At the very outset, I must confess having been unsuccessful in getting sensible answers to the following basic questions pertaining to India’s external macro-management: why did Indian policy makers allow the current account deficit (CAD) to widen to a record high of nearly four per cent of gross domestic product (GDP) when they consider the comfortable level at around 2.5 per cent? Additionally, why has the financing of CAD become more – not less – reliant on volatile capital inflows that are sensitive to shifting global risk appetite?
The answers will force the government to acknowledge that it has been in sleep mode in addressing the increased economic vulnerability that often accompanies unsustainable CADs. More strikingly, they will confirm that the government has done little to check the worsening CAD; instead, by encouraging more foreign borrowing, policy actions have increased India’s vulnerability to global risk-off, or a slowdown in capital inflows.
There are two key issues plaguing India’s balance of payments (BoP): one, the size of CAD is unsustainably large; and two, the majority of financing of the deficit is via volatile capital inflows that can reverse quickly. Thus, India is vulnerable to the risk of inadequate financing of the deficit and to uncertainty regarding the sustainability of financing. This combination is worrying even if easy global liquidity aids financing of the deficit in the near term. The vulnerability is best reflected by the combination of wider CAD and lower capital account surplus that caused the overall BoP to post a deficit of $12.8 billion (Rs 65,000 crore) in the fourth quarter of 2011-12, the first such shortfall in three years, and took a toll on the rupee.
Crude oil and gold and silver imports are two of the biggest categories in India’s imports. Thus, in April-December 2011, India imported $109 billion (Rs 5.5 lakh crore) of crude oil and $45.7 billion (Rs 2.3 lakh crore) of gold and silver, which together accounted for 43.4 per cent of the total import bill. Price movements in these two items significantly affect India’s merchandise trade and CAD.
While imports of crude oil, machinery and intermediate goods are consumed in domestic economic activities and exports, a sizeable portion of gold imports is retained domestically for both consumption and investment. Unlike other import items, the gold “consumed” does not disappear and still retains its store-of-value feature. A sizeable portion of the gold imports retained after what is used for gems and jewellery exports functions as an asset that can be used to pay for widgets. This retained import of gold functions as a store of value that is perversely recorded as a current account transaction, thereby seemingly “overstating” the CAD.
It is important to use “net” gold imports rather than just gold imports because of the sizeable exports of gems and jewellery that use gold as an input. The approach to include net gold import in the trade balance is technically correct as per International Monetary Fund guidelines, but the analytical “overestimation” of CAD due to net gold imports could be 20 to 30 per cent. However, this is just an analytical distinction that does not affect the currency market, since gold imports still need to be paid for.
There is increasing demand for gold for investment. The increase in gold imports in recent years has several drivers apart from higher exports of gems and jewellery. Household incomes have been rising, and there is a strong cultural bias towards gold. Gold has also been used as an inflation hedge locally and the thin spread of banking facilities means that a sizeable portion of household savings is locked up in physical gold. Indeed, excluding gold imports from the calculation of CAD (highly inadvisable) or clamping down on gold imports will not correct any of the macro factors, including low inflation-adjusted returns to depositors, responsible for the high demand for gold.
A striking feature of India’s BoP in recent years has been that policy makers have had to deal with extreme outcomes of capital flows — large destabilising inflows and outflows. The magnitude of capital inflows was rising until 2008-09 (along with the global credit cycle) and culminated in an unprecedented surplus of $107 billion, or Rs 5.4 lakh crore (a nerve-racking 8.6 per cent of GDP), in 2008-09. At the other extreme was the sharp reversal of foreign capital following the Lehman bust in 2008, which froze global financial markets and triggered a boom-bust cycle, which in turn crippled India’s economic cycle.
There are three key shortcomings in the nature of capital inflows into India: first, the contribution of net foreign direct investment to overall net capital inflows is low; second, dependence on portfolio inflows is high; and third, foreign borrowing by the private sector has increased despite greater uncertainty about the outlook for the rupee. An interesting feature of Indian policy makers’ approach has been to focus on attracting more foreign capital than on narrowing CAD. Thus, the government has liberalised investment by foreign institutional investors in local currency debt and has also eased the restrictions on external commercial borrowing by Indian companies — but has done little to limit the deterioration in CAD.
There is nothing wrong in liberalising the restrictions on capital account transactions. In fact, it is an important reform for India as it integrates with the rest of the world. But it would have been much more effective to complement these measures towards greater financial openness with real sector reforms. However, real sector reforms have been inadequate, uncertain and uneven.
Increased BoP vulnerability has a familiar pattern and ending: CAD is allowed to become unsustainably large and financing becomes a bigger concern. The financing risk is more pronounced if there is greater reliance on volatile capital inflows that could have been boosted by easy monetary policies in one or more key developed economies/regions. Excess global liquidity, low interest rates and easier lending norms facilitate easy financing of the wider CAD. That seduces policy makers into avoiding checking the deterioration in the CAD. Then, almost suddenly, liquidity conditions and capital inflows reverse — but the large CAD still needs to be fed. Consequently, the currency collapses.
Apart from the interplay of global risk, crude oil price and volatile capital inflows, the rupee’s path will also be affected by the Reserve Bank of India’s (RBI’s) currency intervention. Currency intervention to prevent depreciation if economic fundamentals favour it is a losing proposition. Such an approach could leave the central bank with a combination of lower foreign reserves and still-weak currency, and could also be an invitation for a speculative attack on the currency. Thus, currency depreciation is part of the solution, not part of the problem. Hopefully, the RBI will manage the movement better. In any case, prepare for a much weaker rupee.
The writer is senior economist at CLSA, Singapore.
These views are personal