The external constraint

Higher exports and FDI needed to contain CAD

After several years of comfort, is India under pressure on the external account? The sharp rise in India’s current account deficit (CAD), by a whopping 72 per cent year-on-year, as shown in the latest balance of payments data released by the Reserve Bank of India (RBI), suggests that the external account needs careful management. The rise in CAD has occurred both on account of a higher trade deficit, despite exports growing faster than imports during the last quarter, and a slowdown in foreign direct investment (FDI). The trade deficit of $35.4 billion was about 20 per cent higher than for the corresponding period last year. The capital account surplus increased slightly based on higher volumes of portfolio investment, external commercial borrowings (ECB) and short-term capital inflows. However, net foreign direct investment dropped alarmingly by two-thirds on year-on-year basis, due to both lower inflows and greater outward FDI by Indian firms.

A current account deficit is in itself not a bad thing. Several countries have run up current account deficits, especially during their respective phases of industrial take off, due to high technology imports to tool their domestic industrial sectors. Such strategies worked just fine in so far as these imports enabled higher volumes of manufactured exports, which eventually reduced the trade deficit. India needs to similarly focus on rapidly increasing the proportion of manufacturing exports to ensure that the external sector emerges as a significant driver of aggregate demand.

It is the composition of capital flows into India in recent times that is a cause of greater concern. India’s current account deficit is being financed by short-term capital flows which, as the Financial Stability document of RBI has pointed out, is a cause for serious concern. Short-term capital flows, which increase both short-term debt and vulnerability, are notoriously foot loose and could exit at the first sign of trouble or better opportunity elsewhere, leaving India dangerously vulnerable. A healthy capital inflow mix would include a greater share of FDI, which is not only more stable, but brings with it a basket of benefits such as technology transfer, access to export markets, best management practices among others which can have economy-wide benefits, with the right policy mix in place.

The present scenario is unlikely to change significantly in the foreseeable future. Quantitative easing in the United States will lead to a surge of liquidity, which will find its way to star performing economies like India to leverage the interest rate differential. India’s ECB is headed north for the same reason. With Indian firms aggressively scouting for natural resources, commodities and technology abroad, outward FDI from India is also expected to increase sharply. Policy focus in India should necessarily be directed towards improving the global competitiveness of Indian exports and creating the enabling conditions to attract and retain FDI. A beginning has been made but progress is tardy. That needs to change.

India finds itself in a sweet spot with a rapidly growing economy, high levels of savings and investment and levels of foreign exchange reserves. A revitalised external sector can ensure that double-digit growth is not a flash in the pan. A dysfunctional external sector on the other hand can easily derail hard-earned progress.