India’s ‘carry trade’ bubble growing big

The world economy is heading for a period of great economic uncertainty, in which instability, trade and currency conflicts and possibilities of economic stagnation all loom large. There are three major imbalances that continue to characterise the global economy: the imbalance between finance and the real economy; the macroeconomic imbalances between major economies; and the ecological imbalance created by the pattern of economic growth. While these are obviously unsustainable, the very process of their correction will necessarily have adverse effects on current growth trajectories.
As it happens, the US current account deficit is already under correction: the current account deficit in 2009 was just above half its 2008 level, and the data for this year suggests that it will stay at around that level. For the rest of the world, it does not really matter whether the reduction occurs through currency movements or trade protectionism or domestic economic contraction: the point is that some other engine of growth has to be found.
Curiously, the governments of the major economies in the global system, including Group of Twenty (G-20), do not seem to have grasped this. Instead, all governments think they can export their way out of trouble. This will have inevitable implications for trade and currency wars, and the likelihood of global economic stagnation.
So how well is the Indian economy likely to cope in the near future, and how will the population as a whole fare in these uncertain times? There has been much celebration in the financial media in India about how well we have weathered the Great Recession, and certainly the output indicators are impressive in the overall global context. Despite poor agricultural performance, rates of growth of aggregate gross domestic product (GDP) have remained high because of continued high growth in services and significantly accelerated growth of industry (dominantly manufacturing).
However, the recent pattern of growth has in general been so heavily skewed towards certain services that it has created an apparently unbalanced economy. Agriculture and other primary activities account for less than 15 per cent of GDP, even though they continue to employ well over half the workforce in what is obviously mostly low productivity activity. Manufacturing has remained stable, but relatively small in output and even smaller in employment. However, the newer services that now dominate the GDP do not employ too many people either, so that most other workers are engaged in low remuneration services. Meanwhile, the FIRE sectors (finance, insurance, real estate, and business services) have been growing rapidly (17.2 per cent) and now account for an even higher share of GDP than manufacturing — a sure sign of a bubble economy.
So this means that we are back to the same unsustainable pattern of growth that generated the images of “India shining”: boom in retail credit sparked by financial deregulation and enabled by capital inflows. These have been combined, especially in the wake of the global crisis, with fiscal concessions to spur consumption among the richest sections of the population. This has generated a substantial rise in profit shares in the economy and the proliferation of financial activities, and combined with rising asset values to enable a continuation of the credit-financed consumption splurge among the rich and the middle classes along with debt-financed housing investment.
The problem is that this is associated with a balance of payments trajectory that is fundamentally unsustainable. It is only the invisibles account (led by remittances from India workers abroad and software and related exports) that has kept the balance of payments from appearing to be even more stark. The trade account shows ever growing deficits, which are increasingly driven by non-oil imports. Meanwhile, the large inflows of capital are being stored up in the form of foreign exchange reserves, for fear of causing excessive exchange rate appreciation.
This is a problem plaguing several emerging economies, and underlines the need for captial controls to prevent unwanted inflows of speculative capital. So much so that even the International Monetary Fund has started advocating such controls for developing countries that are being swamped by the “carry trade” based on interest rate differentials across economies.
Unfortunately, our own government seems much less conscious of the dangers such inflows pose, especially for an economy that is clearly in the midst of another bubble-driven expansion. Instead, ministers are talking about the economy being able to absorb at least another $100 billion of capital inflows — unmindful of the reality that the economy has not even absorbed the smaller amounts that are currently pouring in, and instead is simply accumulating reserves.
In any case, such absorption has to be sustainable, which is why much more attention is required to improving the trade account. This is going to be much more difficult in the current global economy, but clearly the need is for both diversification of trade and more attention to sustainable expansion of the domestic market.
However, without sustained expansion of the domestic market, the condition of the bulk of the Indian population will not improve. This really requires increasing the disposable incomes of wage earners and the self-employed, not just a credit-based expansion of demand that is bound to end in tears. But for this there has to be more official focus on generating both employment and better remuneration. This is actually quite doable, since it can be led by increased public provision of essential goods and services, all of which are employment generating and have high multiplier effects. But for that, we need genuine political will.

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