Friday, November 9, 2012

FDI - If you have a hammer not everything is a nail

Today I would like to touch upon the raging issue of "FDI". Being a "centreright" myself I am an ardent supporter of free market but that also means that one should keep a sense of reason and rational alive. I am afraid to say so but the fact is that the reason why majority (certainly not all) of our top journalists are psuedo liberals is because the only way you could have climbed the upper echelons in the previous decades was by being a sycophant and not applying your brain, so before 1990s anything foreign was bad and now anything foreign is not just good but is characterised as "Reforms" and anyone who opposes it is termed as a backward moron.

Well let me start my argument by saying that when you have a hammer in your hand not everything you see is a nail. Let me first point out quickly and we have discussed this many times before as to what makes an economy grow: Increase in goods and services ->To achieve this objective we need to increase productivity -> One way is to start from scratch and create new machines etc. (a slow process), other way is to import them from abroad -> Requires FX reserves.

So FDI in turn solves this conundrum and also directly brings in the technology as well thus giving a further  boost to productivity and hence growth, so then where is the problem FDI must be good isn't it. Well not everytime specially in sectors of Retail, Real Estate (excluding construction of projects etc.) and Finance.

First in these sectors there is nothing really technological that FDI develops that can boost productivity and hence supply of goods, In India unlike the West we have a perennial supply problem and not really a demand problem.

Ok so even if you agree with the notion that investment in these sectors,retail to be specific for today's discussion may not increase too much productivity but then atleast we are getting foreign inflows, surely this is what we need in the sequence of events that I discussed before then what's the harm. Well this is where a little bit of thinking comes into picture.

First of all there are lot of sectors in manufacturing, mining,refining, exploration,research and infrastructure that is opened to FDI, why can't India attract much dollars in those is a pertinent question (we can discuss this some other day), second certain point is that with only 30 percent of sourcing to be done internally and that too monitored by the corrupt system it would not be long before one can see Chinese goods flooding domestic markets thus threatening the domestic manufacturing setup. But I guess these two points even though critical you must have heard at various places. There is a third critical point to fill in the puzzle and it relates to the monetary impact.

Credit growth without a corresponding growth on the output and productivity leads to inflation and consequently deflation. These are not just monetary phenomenons as I have been discussing in my previous articles but inflation is essentially misallocation of capital accompanied by re-distribution of wealth  specially widening the income gap which is eventually followed by a deflationary spiral. When foreign capital comes in a corresponding amount of rupee liquidity gets created, further if these forex inflows are absorbed by RBI then they act as leverage to the rupee liquidity just like taking a position in futures market you deposit some margin. Now as discussed in previous many articles i.e. under the modern monetary mechanics the increase in credit is equivalent to the increase in money supply and since the credit has to be repaid back, the money supply would shrink unless replaced at a faster rate by infusion of more credit.

This my dear readers is a problem in the West and Japan since 2008 with people already under debt thus making it harder for the dollar credit/money supply to increase. With the opening up of sectors like retail and finance in emerging markets it provides an easy avenue for this to happen; without setting up much of fixed/physical infrastructure.and expending any serious technical know-how to foreign lands.

From our perspective, since interest rate abroad is far lower the new infusion of credit has to be replaced at even faster rate than the domestic factors could supply e.g. if the foreign inflows lead to creation of metro then even though the credit/money supply has increased but because of the forex we were able to buy goods that helped in building that metro and because of that it takes less time to travel thus increasing the overall output which may  increase the demand for productive credit and thus even when the foreign credit is paid back, the domestic credit backed by increased output can replace it without causing much of a flutter in the exchange rate and the output (Link).

However if the same capital goes into unproductive use then there is no increase in productive demand for credit thus when the foreign credit retreats then either we set ourselves to witness a deflationary spiral as the equivalent rupee liquidity also ceases to exist or with the intervention of government unproductive credit is increased causing a waterfall decline in exchange rate. In either case real output is severely impacted, the credit goes into unproductive use and in wrong hands (increased graft), widening the income gap and ensuring that poverty remains in this land and ofcourse doling out some pieces of bread from the amassed wealth to the many fools on the eve of elections to get votes and celebrating a triumph of democracy in front of the cameras and fluttering lights.

In an ideal world there should be a free flow of capital, goods and labour. But we are not living in such a world; when the inflow of labour and goods are heavily regulated it's stupid to allow inflow of capital in such sectors that serve no role in increasing the productive assets of the country and only serve as a conduit to redistribute wealth and thus eventually reduce actually output.

So why would someone persist with such a flawed policy, well I can think of four reasons as of now:

- Flawed Thinking
- External pressure/charm (refurbishing one's image) remember the dollar liquidity has to increase to avoid the Western world to get out of the credit mess
- Need more conduits to transfer money to and fro (India and abroad)
- Giving permission for new business opportunity would mean more power which is nothing but a proxy for more graft rewarded in the form of sizeable equity in the new businesses


Hemant said...

Interesting article. I would say the lure is primarily because Govt gets the credit for any increase in GDP, and can avoid blame for any unintended consequences.

Your view on misallocation of capital is spot on! Many sectors in India currently experience this - a) agriculture (RBI mandated credit flow in the sector), b) real estate (not defined/articulated productivity improvement and c) infrastructure (misallocation in terms choice of infra - rail or road or metro or airports, keeping larger interests in mind).

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