Finally, a good deficit

The Prime Minister's Economic Advisory Council released its assessment of the country's balance of payments situation on Wednesday. It estimates that the current account deficit (CAD), the difference between the country's annual earnings and expenditures on goods, services, remittances and investments, will be 2.9 per cent of GDP in the current year. This gap is likely to widen somewhat to 3.1 per cent of GDP in 2006-07, driven primarily by the rising oil import bill. In another era, in another macroeconomic environment, this estimate would have precipitated a collective heart attack amongst economy watchers. Where were the dollars (or pounds, euros and yen) going to come from to finance this, they would have gasped. The spectre of the IMF would have raised its ugly head. But that era is long past. The Council itself asserts that this magnitude of deficit is "in the comfort zone", as close as it can come to saying that it is actually a pretty healthy development. Of course, a group of economists like this cannot resist the temptation to qualify such an assessment. It is seen to be in the comfort zone as long as it is "used to finance productive investment".

The fact that this is a healthy state of affairs does not really require any qualification. India worried about a current account deficit when there were hardly any market-driven capital inflows to finance it. Then, the country had to rely on either aid flows or multilateral loans; if the gap became too hot to handle, the IMF, as distasteful as it might have been, was always there. These days, the rest of the world seems to be falling over itself to invest money in Indian markets. Capital inflows are estimated to be around 4.1 per cent of GDP, which not only cover the current account deficit, they leave some over for the Reserve Bank of India (RBI) to deal with.

Until two years ago, after investment flows into India had begun to accelerate, the current account was in surplus for three years in a row. All the extra foreign exchange coming in, therefore, did not have any place to go. Left to itself, the rupee would have appreciated sharply; the RBI did not think that this would be desirable and proceeded to absorb the excess inflows, transforming them into the mountain of reserves. Over the last couple of years, a combination of higher oil prices and rapidly growing imports in other categories has taken the current account to the deficit situation that the report refers to, thereby significantly easing the pressure on the rupee to appreciate and giving the RBI some breathing space in its management of the country's monetary situation.

As long as India remains an attractive investment destination, a current account deficit will remain a good thing. To ensure that, of course, the present growth momentum has to be sustained. Also it must be accompanied by low inflation, reasonable interest rates and a declining fiscal deficit. Otherwise, the capital flow can reverse and India will either have to let the rupee drop in value or use up its reserves to shore up the currency. The country's macroeconomic discourse has to change therefore from viewing all deficits as dangerous to recognising that some are quite all right as long as the overall management of the economy is such as to ensure that the deficits are matched with compensating surpluses elsewhere. The Council, if one were to overlook the caveat, has taken exactly the right position on this issue.