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Rewind the tape, please

V. Anantha Nageswaran

Taxing foreign money, as was suggested by the RBI Governor, may, after all, be a good idea. India may not really be able to prevent such hot monies coming and leaving at short notice. How India survives and handles the fallout of the potentially lethal combination of a weaker dollar, higher bond yield and rising oil prices and that too compared to other developing nations would shape not only its short-term growth prospects but also its stature in the world, says V. Anantha Nageswaran.

FIRST, mea culpa is in order. In this column of January 17 on the role of central bankers, I questioned the Reserve bank of India Governor, Dr Y. V. Reddy's concerns about the foreign money coming in to the market and his "proposal" to tax it. To be more precise, I questioned his loud thinking on the matter more than the merits of his proposal.

Nearly two months later, I do not think that it is such a bad idea and would go one step further. It is perhaps a sensible idea. There is no other way in which the message can be sent out that the amount of foreign money that has come into Indian stocks is more than what the country can digest. More than that, some of this money is chasing rapidly diminishing global opportunities to make easy money and, hence, likely to leave the country very rapidly.

More money pours into Indian stocks

This about-face has been prompted by the news that some $2 billion of foreign money poured into Indian stocks in February and in just two weeks in March, another $1.27 billions came in.

Surely, if India proposes to tax inflows, it would be one of the most politically incorrect moves in today's world dominated by so-called liberal economics but the same pundits would have schadenfreude (enjoyment obtained from the troubles of others) if India were to buckle under hot money inflows first even before the neighbour to the North, under the sheer weight of its own credit creation and investment bubble. They are a Communist nation and, therefore, they have big carpets to hide things under. That means more time than we have.

Why is it important now to heed Dr. Reddy?

Global imbalances intensify

The global economy is too hot. Many examples, not-so-evident at first glance, can be given:

(1) China's exports accelerated in January and February. The economy is yet to slow down and Beijing has stopped talking about an overheating economy.

(2) Commodity price indices are at 24-year highs. The price of oil is heading higher and the International Energy Agency has increased its forecast of oil demand in 2005 for the third time. Crude oil at $60 per barrel appears very probable.

(3) US Imports figures for January showed a healthy chunk of capital goods imports, indicating a buoyant investment environment.

(4) US capital goods orders for December and January show a healthy momentum heading into the New Year. Q4, 2004 growth in the US would be 4-plus per cent and Q1 2005 would also be that much.

(5) Consumer credit in the US is growing briskly as also commercial and industrial credit.

The Federal Reserve chief, Mr Alan Greenspan, without judging him one way or the other, is indifferent to the current account deficit.

His latest speech at the Council on Foreign Relations is evidence of that, if one were needed. Asian central bankers are making more noise (and actually moving too) about diversification of currency reserves.

Actually, India appears to be ahead of others in this. Excluding US Treasury Notes and bonds, India's dollar holdings is only 43 per cent — perhaps, the lowest among global central banks.

Given the likely rising current account deficit fuelled by stronger growth in the US than elsewhere, the indifference of the Federal Reserve to that prospect and the increasing caginess of the Asian financiers of that deficit, the US dollar would depreciate further.

Two, the US bond market is beginning to show signs of pricing in reality. The 10-year US Treasury yield has climbed to 4.5 per cent from below 4 per cent in early February. The yield could rise above 5 per cent in the next few months.

Euphoria peaked in February

Further, as research from Credit Suisse First Boston shows, global euphoria reached peak levels in February 2005, similar to the level it reached in March 2000 — before technology, telecom and Internet stocks collapsed globally, including in India.

Their research also shows that within six to twelve months of the indicator reaching the euphoria-high, emerging market assets, on most occasions, experience significant negative returns.

While it may be hard to predict how and when all this would come to a head causing a fairly significant turbulence in financial markets, only the bravest (or the most foolhardy) investor or policy-maker would ignore their potential to wreak tsunami-like damage in the financial markets spilling over into the real economy.

When it strikes, the money would leave the country as quickly as it came in. This time around, it will not come back so quickly as it happened last year. Then, the global environment was benign and the crisis was local. So, calm was restored quickly.

More than the level of Sensex at stake

More important, a financial market crisis can have real and political consequences for India. When turbulence hits financial markets and Indian stocks drop with possible consequences for the real economy, all those who currently wax eloquent about the Indian economy's resilience would, with the remarkable clarity that hindsight provides, argue that it was always a house of cards.

As bad luck would have it, if China does not experience a similar negative growth shock or manages to hide it successfully from the unsuspecting and mostly superficially analytical global financial journalists, India would experience a geopolitical shock as well.

It can kiss goodbye to its aspirations to become a permanent member of the Security Council, in the foreseeable future. Of course, placing restrictions on inflows of funds is a better way than to lock it in after it has come in. The latter is more unpopular with overseas investors.

In any event, unless handled properly, it has the potential to cause not only a public relation disaster but could also hasten the arrival of the very stock market decline that it seeks to prevent or ameliorate.

It is far too easy to be an arm-chair policymaker than being a real one. While a sovereign has potentially many options, it might also be a prisoner of circumstances. India might thus not really be able to prevent these hot monies coming in and leaving at short notice.

If so, it should have a `disaster relief' plan at hand to mitigate the fall-out of the risk of overseas investors pulling out.

How India survives and handles the fall-out of the potentially lethal combination of a weaker dollar, higher bond yield and rising oil prices and that too compared to other developing nations would shape not only its short-term growth prospects but also its stature in the world.

(The author is founder-director of Libran Asset Management (Pte) Ltd., in Singapore. The views are personal. Address feedback to van@libranfund.com)

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