The cost-benefit analysis of running a current account deficit needs to be objective
It is unfortunate that the discussion over the important issue of current account (CA) deficit has taken on an unappetising flavour, both in the coverage by the press and in some economists’ analyses. Barring a couple of exceptions, they mostly add more noise and sensationalism around the issue rather than offer insights that educate.
A CA deficit is not inherently always bad, and, in India’s case, it also indicates a higher absorptive capacity to digest foreign capital inflows. Interestingly, excluding the net trade in crude oil and petroleum products, India actually runs a CA surplus: in 2009-10, the overall CA balance had a shortfall of $38 billion, but a surplus of $21 billion if the net oil and petroleum trade is excluded. Separately, adjusting the headline CA deficit for the net import in gold, jewellery and precious stones retained domestically as a store of wealth, the underlying CA deficit appears to be better than what is reported by round 10-15 per cent.
The aggregate CA deficit is undoubtedly important to track because the deficit still has to be financed. But the adjustments mentioned above are relevant for India as they are unique and are also sizeable influences on the underlying CA deficit. Finally, the habit of some lazy analysts to annualise the CA deficit for a quarter almost always overstates the full-year CA deficit. That is because India typically posts a significant smaller deficit, or at times even a surplus, in the January-March quarter.
The key issues with the CA deficit are its size and the nature of financing. Since India is growing faster than the rest of the world, it will post a higher CA deficit during this phase than would otherwise be the case. Indian policy-makers’ preference for low volatility in GDP growth even as global dynamics remain volatile also contributes to a higher CA deficit.
But the growth differential in India’s favour is also the reason why foreign savings are being recycled into India. As and when the global economy recovers, India’s CA deficit will narrow as exports will likely rebound more than imports. Capital flows will also adjust, although the broader structural trend of asset allocation towards EM in general and India in particular should still persist. Obviously, there is no guarantee that capital flows will always be smooth.
Indian policy-makers have two options: one, they can target GDP growth at 6-7 per cent and have a much smaller CA deficit; or, two, aim for 8-9 per cent growth and a CA deficit is between 3 and 4 per cent of GDP, depending on the phase of growth and the global backdrop. In the first option, the smaller size of the CA deficit will likely be replaced by increased pressure of the rupee to appreciate (something that has been less of an issue this year). Depending on how overwhelming that appreciation pressure is, it might even prompt stronger calls for restrictions on capital inflows, a script that has been acted upon before.
However, the complication is that the current economic setting is vastly different from what existed in 2007-08. Now, an active divestment programme of the government, the still-low overseas borrowing by Indian companies, and the need for foreign financing of investment, all argue against such restrictions. It is not a mere coincidence that while several other Asian countries have adopted restrictions on capital inflows, India has so far avoided them. Thus, there is a positive dimension to the typical negative-only assessment of the CA deficit.
Under the second option, a CA deficit of 3.5-4 per cent of GDP could be interpreted as being worrying because India has never posted a deficit of that magnitude. But then India has never been in the kind of the global backdrop as it is in today, or experienced a structural transition into 8-9 per cent growth orbit. In the final tally, it is not worth sacrificing, say, 2 percentage points of annual GDP growth to narrow the CA deficit, and then have to resort to all kinds of measures to restrict capital inflows, many of which will further adversely affect growth and fiscal dynamics.
The above analysis does not mean that Indian policy-makers can afford to ignore the issue. A wider deficit makes India vulnerable to a sudden shock of reversal in short-term capital inflows. However, this plays out differently than most people realise. Indeed, running a CA surplus does not mean that a country is immune to the adverse effect of a reversal in capital inflows, or else most of Asian currencies should not have the hit by the impact of capital outflows during the global credit crisis.
For example, Singapore runs huge CA surpluses (typically in the high teens, as percentage of GDP), but the Singapore dollar is affected every time there is an increase in global risk aversion and/or the US dollar strengthens and capital flows reverse. The difference in India’s case is that the rupee’s movements are more exaggerated owing to the CA deficit, and volatility of portfolio inflows. Also, because of the deficit, the rupee will typically underperform other Asian currencies that are experiencing appreciation pressure from large CA surpluses (essentially indicating that saving rates in these countries are well above the investment rates), and from net capital inflows.
Is the widening of the CA deficit indicative of the rupee’s overvaluation? Export growth in the first 10 months of the current fiscal year was 27 per cent year-on-year, admittedly on a weak base. But that still does not hint that exports are hurting from rupee dynamics. On a real trade-weighted basis, the rupee has essentially recovered the ground it had lost in the depreciation to deal with the global credit crisis. That return to pre-crisis level should not be termed as the rupee is becoming overvalued. Further, exporters are not howling for currency weakness, as was often the case, and all are becoming more used to two-way movements in the rupee. Export growth will surely moderate owing to softening global demand, but that does not mean that the rupee is overvalued.
Still, the widening of the CA deficit will need to be checked. Nothing can beat policy initiatives to enhance the competitiveness of the export sector but precious little is being done in that area. Hopefully, the ongoing debate about the financing of the CA deficit will finally push the government to announce measures to attract more FDI, so as to increase the share of stable capital inflows. Also, India needs to diversify the channels of capital inflows rather than being too reliant on equity inflows.
There used to be a time when trade flows dictated currency movements. However, in recent years, capital flows have become a more important driver of exchange rates and commodity prices. It is anybody’s guess how long that will last, but for now it is up to the policy-makers to undertake initiatives that will convince investors that a widening of the CA deficit to around 3.5-4 per cent of GDP is temporary and that it can be financed.
The author is senior economist at CLSA, Singapore. The views expressed are personal
