Imbalance of payments

That the Indian economy would have to live with a substantial current account deficit for at least a couple of years has been evident for some time now. The Prime Minister's Economic Advisory Council estimated a couple of months ago that the deficit would be around 3 per cent of GDP in the current year. However, unlike in the past, this is not necessarily a bad thing. With the kind of inflow on the capital account that has been seen over the last few years, the current account deficit has prevented the rupee from appreciating too much, by absorbing the capital account surplus. Unfortunately, with the goings-on in the stock market over the last few weeks, what appeared to be a steady net inflow of portfolio investment flows has changed into a rather dramatic outflow and the old doubts about being able to finance a current account deficit have resurfaced. The parties most concerned are global investors, those who bring in their own money as well as those who invest on others' behalf. This group naturally sees the widening deficit in the absence of offsetting capital inflow as a risk factor in the coming months, setting off a vicious circle""increasing risks on the balance of payments means even less money coming in on the capital account.

The threats and risks are real enough, but how likely is a return to the bad old days of foreign exchange worries? Dispassionate analysis suggests that there is cause for concern, but not for anything approaching panic. For starters, India has a substantial reserve of foreign exchange, some of which can be used to buy the time required for making economic adjustments. Then, it should be recognised that 15 years of trade and financial sector reforms have changed the country's external scenario fundamentally, and along with that the old dynamic. For instance, the exchange rate has been freed from the burden of overvaluation, in which scenario foreign exchange was constantly in short supply. The Reserve Bank may well be "managing" the floating rupee, but it is not bound to any particular rate of exchange and, if the pressure grows, it will hopefully allow the currency to depreciate. Over time, this will have an automatic corrective influence on the current account, by increasing exports and reducing imports. Second, the country's export base has diversified considerably with the increased opportunities for trade in services. This should keep total export earnings growing at reasonably healthy rates even in the event of a global downturn.

These positives notwithstanding, oil prices loom as a huge and unwavering threat to the global economy. From the Indian perspective, moderate achievements in conservation, which will result from fully passing on the high prices to consumers, will not be enough to eliminate the pressure on the balance of payments. More so when a global slowdown will also impact exports adversely. Under the circumstances, effective economic management will involve a balanced use of a number of instruments""effective use of the country's reserves of coal and development of alternatives to oil (like ethanol), and sound macro-economic management: orderly depreciation of the rupee, inflation control and export promotion. In the longer term, there has to be a shift in the composition of capital inflow from the portfolio mode to the direct mode. This is going to depend on a host of policy and regulatory reforms, for which the ruling coalition seems to have lost its appetite. It is ironic that, while a payments crisis precipitated the reforms of 1991, a gridlock in reforms could head the country in the direction of a payments problem all over again.