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BoP: Zero Dark Thirteen?

The current external fragility has not appeared suddenly; it is a result of sustained neglect and economic mismanagement

Shankar Acharya 

Shankar Acharya

Fourteen months ago ('Roosting chickens, building crises', January 12, 2012) I warned that at least four crises were in the making: an external payments crisis, a crisis of several years of slow growth, a for the "youth bulge"and a serious weakening of our national security capacity. Where do we stand today? Well, we seem to be well into the crisis of prolonged low growth: 6.2 per cent in 2011-12, five per cent this year and less than six per cent in 2013-14. Even if you take the government's more optimistic forecast for 2013-14, in the three years from 2012-13 to 2013-14, the Indian economy will have grown at less than six per cent a year, well below the risible expectations of nine per cent plus hardly a year back. There are plenty of indications that the crisis of job scarcity for the burgeoning young population is also upon us, although we lack reliable, national data on the employment situation after 2009-10. Despite mounting threats to our national security, the budget allocations for our defence forces have been falling in recent years as a proportion of GDP, testifying to the weakening of our defence capabilities.

Today my focus is on the first of the four crises mentioned above, namely the growing fragility of our external finances. The basic data in the table and graph are clear enough. Since 2003-04 our merchandise trade deficit has risen five-fold from two per cent of GDP to about 11 per cent at present. The current account deficit (CAD) has worsened in tandem, and is now running at a completely unsustainable five per cent of GDP, four times higher than the 1.0-1.3 per cent level of 2005-08 and double the 2.5 per cent level indicated as sustainable and "safe"by the prime minister and his senior economic colleagues, including in recent Budget interviews. Basically, since 2005-08, the trade deficit has widened by about four per cent of GDP, while the surplus on "invisibles"(mostly software exports and remittances) has hardly risen as a share of GDP. As a result, the has been higher than the safety benchmark of 2.5 per cent of GDP in each of the four years since 2009-10, and over four per cent in the two most recent years. (Key components of India's balance of payments (% of GDP))

So, and this is important, our current external fragility has not appeared suddenly; it is a result of sustained neglect and Several strands of mismanagement can be readily identified (and have been, repeatedly, in these over the years). First, the high fiscal and revenue deficits of the last five years have spilled into the external sector, just as they did in the late 1980s. Second, the relatively hands-off approach to exchange rate management, adopted by the Reserve Bank since spring 2009, has allowed a completely unjustifiable nominal and real appreciation of the rupee, especially in 2009-10, contributing to the burgeoning trade and current account deficits. This loss of external competitiveness has been exacerbated by the more recent policy disarray in core infrastructure and mining sectors, which has seriously hurt the manufacturing sector, and directly damaged exports and import-substituting, domestic production in mining. The problems have been further compounded by growing labour market inflexibilities and rising costs.

Of course, these policy failures have been magnified by some external factors, such as recessions in industrial nations and (somewhat paradoxically) high prices of oil and metals. But these are outside India's control; it does not absolve our policy-makers from adjusting policies to deal with external problems. Instead, their approach seems to have neglected the difficult, "bullet-biting"decisions and has preferred the soft option of seeking higher external financing (notably foreign direct and portfolio investment and external commercial borrowing) to plug the rising external deficits. The problem is that such financing has a proven track record of becoming scarce just when you need it most, especially when tax and regulatory policies are negative and unstable.

Does the recent Budget significantly reduce our dangerously high external vulnerability? Not much. Consider the following. We need to reduce the gaping fairly quickly, from around five per cent of GDP to 2.5 per cent. It is an accounting truism that this needs an equivalent reduction in the domestic savings-investment gap. Presumably, we would prefer that most of this comes from an increase in domestic savings rather than a further decrease in investment. One source is the central government budget. But this only targets a reduction in government dissavings (the revenue deficit) of 0.6 per cent of GDP from 3.9 per cent in 2012-13 to 3.3 per cent of GDP in 2013-14 (still thrice the level of 2007-08!), that is, only about one-fifth of the required reduction in the investment-savings gap. And that is if you believe the patently optimistic projections for tax revenues, spectrum auction receipts, disinvestment and subsidies! India's external vulnerability remains largely untended. We may still need $90-100 billion of net external financing in 2013-14.

How might vulnerability transform into crisis? It is, unfortunately, quite easy to envision plausible scenarios. For example, a return to "risk off"in global markets could easily lead to a $ 10-20 billion reduction in foreign inflows in a short time period, triggering a rupee depreciation, which could become unmanageable as speculative leads and lags in current and capital account transactions swell in response. A sharp and disorderly currency depreciation would fuel inflation, seriously damage externally leveraged companies, weaken the banks exposed to such companies and generally disrupt economic activity. A similar scenario could be induced by a spike in oil prices. Indeed, even the publication of unexpectedly large trade and current account deficit results could trigger a damaging run on the rupee. When vulnerability is high, fairly modest external or internal economic shocks can precipitate a large problem.

What can be done? The hard truth is that there is no easy way to quickly reduce vulnerability, when policy-makers have allowed the situation to deteriorate for so many years despite all the warning signals. The opportunities to resist rupee appreciation (in a context of growing deficits) and build-up forex reserves were missed earlier and may not return soon. The manifold costs of high fiscal deficits for five years cannot be rectified in a few months. Exports cannot be ramped up overnight when labour-intensive manufacturing has been penalised for many years by bad policies. What can be done is limited. It includes undertaking a sharper reduction in the revenue deficit than the budget has presented. The disarray in core sectors has to be addressed urgently. Forex reserves need to be deployed with finesse in the face of currency volatility. And, perhaps, the finance ministry should engage the IMF in discreet but serious discussions about emergency loan facilities in case the liquidity crisis does hit.

None of this is palatable. But we need to remember that if the crisis does strike, it may be a lot harder to bounce back than in 1991. The global economic environment is much weaker. More importantly, the low-hanging fruits of easy policy reform were consumed earlier. Now the going will be much tougher. Meanwhile we have to hope for the best. We are good at that!

The writer is Honorary Professor at Icrier and former Chief Economic Adviser to the Government of India.
Views are personal