Columns - The Sunday Times Economic Analysis

Who is afraid of foreign borrowing?

By the Economist

Who is afraid of foreign borrowing? Certainly, not this government. In fact continuous borrowing appears to be the strategy to cope with the economic difficulties facing the government. At the end of March 2008 foreign borrowing amounted to Rs. 1443 billion. This is 20 percent higher than it was a year before. There have been further borrowings since March and the country’s foreign debt is likely to be much higher by end June this year.

While the bond issue for US$ 500 million last year raised many eyebrows, a string of borrowings after that appears to have not drawn much attention or opposition. In any case the criticisms against foreign borrowing and the several arguments against incurring a large foreign debt have gone unheeded. The government is now borrowing in order to meet its obligations for repayment of loans that expire this year. In the next two to two and a half years the amount of foreign debt repayment will be very high. Will we continue to borrow to repay?

There are several reasons why the government is continuing to use this contrivance of meeting its expenditure. It is able to avoid a depreciation of the currency that is needed in the context of increasing inflationary trends. The foreign borrowing enables a high amount of foreign reserves that obviates the need for a depreciation of the currency. The level of foreign exchange reserves gives the impression that the economy is apparently in good shape. In fact official foreign exchange reserves were US $ 3,383.8 million that was adequate to finance about three and a half months of imports. With further borrowing the reserves are likely to have been enhanced. Therefore it can continue to keep the exchange rate fairly constant.

The depreciation of the currency is politically disastrous as it would mean that the rupee value of imports would rise. When international prices of essentials are rising, the government can hardly risk further waves of inflationary pressure from increasing oil and food import prices. Therefore foreign borrowing is an economic and political tranquillizer.

However there are no easy solutions to this problem of import inflation. In fact, foreign borrowing could itself be the cause for further strains in the balance of payments. Keeping the exchange rate fairly constant could have serious repercussions on the trade balance. This is becoming patent. In the first four months of this year exports grew by only 11.3 percent, while imports grew by 37.4 percent. The position is much worse as the growth in industrial exports is dismal. They grew by only 4.3 percent in the first four months of January-April this year. The most important industrial export garments grew even slower by a diminutive 3.7 percent. Export growth has been mainly maintained by the growth in agricultural exports. In the case of tea and rubber exports the buoyant markets for these products have resulted in an increased demand for them in high prices. Therefore these agricultural exports would be able to face the increasing costs of production and actually perform better than they have done in the past. Industrial exports are a different kettle of fish as they have to face competition from countries whose rates of inflation are lower.

Since the growth in imports in dollar terms is huge in comparison to the value of exports, this has led to a trade deficit of US$ 2,045 million for the first four months of this year. This means that at the end of the year the trade deficit may be as large as US$ 6000 million. Such a huge trade deficit may be difficult to bridge with capital inflows. The main source of bridging the deficit has been the increasing inflow of remittances. Although remittances are increasing the momentum of the increase is not likely to match the rise in import values. It is quite possible that the surpluses that we have been having in the recent past may turn to a deficit at the end of this year. This could be so owing to the capital and interest repayments on the foreign debt that is increasing. However this too could be averted by additional fresh borrowing!
The national economic situation can be likened to a household that is living beyond its means and borrowing to meet its increasing spending. The cost of the increased borrowing is not of immediate concern as the family is continuing to borrow to repay its debt obligations. There is a very deceptive feel good condition that will sooner or later turn into a debt trap and make existence difficult. The country is slowly but surely moving into that situation.

There is a grave danger in this move to meet a potential balance of payments crisis by borrowing. The conventional dangers that are recognised are the burden of the debt and its servicing costs. These are seen in terms of two issues. One is that the highcost of servicing the debt is seen as a large proportion of export incomes and therefore resulting in a strain in the balance of payments. The other danger is that the foreign debt is a part of the total public debt that has to be serviced from the budget. Consequently fiscal deficits of a high amount that distort public spending, increase inflationary pressures and throttle investment are inevitable. However there is another danger lurking that is not recognised adequately. This is the impact on the export capability of the country.

Despite the large trade deficits of recent years, foreign borrowing and large inflows of remittances from expatriates have resulted in a balance of payments surplus and adequate foreign exchange reserves. Consequently the exchange rate has been stable and at times when these foreign capital inflows have been high the Rupee has even appreciated. This is a dangerous phenomenon as the stability or appreciation of the currency could hurt exports in a context when there is a very high rate of domestic inflation. The high rate of inflation implies that the cost of production of exports would increase and the price of exports would rise. This increase in costs would then reflect as a higher export price when the exchange rate is stable and even a still higher price, if the exchange rate were to appreciate. This would mean that our competitiveness in international markets would be adversely affected. This may be already happening with respect to industrial exports that grew by only 4.3 per cent till April this year.

The plain truth is that the country should be wary of the stability of the exchange rate sustained by foreign borrowing and capital inflows. We should be afraid of foreign borrowing not only owing to the costs and burdens of such borrowing that are well known but also the injurious effects of such borrowing on the country’s export capability.

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