Sunday, February 2, 2014

The crisis with "Fragile Five" is another reminder about the perils of capital account liberalization

In recent months, the Indian rupee, among emerging market currencies, have faced the wrath of global financial markets. The sudden stop and reversal of capital flows to emerging economies has been blamed on their weak external account.

An examination of India's external debt distribution reveals that while the share of public sector debt has been declining that of private sector has been rising. The biggest concern is the rising trend in short-term debt, mostly accumulated by private sector. The liberalization of capital account, especially that of the external commercial borrowings, in recent years has helped private sector accumulate this debt.
The distribution of medium and long-term external debt owed to public and private creditors reveals a rising trend in private creditors. This is understandable given the decline in multilateral and bilateral borrowings and assistance as the economy develops as well as the growth of private sector's external borrowings.
India's external debt ratios have been healthy. The total debt to GDP ratio is low and has been stable, whereas the export cover of external debt has declined though not by much in recent years. One of the worries has been the declining foreign exchange reserves coverage of external debt.
A cross-national comparison of the similar data of other emerging economies from 2007 and 2013 reveals that the shares of short term debt poses problems for Turkey, Thailand, and Malaysia. Short term debt is a concern for India and South Africa too.
A cross-national comparison of total debt to GDP ratio reveals that India has the lowest ratio, whereas Turkey and South Africa, whose currencies have been worst hit in recent days have the highest exposures. 
Similar comparisons of export and reserves cover of external debt reveals that India has the best export coverage and...  
 ... its foreign exchange reserve coverage is among the highest in emerging economies. Note that Thailand and Malaysia with the largest forex cover have not been spared runs on their currencies.
India also has among the highest rate of exports growth. 
None of this is to deny deep structural problems with Indian economy. Inflation remains entrenched at elevated levels, fiscal deficit is high, supply side bottlenecks are choking growth, labor and other business regulations are stifling, and so on. But none of this should give the impression of a country at the precipice of an external account crisis. A few lessons. 

1. It is important for governments to manage capital inflows in a manner that does not allow disproportionate build-up of short-term as well as private sector debts. Private sector debt becomes dangerous when their revenues are in domestic currencies. Infrastructure sector borrowings are especially vulnerable to this, given the domestic currency cash-flows. In general, it is difficult for large countries to use external capital borrowings to sustain their non-tradeables sector without risking serious external account vulnerabilities. 

2. Once the tide of capital flows reverses, the backlash on the economy can be very damaging. The severity of this bears little relation to the economy's external account fundamentals. If the markets sense any political instability or macroeconomic weakness, both always likely in most countries at any time, the animal spirits of the market takes over, driving the currency down. The country stands at the mercy of these spirits, as the contagion effect of spooked investors can potentially swamp the economy.   

3. Mechanisms like large foreign exchange reserves cannot be an insurance against runs on currencies. As one of the graphic shows, even countries with high reserves and export cover have not been spared the damage from the recent sudden-stop crisis. And running up large foreign exchange reserves, by itself, contributes to both global macroeconomic distortions as well as being a very sub-optimal use of the country's scarce savings. 

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