8/17/13 Causes and cures for India’s current account deficit | Business Line

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Causes and cures for India’s current account deficit

Ashima Goyal

India’s CAD rises when output falls and not when demand rises.

August 8, 2012:

India’s current account deficit (CAD) has been a source of worry and merits deeper discussion.

The CAD reached 4.2 per cent of gross domestic product (GDP) in 2011-12. As global risks rose, capital inflows werelower at 3.7 per cent, requiring the Reserve Bank of India’s (RBI) draw-down of reserves, amounting to $ 12.8 billion,to make up the difference.

EXCESS DEMAND OR SUPPLY SHOCKS?

Does such a large CAD imply that the country’s aggregate demand (consumption plus investment) hugely exceeded itsaggregate domestic output or income?

The problem in this formulation is that 2011-12 also happened be a year when India’s GDP growth rate fell to 6.5 percent, compared to 8.4 per cent in the previous year. Moreover, growth in aggregate demand categories likeconsumption and fixed investment fell from about eight to five per cent.

Research at the Indira Gandhi Institute of Development Research shows the Indian CAD is countercyclical. That is, itrises when output falls and not when demand rises. This is exactly what happened last year as well.

In this, India – or the South Asian region – is unusual. In all other emerging markets, the CAD tends to be pro-cyclical, linked to overconsumption in good times. Overconsumption, which can also be due to low policy credibilityand the associated belief that good times may not last, leads to widening CADs in such times.

In developed countries, the CAD exhibits no such firm relationship with income fluctuations.

A countercyclical CAD in India’s case suggests dominance of external supply shocks rather than excess demandfactors.

For example, if oil shocks raise costs, and as a result growth falls, the CAD would rise along with falling growth. It canalso be due to export-led growth: As exports rise, they raise income and reduce the CAD. On the other hand, a suddencollapse of export markets, due to a global shock, reduces income and increases the CAD.

In line with this analysis, 2011-12, the year of the peak CAD of 4.2 per cent of GDP, saw both a sharp rise in oil pricesand fall in growth. As against this, the CAD was only 1.3 per cent in 2007-08, a year of high consumption, investmentand output growth.

In the first quarter of this fiscal, however, softening international oil prices have reduced the rupee value growth of oilimports, thereby implying the CAD may improve. The table shows the sharp fall in import growth in Q1 this year,compared to what it was in 2011-12.

THE ROLE OF PRICES

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If a CAD is not due to excess demand, can it be due to prices that encourage excess imports?

A depreciation of the rupee increases the price of the country’s imports, and also makes its exports cheaper forforeigners. But this may be a blunt instrument in the Indian context, where oil and gold account for a major share ofimports, while imported machinery and other intermediate goods are inputs, whose higher costs would raiseproduction costs here.

The effect of depreciation on exports is normally delayed and uncertain. Exports actually grew at double digits in2010-11, when the rupee appreciated on the whole. The table shows export growth has been negative this year, whenthe currency has depreciated sharply.

Diversification of the export basket and the destinations they go it, improvements in domestic supply conditions, andoverall global demand conditions are more reliable export boosters than depreciation. Excess volatility in exchangerates, in fact, does not help exports. Since sharp depreciation today could be reversed tomorrow, exporters are wary.

As regards reduction in imports, it is possible to achieve that by just raising the relative prices of the major importedcommodities. Part of the reason why demand is inelastic is only because prices do not, or are not allowed to, adjust.The recent higher gold taxes have proved helpful. Greater pass-through of oil prices can do the same, besides alsoserving the important goal of improving the energy efficiency of the economy.

Some nominal depreciation is required to correct for India’s higher inflation rates, softening global oil prices nowmake it possible to absorb it without adding to inflation. But overcorrection, leading to real depreciation beyondcompetitive rates, will only sustain inflation.

MONETARY POLICY

Specific relative prices and overall structural changes, which can improve the CAD, are in the domain of fiscalpolicies. What monetary policy can do is prevent excess movement of exchange rates.

Excess demand, we have seen, is not driving the CAD, since growth has fallen below potential and the latter itself isfalling as investment slows. Even so, the RBI cannot afford cuts in its repo rates now. Credit growth has fallen, butdeposit growth has fallen even more. If banks cannot, then, reduce deposit rates – post-tax real returns to them arestill negative – it limits the transmission of lower policy rates.

Loan rates can come down only if spreads for banks reduce. Easier money market conditions can contribute to that.High food prices impact inflation expectations. It is, hence, necessary to anchor these – since the monsoon is poor.Policy rates are a good instrument for this, as interest rates give a clear signal.

Liquidity can, however, move in the opposite direction, to support stable credit targets and also the supply responsethat lowers inflation expectations. Easier liquidity is also required to compensate for the drying up of internationalcredit sources.

(The author is Professor, Indira Gandhi Institute of Development Research.)

(This article was published on August 8, 2012)

Keywords: current account deficit, capital inflows, GDP, Demand & Supply, money market conditions, Foodprices, inflation, fixed investment

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