Current account-ability

Risks of not taking quick and strong action are enormous

The current account deficit for the October-December 2012 quarter was generally expected to be above six per cent of GDP. Even then, it surprised negatively, coming in at 6.7 per cent. By far the largest contributor to this is the trade deficit, the gap between merchandise exports and imports, which was over 12 per cent of GDP. During the quarter, exports were stagnant, while imports grew by over nine per cent over the corresponding quarter of 2011-12. This clearly suggests that, while exports are not really responding to a depreciated rupee (slightly cheaper compared with the corresponding quarter), imports of essentials, mainly energy, are simply costing more as a result of the depreciation. The fact that many domestic consumers of petroleum products are not being asked to pay the full rupee price of these products is a big reason for this. But other factors are also at work. For instance, coal imports have gone up significantly both in terms of quantity and value, as major exporters have raised prices. This reflects the inability of the domestic coal supply chain to meet the requirements of the recent expansion in power generation capacity. Iron ore exports have been impacted by restrictions on mining, which have also affected domestic iron and steel production. And the powerful surge in gold imports seen over the past few years continues unabated.

The size of the current account deficit is a matter of concern in and of itself, reflecting as it does a decline in effective competitiveness of the economy as a result of the factors indicated above and others. But it is an even greater worry in current global conditions. It implies greater dependence on stable capital inflows at a time when these are clearly in short supply globally. Foreign direct investment (FDI), the most stable and committed source, actually declined relative to the corresponding quarter of 2011-12. This shouldn’t be a surprise; if domestic investment is sluggish, so will FDI be. While capital inflows were relatively robust during the quarter, they are likely to have been skewed towards relatively short-horizon equity investments and debt, restrictions on which have been considerably eased over the past several months. This kind of financing pattern creates significant vulnerabilities. Any shock, external or domestic, could lead to rapid outflows, impacting domestic financial markets and the rupee adversely. A large current account deficit, in fact, sets off a vicious circle, in which sudden capital outflows can, through rupee depreciation, widen the deficit further, making even more foreign investors even more nervous.

There is no question that a significant policy response is needed. It is also obvious that a single instrument is not available. Each major contributory factor to the massive trade deficit – oil, gold and minerals – needs focused short-term and medium-term fixes. Pricing energy correctly, introducing financial products with gold-like qualities and increasing mining capacity along with enforcement of sustainable mining practices are critical steps that need to be taken to rein in the current account deficit over the coming years. On the financing front, facilitating FDI by addressing the hindrances that have plagued large projects in recent times should be the priority. The government must accept the fact that the risks of not initiating quick and strong action are enormous.