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Alas, there is no free lunch

Arvind Panagariya

A common misconception among policy makers and analysts is that trade deficit can be cured by increased foreign investment. According to one report, even the finance minister seems to have suggested this prescription for India’s rising trade deficit (‘FM to open FDI floodgates to keep trade deficit in check,’ ET May 23, 2005).
 
Interestingly, however, the correct relationship is just the other way around: an increase in foreign investment increases trade deficit. Accordingly, the ability of a country to boost domestic investment through foreign investment is essentially capped by its ability to run trade (or, to be precise, the current account) deficit.

To explain how this works, consider an exogenous increase in foreign investment. Specifically, suppose improved knowledge of the Indian markets leads the General Electric (GE) to invest an extra $10 million in India.
 
Taking the simplest case first, suppose the investment goes into a new machine made outside India. This will entail GE importing the machine and the transaction will automatically raise trade deficit. This is almost trivial.

But what if GE invests $10 million in a machine made in India. In this case, it first goes to an Indian bank, say, the ICICI Bank, which sells it equivalent rupees. Letting the exchange rate be Rs 50 per dollar, GE now has Rs 500 million and ICICI Bank $10 million. GE uses the rupees to complete the purchase of the machine. But the ICICI Bank now has $10 million that it did not plan to hold.

One option the bank has is to sell the dollars to the Reserve Bank of India (RBI) for Rs 500 million. In this case, the RBI ends up with the dollars that it invests in the US Treasury Bills. Under such a scenario, there is no net inflow of foreign investment into India: the $10 million inflow by GE is exactly offset by $10 million outflow in the form of the RBI purchase of the US Treasury Bills. It is as if the dollars never entered the country and the RBI simply gave GE Rs 500 million for $10 million, with GE using the rupees to purchase the machine.

Indeed, the RBI will likely view the unplanned injection of the extra Rs 500 million into the economy as inflationary. Therefore, as is its practice, it will neutralise (in technical terms, “sterilise”) the increase in money supply through a sale of Rs 500 million worth of government securities. The end outcome will be no change in money supply and no inflow of foreign funds.

Indeed, under this scenario, the GE investment ends up displacing an exactly equivalent investment by an Indian firm and no other effects. Absent the GE investment, the Indian firm would have bought the machine now owned by GE. And it would have financed the purchase using precisely the funds that financed the purchase of the government securities sold by the RBI as a part of its sterilisation operation.

Therefore, if the GE investment is to translate into a net increase in investment in India, the RBI must refrain from the purchase of the dollars GE brings into the country. Under this scenario, ICICI Bank must find a buyer for the $10 million it receives from GE. Such a buyer is, of course, present in the economy: the firm deprived of the purchase of the machine bought by GE. This firm will exchange the rupees not spent on the Indian machine for dollars and import an equivalent machine from abroad. The GE investment now makes a net contribution to the investment in India but it does add to the trade deficit.

Underlying this discussion is the fundamental balance-of-payments identity: the current account deficit (CAD) equals net capital inflow (K) minus the purchases of foreign exchange (FX) by the RBI or, symbolically, CAD = K - FX. For our purpose, the current account deficit can be identified with trade deficit. Capital inflows, on the other hand, include foreign investment, NRI deposits and loans abroad. Just as in the GE example, if K rises by $10 million and FX does not increase, CAD must increase by $10 million.
To complete the story, we must link the foreign investment and current account deficit to the domestic investment, however. This requires introducing the fundamental savings-investment identity: private investment (I) equals the sum of private savings (by households and corporations) (S), government savings, and savings from foreign sources. The government savings equal fiscal surplus in the budget [negative of fiscal deficit (FD)] and savings from foreign sources equal the current account deficit (CAD). Symbolically, I = S-FD+CAD.

The government finances the fiscal deficit - the gap between its spending and revenues - by selling securities to the banks and financial institutions. As such, it absorbs a part of the private savings that households and corporations deposit with the latter. The net savings leftover for private investors are correspondingly reduced.

Similarly, when foreigners export to us more than we export to them (CAD is positive), they effectively invest a part of their savings into our economy. For example, we get to import machines to the tune of the current account deficit without having to pay for them in the current year. Foreigners effectively extend us a loan.
Armed with the two identities, consider a boom in the domestic investment demand. If the government does not lower its deficit and private savings are also unchanged, the only channel of savings left to finance the extra investment is the current account deficit. If the RBI further frustrates this channel through increased purchases of foreign exchange (recall CAD = K-FX), inflation or rising interest rates will choke off the investment demand.
 
But persistent large current account deficits as a source of financing investment themselves carry the seeds of an external crisis, as happened in 1991.

Free lunches are hard to come by: raising investment without lowering fiscal deficit is not sustainable in the long run unless we get lucky and households decide to increase their savings in a big way.

June 28, 2005

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