Financial Express, March 21, 2013

A view from Silicon Valley

 Silicon Valley, a short distance from where I teach, is aptly viewed as one of the most important symbols of India’s success. This is paradoxical, of course, because the success of Indians in the Valley (as it is often known locally, with an implicit sense of uniqueness) has come at a cost to India—the talent that thrives here has been lost, in some sense, to India. On the other hand, the success of Indians here in the Valley has served as a powerful signal to those who did not migrate, of what knowledge, talent and hard work can achieve. Just as importantly, it has signaled to non-Indians what might be possible in India, in the right circumstances. 

Every year, for several years now, I have participated in a panel in the Valley that discusses India’s Budget in the context of the country’s economic prospects. My fellow panelists and the entire audience are representative of the area’s ecosystem—smart, well-educated, experienced entrepreneurs and financiers, with global perspectives. Their views on India are worth noting. Here is what I took away from their remarks earlier this month. 

It was unsurprising that the businesspeople expressed dissatisfaction with the current state of the laws governing the use of land and of labour. These are well-known, long-standing issues that successive Indian governments have not managed to come to grips with. What struck me, though, was a sentiment that, even worse than inefficient or overbearing regulation, uncertainty about policy has been a major recent problem. The prime example of this, of course, is the General Anti-Avoidance Rule (GAAR), proposed in last year’s Budget to general consternation. The postponement of GAAR, and a promise to rethink provisions that have been criticised as poorly drafted, have created a period of prolonged uncertainty, which can act as a major deterrent to investment. There was appreciation of the current finance minister’s outreach to foreign investors, but a clear sense that ultimately, it is the certainty of the rules in place that matter, not just wooing through words. 

A closely-related concern that I heard expressed was that India’s rules for business also lack clarity. This, too, is an old problem, but one that has been growing worse in a more complex economic world. Transfer pricing was raised as a major issue in this context. There is a connection to GAAR here too, and national government concerns about tax avoidance through transfer price manipulation are common across many countries. The point here, though, was that poorly written rules unnecessarily increase litigation and other administrative costs: businesses have to pre-emptively spend on trying to get clarification in advance, or they have to bear risks of lawsuits, or both. 

On the positive side, panelists and audience members emphasised that Indian-Americans in senior positions in high tech companies have made a difference in those companies’ strategies towards India. The importance of personal knowledge and networks has been recognised of course, and the Indian Consul General in San Francisco plays an important and visible role in nurturing some dimensions of these, but my outsider (and possibly not fully informed) view is that India’s government could do more to deepen and systematise these networks of Indian-born leaders of high tech companies, to benefit India’s economy. 

As it is, I got the sense from other remarks that India’s political leaders often still do not understand how business at its best can work, and the importance of innovation in its many dimensions, including technology transfer and adaptation, as well as indigenous research and development. One venture capitalist in the discussion remarked that greenfield foreign direct investment (FDI) remains relatively low. Another noted the lack of coordination across ministries. Another observation was on the arbitrariness of some kinds of FDI restrictions, such as those governing e-commerce. One senior investor and entrepreneur suggested that the push for a semi-conductor manufacturing plant did not make sense, either in generating employment or being a fruitful avenue for spurring innovation. 

One can debate these kinds of specific issues, which have to do with the innovation and employment potential of various technologies or combinations of technologies. What is perhaps missing for India is a systematic dialogue with Silicon Valley. The US-India Business Council, which co-sponsored the panel at which I spoke, is certainly systematic in its efforts to build business ties across the two nations. But it represents the interests of its members. There are other institutional linkages as well, such as a sister city initiative between San Francisco and Bangalore. But my sense is that there is room to create a richer interaction that is more balanced in representing various interests, and does more to integrate academic and business knowledge, to further investment and innovation in India by leveraging the tremendous human capital of Silicon Valley. What institutional form that interaction takes would have to be thought through, but the need and potential are both present.

