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S. Venkitaramanan

Export-related direct tax concessions for software parks and export-oriented zones can are demonstrably good value for money. If sympathetically implemented, they will make a big difference to our level of export earnings.

"It is the best of times; it is the worst of times" said Charles Dickens in Tale of Two Cities. The question arises whether we are also witnessing a similar phenomenon — a boom that will end in a bust. Is our exuberance rational and sustainable?

The former US Fed chief, Mr Alan Greenspan, had warned the US stock market against irrational exuberance. But such warnings are rarely welcomed by market participants.

The stock market has scaled heights above 10,000, thanks largely to a combination of domestic fund flows, aided by international finance, and good corporate results.

But behind it all is a rush of liquidity, thanks to the recent accommodative monetary policies in various parts of the world, especially the US and the EU.

The easy monetary policies have, however, come to an expected end. In the altered scenario, will the flow of foreign funds into India and other emerging markets continue?

This is the ticklish question that a group of experts from Morgan Stanley addressed last week in a television interview. In India to host an investors' conference on India's prospects, the participants were frank enough to distinguish between their roles as conference organisers and independent experts on the economy and markets.

True, their dharma was to "sell" the India opportunity to their clients. But their dharma as economists was also to point out the risks and pitfalls. They pointed out that while liquidity drives most of the emerging markets in Asia, India is a particularly extreme case. The stock market depends heavily on FII flows. Much depends, though, on the prospects for economic growth and corporate earnings.

Fund flows vital

The fund flows, important as they are to sustain the market, also play a vital role in the macro-economy, with the emerging current account deficit hovering around 4 per cent of GDP.

The economists, incidentally, estimate that India needs a capital inflow of $50-60 billion to sustain an economic growth of 8 per cent — an overestimate by a factor of two, according to RBI data.

Anyway, without the present level of imports, India will face a serious problem in maintaining even the expected rate of growth of 8 per cent.

The flow of foreign funds via the stock market is, therefore, vital for sustaining economic growth. This flow through FIIs, in turn, depends on the attractiveness of the equity market. Truly, a "market"-determined macro-economic paradigm!

India may, as a result, be on the brink of a crisis, if the liquidity in international markets dries up either due to a change in US economic policy, a commodity price shock, geopolitical developments or a combination of all these.

The Morgan Stanley economists ask: "If growth slows down, if earnings come off, will domestic investors still have appetite to buy assets in India?" Clearly, domestic investments have resulted in massive wealth creation over the last two years. They estimate that domestic honchos have created about $250 billion of wealth for themselves from a combination of rising equity, gold and property.

Agreed, a huge risk appetite is there, but all of it would come under the scanner if the (foreign) flows slow down and that causes the economic momentum to slacken. While in the experts' view the markets may come under pressure in the short run from the liquidity front, they are positive on India's markets in the long term.

In the short term, however, the experts are more circumspect "since the markets have gone up quite a bit". They fear there is a risk of reversal in the short-term. This may itself lead to a reverse flow of funds in the FII space. We will then be placed in a difficult BoP situation, given the need to finance our current account deficit. This takes me to a consideration of what we will have to do to avert the doom scenario.

Obviously, there cannot be a return to import controls, given our WTO commitments and a globalising economy. We have traversed a considerable distance on the liberalisation turnpike and we risk an accident in doing a sharp turnaround.

Push up export earnings

The obvious answer is to increase the robustness of our export earnings. This requires concerted action, not the least from the Finance Ministry experts on the revenue side, who count every penny of the tax concessions they give exporters.

They need to focus more on the bigger picture of our balance of payments and the risk of a FII flow-related squeeze.

Export-related direct tax concessions for software parks and export-oriented zones are demonstrably good value for money. If sympathetically implemented, they will make a big difference to our level of exports earnings.

There remain a number of avoidable pinpricks that hinder the growth of our software earnings. Not the least of them is the problem of software-related infrastructure.

The remedy patronisingly offered to the Bangalore software exporters — that they should build their own infrastructure — is not imaginative and is a blow to economic growth.

No effort should be spared to remove the other bottlenecks that stifle India's software entrepreneurs, be they the responsibility of the Centre or the States.

It is equally necessary to increase the domestic fund flow to the stock market. Indeed, from this point of view, the growth of the mutual funds industry is encouraging.

In the last decade or so, this industry has grown both in size and credibility. The Government and the regulator should continue their efforts to remove such irritants as exist in the way of the mutual fund industry's growth.

Similarly, active steps should be taken to institutionalise pension funds and their regulation. The regulator, SEBI, in the case of mutual funds, and the corresponding regulator for pension funds will have to continue to be responsive to the needs of this yet nascent industry, if the stock market is to be weaned away from its excessive dependence on volatile fund flows from abroad.

China's growth is different

An uncomfortable thought arises in this context. Why do the Morgan Stanley experts single out India as among the countries that are vulnerable to a slowdown in liquidity flows? They do not seem to have the same fear about China.

The difference is, perhaps, that China's economic growth carries with it the sustainable growth of exports of both goods and services, a current account surplus that reduces its dependence on FII flows and makes its economic growth a function of its own savings.

It is time we too rid ourselves of complacency on the external front. We have to find ways of increasing our exports of both goods and services and, at the same time, reducing our over-dependence on imports for such materials as crude oil.

This requires a long-term plan in respect of export promotion and energy conservation, both of which seem, unfortunately, to have received scant attention in our current preoccupation with growth.

The Morgan Stanley economists have performed a signal service in pointing out India's vulnerability, amid all the hype about the soaring Sensex and good times. We ignore their advice at our peril.

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