India administers wrong medicine to its current account sickness

Authors: Rajiv Kumar and Geetima Das Krishna, Centre for Policy Research

By the third quarter of 2013–14, India’s current account deficit (CAD) had shrunk in just a year from a record 6.5 per cent to a mere 0.9 per cent of GDP. The CAD for 2013–14 is on track to be lower than 2.5 per cent of GDP. This is a commendable outcome. But is this lower CAD sustainable?

The large CAD had increased India’s external vulnerabilities during July–September 2013, resulting in a sharp depreciation of the rupee after the US Federal Reserve’s ‘taper talk’. India not only became part of the ‘Fragile Five’, including Indonesia, Turkey, Brazil and South Africa (all countries with large CADs) but had the dubious distinction of leading the pack with the rupee being the worst performing currency.

In simple terms, a CAD shows that an economy is importing more goods and services than it is exporting. For an emerging economy like India with high domestic demand, it is neither unusual nor negative to incur a CAD if two conditions are satisfied. First, imports contribute to capacity expansion and productivity enhancement, not merely to consumption. Second, the CAD can be financed by non-debt-creating capital inflows.

But a persistently high CAD with declining foreign currency reserves increases macroeconomic vulnerability to external shocks and puts the domestic currency under pressure. Therefore, the current decline in CAD is welcome news.

However — a word of caution: the current decline in CAD is due to a lower trade deficit achieved through a massive fall in gold and capital goods imports. Gold imports declined on average by 75 per cent during the six months from August 2013, accounting for nearly 60 per cent of the fall in aggregate imports.

The decline in capital goods imports of 14.7 per cent between July and February, the sharpest after gold, was a direct result of a deteriorating investment climate. Moreover, non-oil, non-gold imports also declined due to weak domestic demand and faltering growth.

Restrictions on gold imports will have to be removed to prevent the re-emergence of organised gold smuggling, its associated mafia, and the rechannelling of remittances. Seizures of illegal gold had increased 150 per cent during the first 10 months of 2013–14, according to media reports.

Capital goods imports will also increase sharply once economic growth picks up speed. And the CAD will start rising again. Therefore, a sustainable reduction in the CAD cannot be achieved without improving export competitiveness.

Another way to look at CAD, not often discussed, is that it is equal to the gap between total savings and investments. The gap between the higher investment and lower domestic savings is met by inflows of external savings, which is reflected as the CAD. India’s worsening CAD since 2008 was a result of a sharp fall in domestic savings by a huge 6.7 per cent of GDP, twice the decline in investments, and, therefore, unsustainable.

Of the three major components of savings — household, corporate and public — public savings declined most sharply by 4.8 per cent of GDP during 2008–10. This was a result of the central government’s fiscal deficit ballooning to 6.5 per cent from 2.5 per cent of GDP. Households that maintained their savings levels shifted them to physical assets as low nominal returns on financial investments and high inflation resulted in negative real returns, making gold and real estate more attractive.

During 2008–09 and 2013–14, private investment fell by an alarming 8.2 per cent of GDP due to poor investor sentiment and the fiscal deficit crowding private investment. So, capacity expansion in the economy stalled while consumption continued to rise, fuelled by higher public spending. Consequently, macro instability built up in the system with rising retail inflation and larger CAD. Falling private investment also brought down potential growth from nearly 8.5 per cent to less than 6 per cent.

Plummeting investment has been the principal driver of the current compression in CAD. This is disastrous for an economy seeking to generate massive employment opportunities. Data on ongoing projects from the think tank Centre for Monitoring Indian Economy indicates that investments have continued to decline despite some revival in government projects due to clearances by the Cabinet Committee on Investment.

The number of abandoned or stalled projects has also continued to rise. It is clear that the economy needs to bring private investment back on track and raise public savings if the compression in CAD is to be sustained.

The improvement in CAD has come about by suppressing imports rather than increased exports. This is neither sustainable nor desirable, as it may result in the re-emergence of large-scale gold smuggling. Internally, it has been achieved through much lower investments rather than higher savings. So, the quality of external account correction remains poor, unsustainable and inimical to reviving growth.

Rajiv Kumar is Senior Fellow at the Centre for Policy Research, New Delhi, and former Director of the Indian Council for Research on International Economic Relations.

Geetima Das Krishna is Senior Researcher at the Centre for Policy Research, New Delhi.

A version of this article first appeared here in The Economic Times.