Financial Express, February 27, 2013

Current account deficit worries

 In recent weeks, the Governor of the Reserve Bank of India, Duvvuri Subbarao, has twice highlighted the nation’s current account deficit (CAD) as a cause for concern. The CAD is basically the difference between what is earned on selling goods and services to foreigners and what India pays for foreign goods and services, and it has recently hit record levels—over 5% of GDP. The CAD is typically offset by foreign capital coming into India. Why should a high CAD be a cause for worry? 

The RBI Governor highlighted several concerns. At the G20 Finance Ministers’ meeting, he said, “There are a number of risk factors for inflation. The most important is the current account deficit.” A few days earlier, he had stated, “We would not worry if the widening CAD is on account of the import of capital goods, but here it is high on account of the import of oil and gold. The other concern is the way we are financing it. We are financing our CAD through increasingly volatile flows. Instead, we should ideally be getting as much of FDI as possible to finance the CAD.”

What is the possible reasoning behind the Governor’s statements? It is useful to begin with some basic accounting. Macroeconomic balances imply that the CAD is equal to the difference between domestic savings and investment plus the government deficit. Hence, an increasing CAD can reflect a higher fiscal deficit, an increasing shortfall of domestic savings, or both. In India’s case, it has been both. Domestic private savings have fallen as a percentage of GDP, and the fiscal deficit has gone up. It is important to realise that the CAD is a symptom of more basic factors that deserve attention. A high CAD is not bad in itself: it just signals possible underlying problems.

The problems are poorly managed government spending and taxes, high inflation (and high inflation expectations), and a strong perception that government policies are unfavourable for future growth. The last is based on policy inaction as well as evidence of corruption. These problems deserve focus, not the CAD per se.

Turning to the RBI Governor’s statements, why should the CAD be a risk factor for inflation? If the economy were overheating, and pulling in foreign investment for that reason, this statement might make sense—again, the CAD would be a symptom not a cause. But that does not seem to be the problem, unless India’s potential growth rate has fallen more than policymakers admit. If foreigners were unwilling to finance the CAD, and the Indian rupee had to depreciate, pushing up the domestic price of inelastic imports such as oil, that could fuel inflation in the short run (though not in the long run, unless the RBI made a monetary accommodation). But interestingly, after a temporary pause, foreign investment into India has been strong.

Subbarao’s second point was that foreign investment is of the wrong kind, “volatile” portfolio flows instead of FDI. A related concern was that the CAD itself is of poor quality—fuelled by imports of gold and oil rather than capital goods. This leads back to poor inflation management (people are buying gold as an inflation hedge) and poor economic management (lack of an effective energy policy and lack of confidence for private industrial investment in India). His main point, though, seemed to be that portfolio flows are volatile and therefore bad.

To the extent that portfolio flows bring in foreign capital, they are as good as FDI—domestic firms receiving foreign portfolio flows may be encouraged or enabled to make real investments themselves. If this link is absent, it points again to poor domestic economic conditions. Foreign portfolio flows could be contributing to an asset bubble, but volatility seems to be a red herring. My ongoing research with Ila Patnaik and Ajay Shah suggests that such flows do not create wild swings in the domestic stock market, or harm domestic investors at the expense of foreigners. Separately, I have not seen concrete evidence that domestic stock market movements have much impact on India’s real economy.

In fact, any kind of equity investment involves risk sharing, and in that sense it is good for the recipient. At worst, foreigners exit and the currency depreciates: India can still pay its bills. Problems arise much more if the CAD is financed by borrowing on terms fixed in foreign currency, especially at short maturities—that can create a crisis. The real issue, therefore, is what is happening to India’s external debt stock, and its maturity composition. This is where RBI should be focusing, in addition to domestic monetary policy. Unnecessarily worrying about volatility of portfolio flows (or of the exchange rate) is just a distraction. Meanwhile, the biggest problems lie beyond RBI’s control: in the government’s management of revenue raising, spending, and the conditions for private sector investment. FDI is good, but so is domestic investment. The national government needs to do its job better. If it does, the CAD will take care of itself.