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Wednesday, January 12, 2005

Muddles on Forex for Infrastructure

Arvind Panagariya

The best economists of India, both inside and outside the government, are locked in a fierce debate on the proposal for swapping infrastructure for foreign exchange reserves, put forth by the Planning Commission (PC).

A key concern raised in the debate is that dollars can be spent only on imports while infrastructure largely requires the acquisition of domestic resources. Careful analysis reveals, however, that at least this concern is without foundation: the import intensity of infrastructure is virtually irrelevant to the final outcome!

Thus, consider first an infrastructure project, say, a $5 billion prefabricated power station, which can be wholly imported. For simplicity, let the exchange rate be Rs 50 per dollar. Under the PC scheme, the government of India (GoI) borrows Rs 250 billion from the market in return for securities of equal value and uses the rupees to buy $5 billion.

Simultaneously, the Reserve Bank of India (RBI) sells $5 billion in return for Rs 250 billion and uses the rupees to buy the GoI securities of equal value.

The net outcome of these transactions is the acquisition of $5 billion by the GoI in return for securities worth Rs 250 billion from the RBI with no change in money supply. The GoI uses the $5 billion to import the power station.

These transactions leave the rest of the economy entirely untouched. Not counting the power station, all macroeconomic variables, namely, investment, output, incomes, prices and the exchange rate remain unchanged.

The changes that do take place are the direct result of the transactions that put the power station in place: the current-account deficit rises by $5 billion (import of the power station), the capital-account deficit on the official account declines by the same amount (decumulation of reserves) and the fiscal deficit and debt rise by Rs 250 billion (securities issued by the GoI and now held by the RBI).

Next, consider a water-supply project that costs Rs 250 billion and exclusively uses domestic resources. As before, let the GoI acquire $5 billion in exchange for securities worth 250 billion from the RBI. The GoI then sells these dollars for rupees in the market, uses the rupees to acquire productive resources worth Rs 250 billion and completes the water-supply project.

Remarkably, the final outcome in this case turns out to be virtually identical to the one achieved in the power station example. Thus, observe that the GoI actions just described leave the private economy with two imbalances: it is now short of productive resources worth Rs 250 billion and has an excess of $5 billion in cash.

How are these imbalances corrected? Private economy reduces the output of tradable goods requiring productive resources worth Rs 250 billion and obtains the same through extra imports using the extra $5 billion it holds.

These changes restore the economy’s equilibrium: it has released resources required for the water-supply project, has the same supply of goods as before and no extra dollars. With money supply unchanged, the price level remains unchanged as well. No change occurs in the GDP, incomes, consumption levels or exchange rate.

Thus, unless the production of tradable goods over infrastructure is valued in itself, the import intensity of infrastructure projects turns out to be entirely irrelevant to the PC proposal. By the same token, the assertion by the PC that trade liberalisation (wholly desirable in its own right) will have to be an integral part its package also proves to be based on faulty reasoning.

What, then, are the substantive objections to the proposal? Fiscal fundamentalists would be quick to point out that it entails raising the GoI fiscal deficit and debt.

Infrastructure hawks would respond that the return on the infrastructure projects is higher so that the future income streams from them can more than compensate for the extra interest on the RBI-held securities.

Fiscal fundamentalists would counter that the increase in the GoI debt, which is already large, would make the financial markets within and outside India jittery: the latter may judge the return from infrastructure projects to be lower and more uncertain.

They may also see the larger deficit as a signal that the GoI is becoming further reckless in its spending behaviour. The infrastructure hawks would, no doubt, respond that the cost is still worth the benefit from better infrastructure. There is room for disagreement between reasonable individuals on this issue.

But the story does not end here. Sectoral ministries around the world are notoriously unappreciative of the hard-budget constraint the government as a whole (read finance ministry) faces. This was graphically illustrated recently when the outgoing World Bank president visited India and much to the embarrassment of the Indian public virtually all infrastructure ministries — power, railway, roads and water resources — lined up to file requests for their favourite projects that added to a staggering $19 billion. It was as if the World Bank was going to give the money away with no future liability to repay the principal and interest.

Given this political economy, handing the purse strings of the RBI’s foreign exchange reserves to the PC risks softening further a budget constraint that sectoral ministries already view as soft.

Therefore, the GoI must finance infrastructure like any other public investment or expenditure and not create the illusion that the RBI holds a pot of gold ready to be raided at will. It must also leave the RBI alone to manage the country’s foreign exchange reserves, money supply and the exchange rate.

As a last point, it is puzzling why, at a time when the RBI is rapidly accumulating reserves to avoid a large appreciation of the rupee, the government continues to borrow large sums abroad. The World Bank and ADB are now lending directly to the states, whose view of the budget constraint is not unlike that of the sectoral ministries. Will it not be prudent to place a temporary moratorium on official borrowing and start repaying the past loans more rapidly?