The external imbalance

CAD up due to oil and defence imports bill

The sharp and unanticipated rise in the current account deficit (CAD) in India’s balance of payments (BoP) in fiscal 2009-10 could well be due to the sustained rise in the oil imports bill and the jump in defence imports. At 2.9 per cent of national income (GDP) and $38.4 billion, India’s CAD in 2009-10 is only marginally below the 1991 BoP crisis year level of 3.1 per cent. The only reason alarm bells are not ringing is the comfortable foreign exchange reserves and rising inflows on account of invisibles. Capital inflows in 2009-10 were estimated to be $53.6 billion, compared to a $20 billion drawdown in the year of the Great Recession. Apart from defence and oil imports, the trade deficit was also pushed up by relatively weak performance of exports. It is not, therefore, surprising that the government has acted to reduce the petroleum subsidy and temper the demand for petroleum and petroleum products. It is likely that expenditure on account of defence imports may remain high for another year or two, given the planned imports in the pipeline. The resurgence of economic growth and renewed investment activity suggest that imports of capital goods are unlikely to come down. Therefore, if there is little headroom on the import side, any strategy to keep the CAD below the psychological 3 per cent of GDP barrier would require, on the one hand, sustained increase in services exports and inflows on the capital account, and, on the other, a revival of merchandise export growth.

 

In this lies the conundrum. If the recent surge in capital inflows and inward remittances continues, the rupee would be under pressure to appreciate. If the rupee appreciates, it would have a negative impact on exports and, therefore, won’t be very helpful in reducing the CAD. Clearly, external economic policy has to get its priorities right. An appreciating rupee can be helpful in dealing with inflationary pressures, but will not help deal with the worsening trade imbalance. A depreciating rupee can help push up exports and keep India competitive, but will have inflationary consequences. Sustaining a growth rate of over 8 per cent while bringing the inflation rate down to 5 per cent and keeping the CAD within manageable limits is the macro-economic challenge facing the government.

All of this draws attention to the fact that managing the external balance has once again become a priority for India’s macroeconomic policy-makers. After the post-Pokhran-II and Y2K crisis management phase (1998-2001), when Resurgent India and Millennium Development Bonds were issued and the focus was on accumulating foreign exchange reserves, India entered a phase when the external sector did not pose a major challenge for policy-makers. This made the then governor of the Reserve Bank of India, Bimal Jalan, declare in 2003 that the “external constraint” on India’s economic growth, what economists had for long dubbed the “foreign exchange gap”, had ceased to exist. A formulation that encouraged Prime Minister Manmohan Singh to often assert that the “world wants India to do well, our challenges are at home”. While this may still be largely true, how India deals with challenges at home, for example the petroleum subsidy and inflation management challenge, will shape its response to the new challenge of a rising trade deficit, a high CAD and rising external debt. Reforms that help improve the competitiveness of Indian exports and keep the energy bill under control can certainly help.