Author: Ashima Goyal, IGIDR
India’s current account deficit (CAD) rose to a record 6.7 per cent of GDP in the last quarter of 2012.
That is clearly unsustainable. But an effective cure must address the roots of the problem, for which a correct diagnosis is essential.
There are several possible explanations for such a rise in the CAD.Excess demand cannot be responsible for the higher CAD when GDP growth has fallen to below six per cent and industry is actually experiencing excess capacity.
It is possible that the high fiscal deficit (FD) is raising demand. But the government, pushed by fears of rating downgrades, has made a serious effort to reduce the FD. In the last quarter of 2012, growth in government consumption fell to 1.9 per cent, from 8 per cent in the preceding quarter, while growth in community, social and personal services, which is largely impacted by government consumption, fell from 7.5 to 5.4 per cent.
If the fall in the FD reduced growth but not the CAD, it implies government expenditure creates demand largely for non-tradable goods, not for imported goods. So excess demand may be a problem only in agriculture, where supply rigidities prevent expansion to keep up with rising demand for food. Government consumption contributes to this.
There is also a speculation-based argument, which says that if interest rates do not adequately compensate for, or are even set below, inflation rates, the resulting low/negative real interest rates encourage borrowings and imports. This leads to a higher CAD. But this argument is not credible either given that credit growth was low in the recent period. India’s CAD has also never been high in high-growth periods, when one would expect higher domestic demand to raise net imports.
If domestic absorption or aggregate demand is not responsible for the CAD, the problem might lie in imports being cheap and exports not sufficiently profitable. In that case, wouldn’t a depreciation of the rupee help?
This argument, again, has limits. The CAD was only around 1 per cent of GDP during India’s high-growth period in the mid-2000s, when the rupee was actually appreciating. After the steep depreciation following the 2008 global financial crisis, the CAD rose to about 3 percent of GDP and stayed there until 2011.Then, as the rupee fell against the dollar, from Rs 44 in July 2011 to Rs 54–55 levels, the CAD went up to over 3 per cent. Despite substantial real depreciation, export growth slowed more than import growth. To that extent, the cheaper rupee only worsened the CAD, implying that import and export demand are largely inelastic to exchange rate movements.
Another explanation points to capital flows. It says that higher capital flows lead to higher CADs, since the balance of payments must add up to zero. But this argument falls into the classic Immaculate Transfer doctrine trap. True, the capital and the current account must equal the change in reserves, but that does not mean one is directly causing the other. CAD outcomes are the result of various other macroeconomic adjustments, including in foreign exchange reserves, output, exchange and interest rates. Whatever these adjustments were, capital inflows definitely did not cause the current widening of the CAD. On the contrary, just when the CAD widened in 2011, there were capital outflows that made it difficult to finance the CAD.
A more promising explanation for rising CAD levels emphasises supply shocks that sustained high inflation over the 2007–13 period, alongside lower growth. These shocks, by impacting real incomes and generating low real returns, reduced financial savings in the economy.
The first of these cost shocks was the spiralling of global food and oil prices in 2008. Their slow release through the system owing to poorly administered price regimes kept inflation high. Capital outflows-driven rupee depreciation sustained these shocks, even when international commodity prices softened.
In 2011–2, the CAD rose by 1.5 percentage points to 4.2 per cent of GDP from 2.7 per cent the previous year. Investment fell from 36.8 to 35 per cent, but savings fell even more, from 34 to 30.8 per cent. The widening of the CAD must equal the excess of the fall in savings over the fall in investment — which is what we see here.
Within savings itself, the largest fall was in the household financial savings component: 2.4 percentage points. This, together with a 0.7 percentage point fall in the corporate savings–GDP ratio, almost covers the rise in CAD and fall in investment. In fact, the increase in household physical savings by 1.2 percentage points almost offset the 1.3 percentage point fall in public sector savings of 1.3 percentage points, as both largely impact non-traded goods.
These financial aspects were reflected in trade statistics. Inelastic demand for oil in the absence of local price pass-through, and for gold given the absence of other inflation hedges, widened the CAD. If imports of oil and gold are subtracted from the trade deficit, India actually recorded a trade surplus in this period.
What all this highlights is the inadequacies of the policy of freer import competition without building export capacity, which leads to import growth exceeding that of exports. An example of this is India’s per container trade costs, which are more than twice the East Asia average. The intensification of the European crisis lowered export demand, just as domestic supply bottlenecks raised coal imports. The real story is thus sectoral. Aggregate policy instruments such as interest and exchange rates are constrained — interest rates by their opposite effects on savings and investment, and exchange rates by their opposite effects on export demand and import costs. The correct policy response requires concerted supply-side action to reduce costs, along with a dismantling of the administered pricing regime.
Lower inflation and a better menu of savings instruments can revive financial savings. Better export capacity must be matched by a diversification of export destinations.
Ashima Goyal is Professor of Economics at the Indira Gandhi Institute for Development Research.
This article was originally published here, by The Hindu Business Line.