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The rupee, which had overshot, is now recovering again as the concerns over the current account deficit (CAD) are reduced and the Reserve Bank of India, under a new governor, has provided the markets with some assurance that India will not revert back to a market control regime. But, looking forward, India still faces a twin deficit in the CAD and fiscal account, declining growth and persistent retail inflation as well the possibility of further shocks. We need a better understanding of the relationship between the CAD and the fiscal deficit (FD) if we are to manage a decline in inflation and an increase in growth. India had a high fiscal (5.2 per cent of GDP) and current account deficit (4.8 per cent of GDP) in 2012-13. The government wants to reduce the CAD to 3.9 per cent of GDP by 2013-14 and to 2.5 per cent of GDP by 2014-15. However, if the fiscal deficit (FD) is also not reduced by a similar amount it will have implications for private sector savings and investment balances and on our prospects for growth and inflation.
The CAD is the overall deficit of savings over investment of the country, or what is often called foreign savings; whereas the fiscal deficit is the overall deficit of savings over investment of the government, or government dissaving. Thus CAD (foreign savings) = FD (government dissavings) + private savings - private investment. The last two items together are net private savings.
If the fiscal deficit is the same size as the CAD, it means all of our foreign dissavings is caused by the government. The private sector's savings and investment are in balance. So when our FD and CAD were both at around 5 per cent of GDP in 2012-13, the private sector was in balance. Now fast forward to 2013-14, when our CAD is projected to be around 3.8 per cent of GDP, but the FD will remain at around 4.8 per cent of GDP. This would imply that the surplus of private savings over private investment is around one per cent of GDP. By 2014-2015, if the CAD drops to 2.5 per cent of GDP but the FD stays at around 4.5 per cent of GDP, then the surplus of private savings over GDP will need to increase to two per cent of GDP. Such an outcome will inevitably be hugely recessionary. A surplus in the private sector of around two per cent of GDP could mean reduced private investment, which would not be good for growth; or it could mean another two per cent of GDP has gone to private savings - which would not be easy in a low-growth economy, other than by generating huge inflation. So, while everyone's focus is on the CAD, it's not enough for a sustained recovery. If we reduce the CAD but don't also deal with the high FD we are creating potentially an unhealthy macro-economic environment of reduced growth and/or higher inflation. With the recent real exchange rate adjustment and better recovery in the advanced countries, our CAD is likely to come down, as exports rise and imports are reduced; but now we must focus attention as well on the FD.
How were we able to live with high fiscal deficits and low CADs in the past, one might well ask? The answer is that we lived in a closed economy and we could use financial repression to force net private savings, which was used to finance government dissavings without generating inflation over a sustained period. It meant suboptimal growth, but we were willing to live with that macro-economic outcome.
We are now living with a mostly open capital account in which we cannot control inflows and outflows of capital. As government dissavings fell after 2004 and foreign inflows increased, private sector balances were improved and investment boomed. As growth increased, corporate savings also increased dramatically and gross domestic savings peaked at 37.8 per cent of GDP in 2007-8. Then came the 2008 crisis when the FD shot up again and, while the CAD increased by a small amount, net private savings had to rise dramatically.
As the FD stayed high - at around five per cent of GDP in 2009-10 and 2010-11 - even after the crisis and the CAD was around two per cent of GDP, net private savings (private savings over private investment) had to make up the difference.
But this could not continue for a longer period and as private savings rose and investment declined, growth began to slow down by 2011-12. Foreign inflows picked up and fuelled a consumption boom, as private savings fell sharply and by 2012-13, the CAD and the FD were again in balance and net private savings declined. But this balance was now achieved at a much lower level of private savings and investment.
Looking forward, without a revival of genuine productivity-based growth. India's prospects will remain precarious. To get growth we must create space for the private-sector balances to improve. If the FD remains high we could try to revive growth - but the macro balances will simply not allow us the higher levels of private investment we need. That is simple arithmetic that we cannot avoid. It demands that reducing the CAD is the first step, which must be followed urgently with a reduction in the fiscal deficit. Not doing so makes the reduction in CAD unsustainable and we will be back where we started, staring at another precipice. To revive the economy, and reverse the decline in growth rates fiscal policy is the key.
The writer is a former UN Assistant Secretary General and now DG Independent Evaluation, government of India. Views expressed are personal
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
