The Hindu Business Line : Reduce FDI to control trade deficit

The Finance Minister clearly sees foreign direct investment as a solution to the problem of rising trade deficit, rather than its cause. But, paradoxically, as foreign investment inflows stall the adjustment that should take place through the movement of exchange rates, the high trade deficit is sustained. One solution would be to opt for a "low trade deficit-low foreign investment" regime.

SPEAKING to the Confederation of Indian Industry, theFinance Minister, Mr P.Chidambaram, said that India will have to attract more foreign investment to meet its growing trade deficit: "$30-billion trade deficit would be sustainable only if there was corresponding increase in remittances, invisibles and service exports.

A lot of work needs to be done to ensure that trade deficit does not become an albatross around our neck... there is a constant need to review policies on FDI and FII to ensure that these inflows grow at a pace that can match our swelling trade deficit."

Clearly, he sees foreign direct investment as a solution to the problem of rising trade deficit, rather than its cause. The foreign exchange accounts can be understood by anequation: Exports + Foreign Investment = Imports

If we assume factors such as remittances, accretion of foreign exchange reserves, and outward foreign investment as constantthis equation can be re-written as: Imports - Exports = Trade Deficit = Foreign Investment

Therefore, the Finance Ministeris correct in saying that a higher trade deficit can be sustained only by a parallel increase in foreign investment inflow. However, before we reach a conclusion, we must examine why the trade deficit is rising .

Normally the trade deficit is balanced out by the movement in exchange rates. Higher imports would lead to higher demand for dollars and push up the price of dollar vis-à-vis the rupee.

This makes imports expensive and exports more competitive, causing a decline in imports and increase in exports, thus wiping off the trade deficit . The value of the rupee should decline in tandem with an increase in the trade deficit for this cycle to be effected.

The paradox is that exactly the opposite is happening . The rupee recently scaled a five-year high against the dollar. Instead of a high trade deficit leading to a lower rupee, it is leading to a higher rupee. Consequently, imports are buoyant, exports are relatively sluggish and the trade deficit continues to widen.

This happens because foreign investment inflows stall the process of adjustment that should take place through the movement of exchange rates. A higher trade deficit means that we require more dollars to pay for our exports. Instead of increased exports, the inflow of foreign investment provides those dollars.

The adjustment in the exchange rates is prevented and the high trade deficit is sustained. Thus, foreign investment is the cause of higher trade deficit because it short-circuits the normal process of adjustment through the movement of exchange rates.

The Finance Minister's statement considers the trade deficit an independent variable and foreign investment the solution to this problem . But that is clearly not the case.

The high foreign investment inflows being suggested as a cure for trade deficit are actually its cause. More foreign investment will only lead to yet greater trade deficit. If not by imports, how else will the dollars be sent out of the system?

Trade deficit and foreign investment go hand-in-hand. The choice is to pitch for a "high trade deficit-high foreign investment" regime; or for a "low trade deficit-low foreign investment" regime. I would vote for the "low" option for the following reasons.

One, large imports makes our economy import-dependent. The East Asian countries went into a tumble because they used capital inflows (foreign investment) to meet their current consumption .

Foreign investment inflows are ultimately a kind of debt, that is why they are labelled as `foreign'. The roots of the foreign investor are in his home country and that is where he seeks to maximise his profits. Foreign investment is not a stable source of money like equity. The domestic economy is adversely impacted during the period of high foreign investment inflows. The availability of cheap American apples leads to our Kashmiri farmers uprooting their apple orchards. When the foreign investment inflows come to an end, the Kashmir orchards cannot spring back in a day. The country then has to do without apples till the orchards are replanted and begin to bear fruit after ten years.

Two, the foreign investment has to be serviced just like debt in the form of royalty, interest payments and profit repatriation. The long-term impact of this is negative. In a study by this author (Welfare State and Globalisation, Rawat Publications, 2000) it was found that the Rate of Growth per Capita (1985-94)increased by 0.22 per cent for each one-dollar increase in foreign investment per capita in 1994, but decreased by 0.32 per cent in 1980.This shows that the long-term impact of foreign investment on growth is negative.

Three, there is little evidence that foreign investors are bringing frontline technologies. A study by Veena Jha (Trade and Environment Issues and Options for India, UNCTAD Geneva, 2003) found that acquisition of technology by Indian companies had become more difficult because foreign majors preferred to import goods into India rather than manufacture them here.

Mr Chidambaram should, therefore, reduce foreign investment and allow the free movement in exchange rates to wipe out the trade deficit.

(The author is a freelance writer. Feedback may be sent to bharatj@nda.vsnl.net.in)

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