Policy balance

Higher trade and fiscal deficits can create risks

Global developments would continue to affect economic outcomes and policy choices in the near term. Recent data shows India’s exports declined marginally in August on a year-on-year basis, while it contracted by about 9 per cent sequentially. There are a number of reasons why exports have moderated, and the outlook is likely to remain challenging in the foreseeable future. The global economy is slowing rapidly, which is affecting demand. Higher energy prices are upsetting household budgets in many parts of the world, compressing demand for other goods. Indian exporters have reported a shift in demand to low-value products. Although exports have moderated, imports have remained sticky, partly because of higher crude oil prices. The ongoing recovery in the Indian economy is also pushing up demand for foreign goods. As a result, the trade deficit remains elevated.

Despite some moderation from July’s record levels, the trade deficit in August came at $28.68 billion. Most economists expect it to remain elevated and are adjusting the current account deficit (CAD) forecasts for the year to 3.5 to 4 per cent of gross domestic product compared to 1.2 per cent in the last fiscal year. Although the Reserve Bank of India (RBI) is confident of financing the CAD, global financial conditions could increase challenges. Foreign portfolio investors (FPIs) have returned to Indian capital markets after aggressive selling in recent months, but their participation would remain anchored to global conditions. The recent Jackson Hole conclave of central bankers clearly indicated that central banks, particularly the US Federal Reserve, will use monetary policy aggressively to tame inflation. Sustained rate hikes by large central banks and tightening financial conditions would affect flows to risky assets, such as emerging market equities. Besides, higher interest rates would further slow down the global economy, affecting exports from India. Though slower global growth could soften commodity prices, geopolitical factors may continue to drive energy prices. Sustained disruption in gas supply from Russia could again push up energy prices.

The CAD is expanding at a time when the government is running a higher fiscal deficit, which is expected to remain elevated in the medium term. Even though India has buffers, higher “twin deficits” are always a risk for macro stability. It could become a worry for FPIs and affect flows, making the financing of CAD more difficult. While the government should use the buoyancy in tax collection to improve the fiscal position, the RBI can focus on CAD.  RBI Governor Shaktikanta Das in a recent speech highlighted that the rupee has been comparatively stable. While the US dollar index has gone up by 11.8 per cent in the current fiscal year, the rupee has only depreciated by 5.1 per cent— one of the lowest in the world. This is largely because of aggressive intervention by the RBI.

However, it is worth noting here that this stability could over time increase risks. If the rupee is not allowed to adjust, its relative strength could worsen the current account position by making imports cheaper and exports uncompetitive. Since global conditions are unlikely to change in the near term, it is important that the currency is allowed to adjust in an orderly manner. Visible adjustments in both fiscal and current account positions will help strengthen macroeconomic stability, support economic activity, and boost investor confidence.