflows less transparent by incentivizing agents to disguise
them, and they raise the price of capital, especially for small and
medium term enterprises. This would appear to be at cross purposes with
the need for large capital inflows to ensure continuance of India's high
growth. Ultimately, the only way capital controls are known to have
worked is when they were imposed in a draconian and blanket fashion.
Fortunately, there is no appetite in India for such extreme measures.

Quo vadis, then? Given India's strong medium term fundamentals, it is
quite clear that foreign investor interest in India is here to stay. And
the timing of such heightened interest is indeed fortuitous as it
coincides with the government's recognition of the urgent need to kick
infrastructure investment into high gear. So the right strategy is to
rapidly put in place reforms of financial, labor and product markets to
absorb these inflows efficiently.

India needs to rethink its capital account framework in the light of the
need for $500 billion in infrastructure investment. This means
refraining from ad hoc changes in capital controls in the name of
macroeconomic management, and quickly expanding the country's real and
financial absorptive capacity. In particular, there is an urgent need
for an expedited and time-bound plan to develop the corporate bond
market, including by raising the limits on foreigners' participation in
this market, permitting greater capital outflows, creating fiscal space
to finance infrastructure investment by curbing wasteful spending, and
implementing structural reforms of labor and product markets.

The author is a Senior Advisor in the Asia and Pacific Department of the
International Monetary Fund. The views expressed here are personal.