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India needs an open capital account by 2025

Harsh Gupta Madhusudan



India's 10-year government bond currently trades around 6%, China 3%, and the US less than 1%. The average of the last two annual (2019 and 2018) GDP deflator: India would be around 3.5%, China around 2.5%, the US around 2%. If India’s average weighted sovereign debt yielded 5% instead of 6% say (still more than the Chinese in both nominal and real terms), then over time the government could spend almost 1% of GDP more on railroads, education and healthcare for the same fiscal deficit. In five years, that would be an annual difference of around $50 billion! My guess is that Indian yields will fall even more.


But it is fair to say that right now both nominal and inflation-adjusted yields follow a clear descending order: India, China and US. That also aligns with their broad sovereign ratings, and the general expectation that governments of richer/developed economies can borrow at lower rates. Indeed per capita income is one of the key factors in bond ratings along with inflation, growth, and debt to GDP ratio.


Focusing on per capita income may make sense because for the same GDP, a smaller population could mean more tax intake since a rich country is likely to have a more developed and formalised economy. But then again, a lower per capita income scenario could also mean higher growth. So, it is not very clear cut.



What is perhaps more interesting to explore is that could a larger absolute GDP, irrespective of per capita income, mean lower borrowing costs? Or more technically, could more sovereign debt - especially in local currency - actually reduce borrowing costs? Of course, GDP still matters as the total debt cannot be completely unlinked from the economy’s size. Also, one has to ignore very small states or chronic defaulting ones.


Now this cannot be easily answered by econometrics because there are not too many large states or economies around. In other words, ‘n’ is small. China and India are the only billion plus populations in the world, and no one else comes close. Other ~$3 trillion or more economies such as the US, Japan, Germany, UK or France already have ‘developed economy’ status and hence near zero or negative borrowing costs.



In fact, recent divergence between Indian and Indonesian yields is partially because of this ‘size’ factor (along with the Indonesian over-reliance on foreign denominated debt). Even the gloom and doom about Chinese debt seems a tad overdone as they have created an entirely new debt category between emerging and developed markets in the mind of some money managers!


Before we continue, I want to comment on what being large means in another economic area: trade. Since the West largely followed free trade over the last few decades for geopolitical reasons as much as economic, the relatively mercantilist approach of China came as a shock to many even though all the now-rich countries had also used this strategy earlier. Which is that when you are relatively large, you can use your monopsony power to implement moderate protectionism and industrial policy to get others to invest to access your markets with the surplus being exported -- in effect reshaping global supply chains.



India is now trying the same. Trade policy that may have seemed silly at $1 trillion GDP (2007) seems worth considering at $3 trillion (2021), especially given excess capacity domestically and globally, and may be even more attractive at $5 trillion (say 2025) though one has to be very careful about the crony capture of industrial trade policy mechanisms. Moreover, at some stage it is rational to switch to evangelising free trade yourself. Let us not get ahead of ourselves though.


But this same $1T-$3T-$5T framework also helps us understand why India now needs to gradually give up its old fears about volatile global flows when the capital account is more open and convertible. In any case, without deliberately thinking about it as such, it is the size of the economy and its current state of development that is making India become less open on trade and more open on capital. The latter needs to be strategically accelerated while the former should be dealt with more tactically.



Now pre-corona or around end of FY20, India’s combined sovereign debt was 70-75% of GDP. Say post-corona, that goes to 85-90% and in an effort to reflate our economy since underlying inflationary pressures are low (going by producer price indices), we take this to 90-95% by FY23. To many, this is sacrilege! The NK Singh panel had recommended this number to be 60% (40% for Union, 20% for states, 2.5% fiscal deficit). One can almost hear Viral Acharya complain while he talks about undemocratic fiscal councils! Of course, those were different times: BC or Before Corona.


Not only is Modern Monetary Theory and Average Inflation Targeting being talked about in New York and D.C. (along with Tokyo and, gasp, even Frankfurt), the up phase of the 15-18 year down and up dollar cycle seems to have peaked in 2020 making this decade much easier to approach an open capital account than the last one, though in some ways also trickier.



In any case with say $3.5 trillion combined debt by end of FY23 or $4.5 trillion by FY25 and with no or much fewer capital controls (thanks to continued building up of foreign exchange reserves, which should not be slowed significantly), who would be in a position to hurt our debt markets? The rupee remains floating and India has never defaulted ---who would even dare to break the Reserve Bank of India? Even the Chinese could not if they wanted to during any future tensions -- we will just print or sell more as needed.


With Indian debt finally being pushed into global indices and India more clearly aligning with the West and Japan geopolitically, now is the right time to bravely reimagine what capital account convertibility could do for India. Not only would the gap between our revenue and fiscal deficits fall, Indian industry and consumers would finally have more rational borrowing costs. With due respect to the great Jagdish Bhagwati who has always been more supportive of free trade over free capital, for India -- at least right now -- the opposite is required.



(The author is an investor and co-author of two books: Derivatives (Cambridge), A New Idea of India (Westland). The views are author's own and do not reflect Mint's)

Courtesy - Livemint.

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