The Hindu Business Line : An `interest'ing US is draining for India

Troubles in the American economy cause capital to flow out. Conversely, when American economy rises, capital flows towards that country, impacting countries like India.

The share market has been seeing massive swings. Inflow and outflow of foreign money have lead to steep cycles of boom and bust.

Troubles in the American economy cause world capital to flow towards India.

Conversely, when American economy rises, world capital flows towards that country and India's condition becomes like that of a punctured balloon.

The fall in the Indian market can be attributed to such a flow of world capital towards the US. The US Federal Reserve Board has raised interest rates payable on US Treasuries in steps from one per cent in 2003 to 5 per cent now. Foreign investors have exited Indian markets to avail themselves of this American bonanza.

The question is whether this rise in American fortunes is stable? Is the American economy like a rising sun, or the inexplicable brightening of a lamp before it dies out?

The US Treasury Department submits an annual report to Congress on International Economic and Exchange Rate Policies.

The May report contends that the US economy is strong. It points out that the US economy remained on a sustained upward growth track in 2005.

Growth at 4.8% in Q1

Growth was at a strong 4.8 per cent annual rate in the first quarter of 2006.

But the question is whether this is due to investment or consumption demand. Sale of coffins can also lead to growth. Purchase of a tractor by the farmer or purchase of a motorcycle, both contribute equally to growth.

But the two have entirely different implications for the rural economy. Purchase of a tractor indicates the farmer's confidence in profitability of agriculture, while a motorcycle buy could indicate that he wants to commute to the city in search of a job.

Thus, the purchase of a motorcycle alone by the farmer does not indicate progress of agriculture; similarly the 4.8 per cent growth rate does not necessarily indicate strength of the US economy, as contended by the Treasury Department.

Harvard Professor Martin Feldstein writes in Foreign Affairs of May/June that there is a steep decline in the savings in the US economy. Americans are consuming more and investing less.

Theyare worried about their future. They are building a house to protect themselves from a possible loss of job.

Another indicator is the decline in the Consumer Confidence Index published by the University of Michigan from 87.4 in April 2006 to 86.1 in May.

These indicate that the high growth rate of the US economy touted by the Treasury Department cannot be taken as an indicator of strength of the economy.

The second basis of strength of the US economy mentioned by the Treasury Department is that the confidence of world investors in the dollar remains intact.

But Prof Martin Feldstein points out that the quality of private investment has deteriorated. He says that private investors "thought the potential equity returns in the USwere favourable in comparison to the risks. Now, in contrast, the flow of equity investment to the USis very small, often less than the equity investment that the Americans make in the rest of the world."

No economic considerations

Today, the capital inflows to the US primarily go toward purchasing bonds and making bank deposits. Prof Feldstein suggests that the inflow of money into the US economy is not occurring due to economic considerations. It is more due to investments by foreign governments, possibly out of non-economic considerations.

He says, "It is not clear how much of the overall capital inflow is coming from foreign Governments and how much from private investors. The available data do not distinguish between purchases by banks on behalf of private investors and purchases by banks on behalf of foreign Governments.

"But extensive conversations with officials and private bankers suggest that an overwhelming share of the foreign capital inflows in recent years has come from foreign Governments or from institutions acting on their behalf. Such a change, from private investment in US equities to Government purchases of US debt, could make the continued flow of funds less reliable."

This indicates that world investors are less confident of the future of the US economy today. The third point made by the Treasury Department is that there is little evidence of significant foreign bank diversification out of dollars. Most foreign governments continue to buy dollar-denominated securities to hold their foreign exchange reserves.

The purchase of US Government Treasuries by developing countries such as China and India is more like credit extended by sellers. Big companies such as Boeing routinely provide credit to their borrowers. Similarly, India is providing credit to the US for purchasing Basmati rice and garments. India purchases US Treasuries and the US uses that money to buy Indian goods. Americans have an unparalleled appetite for consumption.

Once a super economy

They are ever willing to buy consumption goods with borrowed money. Thus, the purchase of US Treasuries by foreign governments does not establish vitality of the US economy. If at all, it only establishes that the US was once a super economy and is now frittering away its accumulated wealth in heavy borrowing for consumption.

It can be asked why other countries are not similarly borrowing? The answer lies in prudence. Other countries first assess their repayment capacity. The US Government is running heavy fiscal deficit to meet its ever-growing expenditures.

Mr Paul Kasriel, Director of Economic Research at Northern Trust and co-author of the book Seven Indicators That Move Markets, says: "Our federal government is spending like a drunken sailor so my advice is to put on your safety harness as it is going to be a wild ride. My bet is that we are going to end up on the rocks."

The arguments of resilience of the US economy put out by the US. Treasury Department are not convincing. It follows that the US economy is likely to come under stress in the coming months. There are limits to how much global wealth the US can attract by raising interest rates when the fundamentals are becoming shaky.

In fact, high interest rates will dampen economic activity and put greater pressure on the dollar. As a result, the current outflow of foreign capital from the Indian share market to the US is likely to be short-lived and we may soon see the foreign investors returning to Indian bourses.

(The author is a New Delhi-based freelance writer. He can be contacted at bharatj@sancharnet.in)

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