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Mainstream, VOL LI No 22, May 18, 2013

Long-run Foreign Investors: Are they Easy Nuts to Crack?

Saturday 18 May 2013, by Anshuman Gupta

Recently the Finance Minister was on a tour to Europe to lure the foreign investors to invest in India. Some years back, India was among the preferred destinations for the foreign investors. However, that is no more the case. If one attempts to verify it through figures, foreign direct investment (FDI) has been at an all-time low during the last two years. India’s current account deficit (CAD) is at an all-time high as a proportion of the GDP, and this is being met mainly through portfolio investment. The composition of our reserves, which a few years ago was a reason for comfort, is also skewed in favour of short-term debts and portfolio investment. The persistence of these factors is bound to keep the speculation-mongers active about the imminent depreciation of the rupee, which is also assisted by continually higher headline inflation rate prevailing in India vis-à-vis other trading partners.

All these factors reinforce the urgency for the foreign investors (long-run) to invest in India, though the gap between the investment needs and savings to achieve eight-plus growth rate is another reason to invite them. In this context, three issues need to be analysed—one, why foreign investors turned India into an unfavoured destination for investment in the first place, two, what India should do to win back the lost confidence of the foreign investors, and finally, how far India would be able to meet these requirements given the present circumstances.

On the first issue, it all started in the last years of the UPA I regime under the garb of inclusive growth and was reinforced in the wake of the sub-prime crisis and thereafter during the UPA II rule. Many entitlement programmes were initiated for the disadvantageous groups of the society coupled with many stimulus packages as counter-cyclical measures after the year 2008. All these initiatives progressively led to an unmanageable fiscal deficit as a proportion of the GDP—6.2 per cent in 2011-12, which was somehow, through statistical manipulations, brought down to 5.2 per cent of the GDP in 2012-13.

In fact, the last two fiscal years (2011-12 and 2012-13) were supposed to be the years of fiscal consolidation. However, political compulsions always prevailed over good economic sense. The monetary policy was excessively used in place of fiscal policy to contain the inflation rate, which was persistently running in double digits. All these two years, the government was paying lip-service to contain the fiscal deficit by projecting a rosy picture in the Budgets based on some unrealistic assumptions on the GDP and revenue growth rates. However, with the passage of time, all the tall claims got exposed and it caused irreparable dents in the credibility of the Indian Government. Policy paralysis, delay in clearances of projects on account of environmental reasons, corruption of unprece-dented level, etc. were other reasons contributing to the disenchantment of foreign investors.

In reality, the educated entrepreneurs make their decisions not only on the basis of what is happening currently but also what is likely to happen to the variables of their interest—fiscal deficit, real interest rate, business environment, etc.—in future. They make their own expectations of these variables on the basis of their past behaviours, where the credibility of the govern-ment is very important. However, every time when the government does not meet its promises, it takes an even bigger toll on the credibility of the government, and it requires extra efforts and sincerity to win back the lost confidence of foreign investors.

Regarding the second issue about what the government should do to restore its lost credibility, of course, the government has once again come out with a good-looking Budget, which promises to bring down the fiscal deficit and revenue deficit to 4.8 per cent and 3.3 per cent of the GDP respectively in year 2013-14. It also charts out the roadmap to further bring down the fiscal deficit to 3.5 per cent by the year 2016-17. However, all would depend on how the government delivers on these promises. India cannot expect instant results from these pronouncements. The foreign investors would wait and watch. If these targets are met, it would give the required policy space to the RBI to the manoeuvre the policy rates.

Recently this author conducted an adaptive econometric analysis to study how expectations work in India. The fiscal deficit was one explanatory variable along with the real interest rate. It was found that on the average the fiscal deficit has a negative impact on the growth rate even in the short run. This might be because it works adversely in shaping the expectations of the entrepreneurs about the macroeconomic stability besides having the crowding-out effects.

Coming to the last issue, though the Budget this time is based on some reasonable assumptions about the GDP growth (6.5 per cent) and revenue growth rates, they still look at the higher side given the present conditions in the domestic and world economies. The realisation of capital receipts through disinvestment is also doubtful. Moreover, the year 2014 is an election year and good economic sense might give way to political compulsions which would jeopardise the whole calculation. The assumed exchange rate (Rs 54 = $1) and crude oil prices ($110 per barrel) are also the other risks. However, so far the government is looking sincere about its business, which is manifested through a myriad of measures it has announced recently to improve its image.

Dr Anshuman Gupta is the Head, Economics and IB Department, University of Petroleum and Energy Studies, Dehradun.

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