A recent speech by the chairman of the prime minister’s economic advisory council, C Rangarajan, was interesting in that it directly addressed questions about the sustainability of India’s high current account deficit, and measures that could be taken to moderate its effects. The current account deficit was a worrying 4.2 per cent of gross domestic product last financial year; Mr Rangarajan said he hoped this year it would go down to 3.5 per cent of GDP, and that eventually it would go down, in about five years, to what he said was a sustainable level of about 2.3 per cent of GDP. He also pointed out that, while he had consistently argued that there was a hierarchy of preference over methods by which the balance of payments could be financed – namely, that flows of foreign direct investment (FDI) were definitely preferred to portfolio funds, “hot money” or flows of foreign institutional investment (FII) – the latter was not quite as much of a danger as some would fear. As substantiation, he argued that, in the past 15 years, FII flows into India had only turned negative in the crisis year of 2008-09 — and even then, it had been “modest”, with foreigners selling only six per cent of what they were holding in the month of September 2008, when Lehman Brothers fell. This is, first, a significant challenge to the current wisdom on avoiding financing external deficits through volatile portfolio funds; and, second, a window into the decision-making process in New Delhi, which has gone out of its way to appear welcoming to FII money in the past few months. That’s how the external deficit will be financed; when it comes to growth enhancement, the currency should be allowed to depreciate in real terms, argued Dr Rangarajan, making exports more competitive.
There are several complications to this argument, and Reserve Bank of India Governor D Subbarao has made his questions about it apparent in recent communications. RBI has been doubtful about doing anything more with the exchange rate than managing its volatility. There is certainly disagreement on whether it is more effective to stimulate growth through exports or through rate cuts. More importantly, the point is whether a real depreciation in the currency should be used to allow nominal depreciation or to build up foreign exchange reserves. If New Delhi intends to finance the current account deficit through FII funds, then the size of India’s reserves becomes vitally important.
There are also important questions to be raised about the destabilising effects of dependence on FII flows. As Mr Subbarao has pointed out, although flows are often smoothed out over full years, volatility means outflows can spike within a year and provoke a crisis. In addition, increasing the degree to which foreigners hold Indian sovereign debt (or permitting foreign currency-denominated sovereign debt) will also make the government more dependent on external market sentiment — perhaps a bad idea. Markets view high public debt-to-GDP ratios as much more tolerable if held internally. More, these are essentially short-term fixes for a current account deficit that is driven not by growth compulsions – capital goods, say – but by consumption, of fuel and gold in particular. A structurally high current account deficit will inevitably have problematic consequences. Rather than addressing it through attacking its twin, the fiscal deficit, the government, driven by short-term worries, might well be compromising medium-term stability. New Delhi’s policy makers should address these very pertinent worries forthwith.