High current account deficit tough to sustain: RBI

The Reserve Bank of India (RBI) today warned about the impact of high current account deficit and large capital inflows on India’s economy.

In the second quarter review of the monetary policy, RBI said though India needed capital inflows to finance its widening current account deficit, large capital flows beyond the absorptive capacity of the economy could pose a major challenge for exchange rate and monetary management.

RBI Governor D Subbarao, however, ruled out steps to check capital flows. “Capital inflows have not reached an alarming level as it had happened in 2007 and therefore there is no room for immediate action by the Reserve Bank,” Subbarao said during his customary post-policy press conference here.

“There is no comfort level as such, but we want to roughly correspond it with the current account deficit. So far this year, capital flows are roughly in line with the current account deficit. However, we want to finance our current account deficit with stable flows. The endeavour going forward will be to ensure that the component of stable flows in the overall capital flows is high,” he said. Last month, Finance Minister Pranab Mukherjee said inflows of $45-50 billion through the portfolio investment route were necessary, as they acted as “an insurance against the current account deficit”. He estimated that the current account deficit would be in the region of 3-3.5 per cent of the gross domestic product (GDP) this financial year.

“It is generally perceived that a current account deficit above three per cent of GDP is difficult to sustain over the medium term. The challenge, therefore, is to rein in the deficit over the medium term and finance it in the short term. The medium-term task has to receive policy focus from both the government and the Reserve Bank,” said the review.

During the first quarter of the current financial year, the current account deficit has more than trebled to $13.7 billion, while the capital account surplus has risen to $17.5 billion, as against $4.6 billion in the corresponding period last year. So far, in 2010, net inflows by foreign institutional investors have been over $26 billion, which is a record.

With advanced countries resorting to quantitative easing, an intensification of capital flows is being predicted. RBI recognised this. “As a result (of steps in advanced countries), exchange rates have been appreciating and asset prices have been rising in EMEs (emerging market economies). Excess global liquidity, combined with the significant growth differential, the interest rate differential and higher financial market returns in India vis-à-vis the advanced economies might lead to intensification of capital inflows,” RBI said. It, however, said the impact of rupee appreciation was not significant as competing countries faced a similar situation.

Between April and October 22, the rupee has risen 0.4 per cent on the basis of the 36-currency trade-based real effective exchange rate (REER), though the extent of appreciation based on the six-currency trade-based REER was higher at 3.1 per cent. “Since the 36-currency REER includes the currencies of many countries which are India’s direct competitors in the global market, it is a better reflection of the impact of global exchange rate movements on competitiveness. The relatively small appreciation in this index reflects the fact that many competing countries have also seen their currencies appreciate during this period. From this perspective, the impact of the recent nominal appreciation of the rupee may not have a significant implication for competitiveness,” RBI said.

“Over time, however, additional Fed easing should translate into more flows into India’s markets and rupee appreciation. Against this background, it is interesting that RBI has highlighted that financing the wide current account deficit is the immediate challenge. Capital inflows may require management, but only if they significantly exceed the country’s absorptive capacity,” Standard Chartered Bank economists said in a note.

“Despite the ease in financing the rising current account deficit, two challenges are uncertainty associated with flows and ensuring that flows are not out of line with the economy’s absorptive capacity,” Citi economists Rohini Malkani and Anushka Shah said in a note.