Friday, March 29, 2013

Fixing India’s Current Account Deficit

Joint Note with Prof. Charan Singh 

Dual Deficit Problem 

  The country is in the midst of twin deficits of gross fiscal deficit (GFD) and current account deficit (CAD). The GFD, though high, has been on a declining trend, while the CAD continues its uptrend and is expected to record a new high in the current year after 4.2% of GDP in 2011-12. According to the latest data released by RBI on March 28, the CAD for April-December 2012 was 5.4% of GDP (and 6.7% in Q3). Earlier, the highest recorded CAD of 3% in 1990-91 was followed by a major BoP crisis soon after. This is a worrisome situation

Sustainable Level?

     On the CAD, at the outset, it needs to be mentioned that the sustainable level varies over time. According to the High Level Committee on Balance of Payments (1993), CAD should be 1.6% of GDP which could be met through sustainable level of net capital receipts. According to the Committee on Capital account Convertibility (1997), growing degree of integration of the Indian economy with the global economy would imply variability in the size of the CAD and recommended a CAD of 2% of GDP, while the Committee on Fuller Capital Account Convertibility (2006) recommended a CAD of 3% of GDP. The parameters considered by the latter Committee and some more generally do not show a steady performance, especially rise in debt reflecting a weaker international investment position (table 1). This should be a matter of concern. 

Table 1: Select Indicators of External

Total External Debt to GDP
Short term Debt to Total Debt

Import cover of Reserves (months)
CR - Current Receipts; CP - Current Payments; DSR – Debt Service Ratio.
Source: RBI and GoI.

     The experience of other countries also shows that India’s CAD is not the only outlier in the global economy (table 2). An IMF study published in February 2013 mentions that a CAD of 4% for India in 2012 corresponds to a cyclically-adjusted 2.7% of GDP. However, as argued by Freund and Warnock (NBER WP 11823), high CAD is a cause of concern and should be addressed. 

Table 2: Current Account Balance as percent of GDP
2012 Estimates
2013 Estimates
New Zealand
South Africa
United Kingdom
United States
                   Source: IMF.

Trade and Exchange Rate

      The finance minister has argued that the CAD continues to be high mainly because of high oil, coal and gold imports, and slowdown in exports. The scheme to raise the limit of duty free import of gold jewellery is expected to raise the supply of gold and can also be expected to reduce the demand pressure reflected in rising imports and ballooning the CAD. It may be recollected that, in November 2009, RBI had purchased 200 metric tonnes of gold from the IMF. Since then, taking the cue, probably to hedge against numerous risks, gold imports have increased significantly from $21 billion in 2008-09 to $29 billion in 2009-10, and further to $56 billion in 2011-12
     The government could consider some more bold measures similar to those initiated in the latter period of the last year, including the politically-sensitive issue of oil subsidy. Similarly, the direct measure to correct the CAD would be to allow the exchange rate to be determined by medium term market forces that drive the CAD.
       It has been argued by many learned pundits that given the differences in inflation between the US and India, amongst many other variables, the current level of exchange rate would need a correction. As economic theory suggests that market-determined exchange rate, in this case implying a depreciation of the rupee, would boost exports and restrict imports. As commodity imports, consisting of essential commodities like fuel and fertilisers, which were highly subsidised, are relatively inelastic in the short run, the demand for these responds relatively slowly to exchange rates. But now, given that the subsidy on petroleum, oil and lubricants (POL) is being phased out, higher oil prices would lead to rationalisation of consumption by the public, private and household sector. The demand by households for other major imports like gold and silver, and electronic goods can be expected to be moderated by exchange rate adjustment. On the export front, manufactures and mineral fuels can be expected to respond to exchange rates.
      A number of econometric studies have shown that exports respond to exchange rates and external demand. Illustratively, exports responded to depreciation in exchange rates in 2008-09 and 2011-12. Though global demand was muted in some of the traditional export markets of India in 2012-13 because of the global slowdown, it is expected to improve in the next year. However, India needs to explore how it can make a dent in China’s labour-intensive exports, given that wage rates are finally being allowed to rise in China. Exchange rates driven by short-term capital flow movements also distort prices and preferences in the economy, though the impact is difficult to quantify. Therefore, a bold decision to let the exchange rate be determined by medium-term market forces will help lower the CAD

A version of this article appeared as an Op Ed in the Financial Express of March 29, 2013, under the banner,"Fixing India's current account."

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