How does the balance of payments affect demand?

Thursday, October 18th, 2018

How does a balance of payment problem affect demand in the economy? Neelkanth Mishra of Credit Suisse puts it in an elegant way in an interview with Ira Dugal.

To paraphrase, if you think of it like a household budget: suppose a family has a consumption expenditure of Rs. 120 and an income of Rs. 100. The difference of Rs. 20, which would need to be borrowed from someone, would be the equivalent of the current account deficit. If, say oil prices go up, the consumption basket then becomes Rs. 140 and you would have to borrow more. Quite often it is the case that no one will be willing to lend the family more and therefore their consumption has to be brought back down to Rs. 120. This is the demand adjustment that the economy will have to face.

Neelkanth commented that the demand adjustment may be nearly 2 per cent of GDP and this could be the reason for the current panic in the currency. The balance of payments adjustment also puts a question mark on medium term growth rates. He estimated that even seven per cent growth rate is not sustainable. This is because our energy import bill is at an all-time high even though oil prices are at half the levels seen in the prior peak.

 

The entire interview is worth a watch:

 

Other discussion points from the conversation:

• With the MPC not hiking rates, the burden of the balance of payment adjustment has fallen to the currency. In the run up to an election year, fiscal policy is unlikely to give much relief either.
• Price transmission not happening in petrol and diesel will kick the can down the road and make the problem worse
• Our capital inflows as a percentage of GDP have stalled and are back at 2002 levels. There has been a cyclical decline in capital flows globally over the last few years. The reason for this is that the countries that have been exporting capital are the ones that have a current account surplus. Each country deploys this differently; for example, Japan and China deploy them for strategic interests while Germany may deploy it through banks to help prop up lending. As of now there are no signs of these flows picking up.
• FCNR-B scheme is only meant to stall a stampede. Even if you use the scheme, it will solve the problem for a few months and then will again come back because investors will take back their money
• Term spread continues to be high, 10-year bond yields much higher than repo rate in spite of RBI providing liquidity via open market operations.
• If you see the progression of financial markets in India, there have been phases where the NBFCs have grown very rapidly and then a very large number of them have disappeared. Many smaller NBFCs may actually have to look at shutting down. The assumptions on growth of NBFCs and the market size they could get to would be challenged.
• Earlier five buckets of financial institutions that were doing lending. There were the large PSU Banks, the smaller PSU banks, the private sector corporate lenders, the private sector retail lenders and the NBFC segment. One by one each of these legs have started to fall. The smaller PSU banks are grappling with NPA issues, the private sector corporate lenders are facing promoter and management issues, now even the NBFC segment is hampered. What this means now is that the banking system capacity is constrained.
• FPIs have 80 per cent of their holdings in the top 60-70 stocks. They hold roughly 27 per cent of the top 50 stocks. They own 60 per cent of the free float of those top 50 stocks. The recent correction appears to be a stampede out for foreign investors i.e. basket selling. Domestic flows are mainly in the smaller stock scripts and now those flows are starting to get tested.

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