1/ When Warren Buffett proposed balancing US external trade by introducing the idea of freely tradable import credits whose total quantity is tied to export volume, economists dismissed it. That was in 2003. The US runs a far bigger trade deficit today & is in worse shape now. 2/ Let us review the primary argument the economists made and often still make: the trade deficit is merely a reflection of the fact that foreigners have a huge demand for US assets, and that reflects the strength, safety and liquidity of US financial markets. 3/ Here is the first problem. The financial asset foreigners have been buying the most is US government debt. US has been issuing ever greater quantities of debt, denominated in its own currency, to foreigners. At least since it is its own currency, it is not Sri Lanka. 4/ India does not have the luxury of issuing foreign debt in our own currency. Aside from that, US paid the terrible price of losing a huge part of its manufacturing base, in industry after industry,including semiconductors, PCs & 5G gear, due to that flawed "free" trade policy. 5/ In the Indian context, economists argue that foreigners want to invest in India, so dollars flow in and our trade deficit is easily paid for with those dollars. First, investment in our financial markets, namely FII, does not add any new capabilities to our economy. 6/ FII is flighty capital & leaves exactly when a country needs dollars. Second category of foreign capital that helps bridge our trade deficit is Indian corporates borrowing in dollars to fund investment in India. Unless the corporates are export oriented, this is high risk. 7/ Borrowing in dollars when the revenue is in rupees is a high risk idea. When the dollar strengthens, it creates serious trouble for borrowers & creates non-performing assets within the Indian banking system too.
The only good category of foreign captial is equity based FDI. 8/ Equity based FDI is when a foreign company sets up factories in India. In this case, the foreign company imports machinery (capital goods) & does not bring in dollars directly. The entire exchange rate risk is borne by the foreign company & does not expose India to that risk. 9/ Finally, even if the Indian government could issue rupee bonds to foreigners, eliminating the exchange rate risk, we must resist.
US paid the price of financializing and deindustrializing and structurally distorting its economy. Why should India go down that same path? 10/ Summary: How we pay for trade deficits is important. Trade deficit financed with FII or foreign borrowing by domestic corporates are risky. FDI that creates factories in India without foreign exchange risk is the only good kind of investment because it also creates exports. 