Why have rising trade and current account deficits in the last year not led to a depreciation of the rupee?
In April this year, I raised concerns over India’s curious combination of rising external deficits and a rapidly appreciating rupee (see BS, April 10 and April 24). The articles made the following key points. First, India’s current account deficit had risen above 3 per cent of GDP in the successive quarters of July-September 2009 and October-December 2009 (the latest data then available). Second, this had happened against the background of the sharpest ever increase in the real effective exchange rate (REER) of the rupee in a 12-month period (of 18 per cent, March 2009 to March 2010). Third, this unprecedented surge in real rupee appreciation appeared to have provoked surprisingly little comment or concern, perhaps because market agents, analysts and even policy-makers were unduly fixated on the nominal rupee-dollar rate and insufficiently sensitive to increases in the REER stemming from differential rates of inflation in India versus trading partners or depreciations in other major currencies such as the euro. Fourth, the sharply appreciating rupee was hurting not just exports but all tradable economic activities, including industry, many services and agriculture, particularly labour-intensive sectors such as garments, textiles, leather products and gems. Fifth, if net capital inflows continued to be robust, the authorities (government and RBI) needed to act swiftly to reverse some of the real appreciation by either intervening in the currency market or moderating capital inflows through “capital account management”.
As it happened, after May 2010 (when the REER index peaked at 120, compared to 98 in April 2009), there was a drop in capital inflows and a resulting decline in the rupee’s nominal effective exchange rate (NEER), mainly triggered by rising global concerns over the Greco-European sovereign debt stresses and associated nervousness about risky assets, including emerging market stocks (Figure 1). The REER index moderated to 116 by July. Though less than the May peak, this was still unduly high relative to the pre-global-crisis average of 102 in 2002-03–2006-07, when RBI actively intervened to moderate real appreciation despite a sustained surge in capital inflows. Alas, such exchange rate activism appears to have been largely abandoned after 2008-09, though there has been little transparency about this major change in exchange rate policy.
The results of this policy inertia are reflected in India’s external accounts. Goods exports, which had risen to 18 per cent of GDP in the first half of 2008-09, helped by the global commodity boom, not only fell to 13 per cent of GDP in the second half of the year as global trade plummeted post-Lehman, but pretty much remained there in the subsequent six quarters (Figure 2). Exports of $50.7 billion in the first quarter of 2010-11 were running 12 per cent lower than two years ago. In contrast, imports, which had also peaked in the first half of 2008-09 and dropped sharply in the second half, have grown quite strongly, from the trough of 20 per cent of GDP in Q4 of 2008-09 to an estimated 25 per cent of GDP in Q2 of 2010-11. This means that as India’s good recovery from the “growth recession” of 2008-09 has sucked in more imports, the trade deficit has widened to above 10 per cent of GDP in the current quarter.
That is not all. Our misguided exchange rate policy has also contributed to a significant decline in net invisible earnings (trade in services and remittances from abroad) from 7.4 per cent of GDP in 2008-09 to hardly 5 per cent in the second half of 2009-10. No data for the current year have yet been published for non-trade elements of the balance of payments. But with a trade deficit of around 9-10 per cent of GDP in the first half of the year and net invisibles possibly stagnating at 5 per cent (equal to the latter half of 2009-10, and this could be optimistic given the recent protectionist moves by the Obama administration against outsourcing), a record current account deficit of 4-5 per cent of GDP seems quite plausible in the first half of the current year, and perhaps even for the full year.
Why have such rising trade and current account deficits in the last year not led to a depreciation of the exchange rate in both nominal and real terms? Part of the answer is that there has been a modest depreciation since May and up to mid-August (last date for which RBI data on NEER and REER are currently available). More recently, especially in the past six weeks, there has been a surge in portfolio capital inflows, which has helped finance the widening current account deficit and powered the Sensex to a 32-month high of 20,000. The resurgence in capital inflows, after their stutter in the early summer, may be due to several factors, including the anaemic growth prospects of America, Europe and Japan, and the associated continuation of exceptionally loose monetary policies in these jurisdictions. Basically, there is a great deal of liquidity sloshing around in global financial markets looking for an elusive combination of safety and return. Sometimes, when there are global jitters, as over southern Europe’s sovereign debt issues in May and June, the flows turn wary of the so-called risky assets like emerging market equities. When such jitters are assuaged by policy measures or a change in perceptions, the yearning for better returns brings the tide back to Indian (and other emerging market) shores.
Recent history has underscored the key point: the ebb and flow of these cross-border portfolio flows is volatile and essentially unpredictable. To rely on such flows for stable financing of balance of payments deficits would be a triumph of hope over experience. Sudden surges in these flows also cause asset bubbles and exchange rate misalignments, with adverse consequences for the real sectors. Unsurprisingly, several emerging nations have instituted counter-measures, including significant restrictions on portfolio flows (as in Taiwan) or taxes on capital inflows other than direct foreign investment (as in Brazil). Despite gubernatorial speeches on “capital account management”, the Indian authorities have remained surprisingly inactive over the past year.
With the current account deficit in the balance of payments set to climb to 4 per cent of GDP or higher and labour-intensive sectors taking a beating from a substantially overvalued exchange rate, the time for watchful waiting is surely over. A resurrection of active exchange rate intervention (of the kind successfully pursued in 2003-2007) is clearly called for. The tools and modalities are available and well-tested. Depending on the scale and variability of capital inflows, it might also be necessary and desirable to inject some policy teeth into the stated readiness to undertake capital account management.
The author is honorary professor at ICRIER and former chief economic adviser to the Government of India. The views expressed are personal
In spite of the RBI's rate cut and the Centre's reforms, any recovery will only be half-hearted