[op-ed snap] Tighter is better

Note4students

Mains Paper 3: Economy | Effects of liberalization on the economy

From UPSC perspective, the following things are important:

Prelims level: Current account deficit, Fiscal profligacy

Mains level: Risks associated with India’s CAD and factors affecting it


Context

Sudden reversal of capital flows

  1. Since April, emerging markets (EMs) have been rudely shocked by the sudden reversal of capital flows without any apparent change in economic fundamentals
  2. Financial buffers in EM are much stronger today than they were before the 2013 taper tantrum

Which economies are under pressure?

  1. The ones with large current account deficits and, in turn, high foreign borrowing
  2. Why? There has been a steady decline in policy space because of loose fiscal and, in some cases, monetary policy
  3. Without adequate policy space, the buffers have turned ineffective

Factors influencing Capital inflows

  1. The growth differential with developed markets (DM)
  2. The strength of the US dollar
  • Higher EM-DM growth differential increases inflow, a stronger US dollar lowers it
  • Why? Investing in EM is riskier, higher growth will compensate the risk
  • A stronger dollar raises the cost of funding and therefore investors scale back investment

What happened in April 2018?

  1. Incoming data from the Euro Area and Japan pointed to growth disappointment, but above par growth in the US
  2. The altered dynamics forced the market to reprice US interest rates and the dollar
  3. The consequent tightening of global financial conditions caught investors off guard
  4. Capital outflows from EM ensued and their currencies depreciated

Why are economies struggling even after having buffers?

  1. Along with buffers, Foreign exchange liabilities have also risen and there are limits to the use of reserves
  2. In several, if not all, vulnerable economies, the current account deficit is rising because of growing fiscal and quasi-fiscal deficits
  3. Fiscal profligacy is restraining the space for the economies to grow without increasing foreign borrowing

What needs to be done?

  1. If an EM economy is to maintain or widen the growth differential with DM, it needs to grow faster, requiring more funding
  2. If the government does not reduce its deficit to provide the additional funds, the private sector is forced to borrow more externally, that is, the current account deficit has to widen
  3. The way out is to tighten fiscal policy, even when it might not have been part of the problem so that the private sector has the domestic space to grow

Risks for India

  1. India’s overall fiscal deficit (Centre plus state) has remained virtually constant, around 7 percent of GDP since 2013-14
  2. This year also, both the Centre and state deficits are likely to be under pressure with GST collections running below the budgeted run rate
  3. A continued decline in private investment in last 4 years provided the excess domestic savings needed to keep the current account deficit (foreign borrowing) contained at around 1 percent
  4. With the higher budgeted fiscal deficit, even the hint of a recovery in private investment is raising fears of the current account deficit rising sharply

Way forward

  1. Loose fiscal and monetary policies pushed India to the brink of crisis in 2013
  2. If India doesn’t tighten fiscal and monetary policies early and sufficiently, then it too could be heading down the path of its peers
Economic Indicators-GDP, FD,etc
  • Subscribe

    Do not miss important study material

Leave a Reply

Please Login to comment
  Subscribe  
Notify of