By Ishita Misra
Foreign investment has been rapidly rising since 1992 when the Indian government allowed foreign investors to invest in the country’s financial markets. Since then, foreign investment has become integral for the growth of the economy. With the government facing fiscal and revenue deficits every year, it is the growing foreign investment that is supporting the economic development of the country.
However, the ‘2017 External Sector Report’ by the IMF, has said that reliance on foreign investment through debt financing and portfolio inflows could create considerable external financing vulnerabilities in the Indian economy.
Overdependence is harmful
The danger in relying on debt financing and portfolio inflows for economic growth lies in the volatility of the foreign markets. This is the case with almost every form of foreign investment, leaving the developing economy at the mercy of global trends. If the situation is favourable for investment, foreign investments will pour into the country, advancing economic growth. On the other hand, if the situation is unfavourable for investment, foreign investment becomes limited and leads to shortfalls in capital needed for development.
According to the report, faster-than-anticipated normalisation of monetary policy in key advanced economies, longer-than-expected cash normalisation and slower global growth have resulted in intensified global financial volatility. This increase in intensity is a red flag for all emerging markets, including India. This is because a sudden decline in investment could stunt the development of the country.
What does the report reveal?
The report claims that even though the external vulnerabilities have reduced as compared to 2013, they still pose a threat to India. However, the excess current account imbalances in 2016 represented about one-third of total global imbalances. This has also remained broadly unchanged since 2013. These account imbalances have been increasingly concentrated in advanced economies. The report also mentioned that India’s low per capita income, favourable growth prospects, and development need to justify the current account deficits in the country. Furthermore, it also insisted that it is important to maintain adequate levels of international reserves to safeguard the economy in times of crisis.
The report went on to say that India’s 2016-17 external sector position is largely consistent with medium-term fundamentals and the desired policy settings. Further, the current policy of smoothing the exchange rate volatility from time to time is appropriate and the flexible exchange rate policy followed by the Reserve Bank of India is sound.
Improvement in the external sector position since 2013 can be observed through India’s net international investment position (NIIP). India’s NIIP has improved from -18.5% of GDP at the end of the fiscal year 2013-14 to -17.0% of GDP at the end of 2016. Even the gross foreign assets and liabilities have decreased to 25% and 42% of GDP. The report also predicted that India’s current account deficit is expected to decrease and come under 2.25% of GDP because of strong domestic demand.
Steps to a strong economy
The report also gave a list of changes in policies that, if implemented, could help in making the economy less vulnerable to external financing. The report stated that, though the monetary policy framework of India has been strengthened over the past few years, there are still a few shortcomings.
To improve the policy framework, further supply-side reforms and continued fiscal consolidation are key requirements. This will also enable the economy to achieve a low and stable rate of inflation and keep gold imports contained. According to the report, safeguarding financial stability and making the financial sector more capable to contribute to growth are essential policy steps.
A policy change that can decrease external vulnerability and improve the current account financing would be to increase the non-debt creating capital flows through Foreign Direct Investment. It also mentioned that steps to improve the business climate and ease domestic supply bottlenecks are necessary to improve investment prospects, attract FDI, and boost exports. This, in turn, would contribute towards financing the current account.
Lastly, India would also need to continue fiscal consolidation including measures such as the successful implementation of the Goods and Services Tax and further subsidy reforms.
Featured Image Credit: Flickr
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