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 India’s 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. India’s 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% in 2011-12.
Many will support Reddy’s 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 Rs 45 to Rs 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 that’s 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.