@ Indian Investor IV

Indian Investor Says:
September 8, 2009 at 6:31 pm | Reply   edit

Suppose you look at the financial status of a country in terms of its external financial transactions – exports result in forex inflows, imports result in forex outflows, there’re reserves in forex and there would be external debt. Add in the inflows and outflows of capital on the capital account. An ordinary person’s finances can be studied through income, expenses, savings and debt. You can also study the finances of a country through the above flows.
Since the sovereign can enforce settlement of transactions within its territories through legal tender currency; the theoretical upper limit on government spending is the level that’s tolerable while still ensuring solvency of the country from an external finance perspective.
Excessive government spending resulting in higher imports, high reliance on external debt, etc are situations that lead to a balance of payments crisis.
To make a short point of it, if the Government of India wants to stimulate development through spending on useful public works, they need to correspondingly limit imports of oil, etc. Or else you get a 1991-style balance of payments crisis, also called a currency crisis. That’s what Zimbabwe, Iceland, South Korea, etc went through recently – the bubble burst triggered an external finance solvency problem that caused their currency to collapse.

 

What seems to me patently obvious is that a country’s external trade cannot be its defining or sustaining paradigm.  India was quite content to be a source and not an importer for several centuries.  It is only  a poorly endowed nation like Britain which takes to trade as a livelihood.  We can imagine autarky on the Indian subcontinent for long swatches of time.  Anyway the import content of ordinary life in India would be minimal for long stretches of time.

I would like to study a normal person’s (as well as an institution’s) financial health by recourse to its balance sheet (what assets does it have? what liabilities ? what is its net worth?) and its income statement (What did he earn, what did that cost him? What did he save?)

In addition, I would like to look at the flow of funds accounts, which tell me how the saving done that year was disposed of, into what real projects and into what onlending.  This is where the debt you mentioned comes in.

The external debt of a nation is just a subset of the liabilities side of the international investment position (IIP) statement.  It gives a one sided view of the external situation.  The assets side is included in the other half of the IIP.  The IIP is the financial account of the BOP (Balance of Payments) amplified for holding gains and other changes in value.  The IIP articulates with the BOP.  The BOP articulates with the National Income and Product accounts, which in turn articulate with the Flow of Funds accounts.  The Flow of Funds gives the total picture.

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One Response to “@ Indian Investor IV”

  1. Indian Investor Says:

    I abstracted only the external financial transactions to illustrate the upper limit on government spending on public works. Suppose a new toll road is built in India it might attract ongoing tariffs. Or if it’s a free highway in the longer run its usage might increase the taxable output. Such may not be the case with building more highways in a country with an already advanced infrastructure. Besides this type of spending on infrastructure leads to increased output of say stone, steel, cement, bricks, etc – hence the inflationary effect is minimized.
    So in practice the consideration that stops massive development projects is that it would lead to higher imports, that can’t be paid for in domestic currency. Hence the external financial position determines the upper limit on government spending on public works.
    Many Indians wouldn’t be going to bed hungry on a hard pavement tonight just as I luxuriously complete my comment if only we didn’t have to shell out anywhere from $70 to $ 146 for a barrel of Saudi crude that costs less than $5 to produce.

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