Why the RBIís fears about Indiaís growing current account
deficit are misplaced
The Reserve Bank has expressed grave worries about the current account deficit
(CAD). This hit a record 4.2% of GDP in 2011-12. In January-March 2012, it was
even higher at 4.5% of GDP, in stark contrast to just 1.3% in the corresponding
quarter of the previous year. Some analysts are calling for anti-crisis action.
Their fears are exaggerated. There are problems, but no crisis. We should not
think about ways to curb imports or subsidise exports. Rather we should focus
on reforms to improve productivity.
A succinct exposition of the risk-averse view came recently from YV Reddy,
former RBI governor, at the annual NCAER-Brookings India Policy Forum. He said
the government viewed a CAD of 2.5% of GDP as a safe average. Obviously the CAD
could fluctuate around this.
Reddy said the international climate had deteriorated greatly in the last year,
necessitating a new look at safety limits. The world economy was in turmoil,
with the eurozone in dire straits and slowdowns across the globe. Financial
flows and currency rates seemed far more volatile than earlier. Many
Indian companies had difficulties raising foreign loans.
India suffered from interlinked high inflation and fiscal deficits. This made
it more vulnerable to speculative attacks and sudden stops of dollar inflows,
as in the Asian financial crisis and again in 2008. So, Reddy declared, an
average CAD of 2.5% had become too risky. An average of 2.5% implied permitting
temporary oscillations up to the current 4.5%, which was too dangerous.
Given Indiaís new vulnerabilities, Reddy proposed giving up ambitions of 9%
growth, and settling for less growth along with less risk. His big new target:
the average CAD target should be lowered to zero. This is sheer alarmism. We
must not surrender to it. All the Asian tigers ran large CADs in their
fast-growth phase. Indiaís target of 2.5% is, if anything, too conservative.
The issue is not whether we should voluntarily prune ambitions of 9% GDP
growth. Rather India is incapable of averaging more than 7-8% GDP growth in the
next decade. It has far too many structural flaws embedded in its political
economy to return to 9% growth, which anyway was based on an unsustainable
global financial bubble that has burst for good.
Besides, a high CAD is not necessarily the result of fast growth. It has just
occurred at a time of rapidly decelerating growth, from 8.4% in 2010-11 to 6.5%
Many will support Reddyís thesis that this suggests seriously increased
vulnerability and risk. I disagree. Yes, a CAD of 4.5% is indeed high. But it
looks temporary. Goldman Sachs, for instance, thinks it will decline to 3.5% of
GDP in the current year, thanks to lower oil prices and less gold imports.
Besides, strong self-correcting mechanisms are at work. The big CAD has caused
the rupee to fall sharply, from . 45 to . 56 to the dollar. Many alarmists used
to complain that the RBI was keeping the rupee too strong. Well, without
any effort from the RBI, their wish has come true. The rupee has weakened to a
very competitive level, which itself should trim the CAD.
Despite policy paralysis and a poor investment climate, India received large
inflows of both FDI and foreign portfolio inflows in 2012. Despite bad
publicity from the alleged mistreatment of Vodafone and Wal-Mart, FDI inflows
actually shot up 34.4% to $46.84 billion in 2011-12.
FII inflows are typically far more volatile than FDI. However, despite the
eurozone crisis and recent slowdown in the US, FII inflows into India exceeded
$10 billion in January-July 2012.
This indeed is one reason why our foreign exchange reserves have remained at a
healthy $280 billion or so despite a record CAD.
Now, you could argue that foreigners are being foolish in investing so heavily
in India. But they are not fools. They know India has serious problems, but see
even greater problems in other countries, and so see India as a preferred
destination. They believe the rupee will now appreciate.
Reddy is right in seeing many vulnerabilities in India. But he needs to
remember there are even greater vulnerabilities elsewhere.
He is right in saying global money no longer flows so easily to Indian
companies, and that they borrow at higher spreads over LIBOR than before. Yet,
when LIBOR itself is at a record low, the absolute borrowing rate of Indian
companies is, by historical standards, astonishingly cheap.
The State Bank of India just raised a mammoth $1.25 billion in
dollar-denominated bonds at an interest rate of just 4.125%, less than half the
rate it would pay in India. Remember, in 1998 the Resurgent India Bonds were
issued at 7.75% interest.
Large private sector corporates have no difficulty raising large sums. True,
mid-cap companies can no longer raise foreign currency convertible bonds as in
the past. But thatís not a good test of vulnerability.
Let us not get into a defensive crisis mode. We should not focus on the CAD,
which is an outcome rather than a policy variable.
Reddy got it absolutely right in saying the need of the hour was to concentrate
on increasing productivity.
This requires reforms to improve governance, above all. It also requires
reforms that reduce waste in government programmes and improve the space for
private innovation and enterprise. All such measures will improve productivity.
This is the best way to improve the balance of payments.