Current account caution

Indian Express, 8 October 2010

India's current account deficit widened to 3.7 percent of GDP in the April-June 2010 quarter. Imports are about one and a half times of exports and they grew rapidly as the Indian economy witnessed healthy growth. Exports of goods and services also witnessed high growth, but not fast enough to prevent the deficit from rising.

Is the large current account deficit a matter of concern? Should the government or RBI respond to the deficit? Should they change trade policy, impose capital controls or intervene in foreign exchange markets?

India has, especially after the 1991 crisis, lived with a fear of current account deficits. In addition, the experience of many low income countries with large current account deficits has been unpleasant. A sudden stop in capital inflows in the face of high deficits have led to balance of payment crisis. When a country runs a current account deficit, as an accounting identity, it requires capital inflows in order to finance this deficit. If these capital inflows stop, the country can be thrown into a crisis.

Could the present level of India's current account deficit lead to such a scenario?

The first question is whether this is a long term trend. Is India witnessing long periods of high and rising current account deficits building up to a position of high net indebtedness? An examination of the last 5 years shows that apart from the period immediately following a crash in world trade after the Lehman crisis, there is no such trend. The current account deficit has remained at roughly 2 percent.

Second, the deficit has not been financed so much by debt as by inflows of capital attracted by India's high growth path. The striking fact here is that these flows are continuing even after one of the worst financial crises of the century. The fear of a sudden stop of capital flows is lower than had global finance been in an overheated state. India's relatively stronger growth is likely to continue to attract capital inflows to finance the current account deficit. Further, India's engagement with foreign investment including portfolio and private equity flows has deepened over the years and is likely to get stronger and deeper in coming years.

Third, as the world economy recovers, exports are likely to grow even faster. The collapse in exports that was witnessed during the crisis is the main reason for the present current account deficit. When the world economy is back on track, even though the outlook looks bleak at present, the deficit is likely to go back to its average level.

One may therefore argue that the current level of deficit is a short term phenomenon and does not pose the threat of a crisis. Even so, were action necessary, what could be done? There are 3 kinds of steps that could be taken.

First, there could be direct action on the current account such as restricting imports or encouraging exports either through quantitative restrictions or a change in duties. This is an obviously bad idea. It would be distortionary, create lobbies and be difficult to get rid of.

The second and third set of actions would work through prices, ie. the rupee. Without capital inflows, a high current account deficit would have resulted in rupee depreciation, making exports cheaper and hopefully expanding them. The rupee is not depreciating today despite the crisis, as there is high demand for rupee assets. Blocking capital inflows could put downward pressure on the rupee and the price effect would make imports more expensive and exports cheaper and thus reduce the deficit. This strategy has risks. We may ban one or the other kind of capital inflow, but money usually finds its way around capital controls. Also, changing capital controls makes the economy unattractive to foreign capital in the long run. Flipflops in policy make foreign capital jittery. Apart from a few areas of debt and participatory notes, India's broad approach to capital controls has not been major reversals in policy. This creates confidence among investors and facilitates foreign capital to become a reliable source of funding for domestic investment.

The third option could be for the RBI to intervene directly in the foreign exchange market to push depreciation. This is a bad idea as it would pump up money supply in an already inflationary economy. Sterilisation of forex intervention is difficult under the present levels of government borrowing. The RBI has broadly stayed from forex markets for a year and saved itself a lot of trouble on the monetary policy front. It will be wise to stay that way.

The biggest problem with the set of actions that work through the rupee is that we are assuming, first, that the rupee will move. Second, we are assuming that imports and exports will respond significantly to the change in the exchange rate. If both happen, the current account deficit will come down. Evidence, however, suggests that the price elasticity of Indian exports is very low. The volume of Indian exports is hugely dependent on the volume of world trade and world GDP. In recent years Indian exports grew fast when the rupee was appreciating and slowed down when it depreciated. The overwhelming determinant of export growth is going to be the pace of recovery in US and Europe.

Not only is manipulating the rupee unlikely to be effective in impacting the current account deficit, it will also be inflationary. In the present scenario of high inflation, a weaker rupee will push up the price of imports. While this may or may not reduce the volume of imports, depending on the price elasticity of imports, it will lead to pushing up the price of tradables further. Given the present level of high inflation, this is not desirable.

In summary, first, the high level of current account deficit is likely to be a short term phenomenon. As the world economy recovers and exports pick up, the deficit is likely to go back to sustainable levels. India may see one or two more quarters of high current account deficit, but we should not panic. Second, if we did want to act, we need to remember that all policy measures have costs. We need to carefully weigh these costs before taking any action. At present it does not appear that any of these costs are worth incurring.

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