Welcome the current account deficit

Is the tide turning against India? It ran a current account deficit of $ 6.2 billion in April-June 2005, against a surplus of $ 3.3 billion in the same quarter last year. This represents an annualized current account deficit of over 3% of GDP.

The merchandise trade deficit, says the DGCIS (which excludes defence imports) was $ 20.33 billion in the first half of the fiscal year, almost double $ 11.89 billion in the same period a year ago. Inclusive of defence imports, some analysts predict a trade deficit of $ 47 billion this year, or more than 6% of GDP.

Exports have been booming. But, after growing at a rate exceeding 20% for three years, export growth decelerated to 7.5% in September. One month’s data do not constitute a trend, but Jeremiahs are encouraged to say that the party is coming to an end.

The rupee has weakened against the dollar, from Rs 43 to more than Rs 45. The RBI, which for years has been buying up dollars to prevent the rupee from appreciating, has now started selling dollars to strengthen the rupee. Foreign institutional investors (FIIs) tend to buy Indian stocks when the rupee strengthens and sell when it weakens. So when the rupee weakened in October, they sold $ 280 million of stock, sending the Sensex crashing by 1,000 points.

Prophecies of doom are suddenly spreading. The direst prophecies come from old-time leftists who have been prophesying doom for the last 25 years, but in vain. But the incorrigible left is by no means the only camp expressing worry. The Economist ran a piece last week quoting market players who fear the possibility of a vicious circle, where a falling rupee induces some FIIs to exit, and their exit causes the rupee to fall further, which causes more FIIs to exit, in a downward spiral.

I, however, am quite sanguine about current trends. For years I have deplored the sight of a developing country like India running a current account surplus and increasing its foreign exchange reserves. These rising forex reserves imply that a poor country like India is lending billions to rich countries like the USA (most forex reserves are held in dollars), and I find this utterly perverse. So, I am extremely happy that India is running a current account deficit again.

A current account deficit is the mirror image of a country’s investment-savings gap. It implies that India’s investment rate is, after many years, exceeding its savings rate. This is good news. Investment averaged 26% of GDP in the early 2000s, but looks like crossing 30% of GDP this year. Hurrah!

At June-end, 2005, India’s forex reserves exceed its foreign debt by $ 16.2 billion, despite a sharp expansion of external commercial borrowing to $ 27 billion. No sign of stress here, quite the opposite. Some people are happy that our reserves exceed our debt, and so give us such a comfortable cushion against mishaps. I, on the other hand, am very unhappy about such a large cushion, one that in practice cushions the US more than India.

Rather than pile up reserves in such excess—they exceed one year’s imports– I would like to see them utilized for investment. This implies running a current account deficit large enough to exceed all capital inflows. We have not reached that stage yet. At $ 6.2 billion, the current account deficit in April-June was more than offset by capital inflows. So, India had a marginal net forex inflow. I would prefer to see a marginal net forex outflow.

Caveat: a fall in forex reserves is good if caused by accelerating investment, but not if caused by capital flight. Leftists are already warning that India is recklessly depending on hot foreign money to finance a huge current account deficit. They remind us of the Asian financial crisis, when overconfident Asian countries ran huge current account deficits to finance rapid GDP growth. They were called miracle economies, but plunged into disaster in 1997-99 when capital inflows reversed.

Can this happen to India? The chances are very remote. First, India’s current account deficit has been swollen by high oil prices, which will not keep rising so rapidly. In the US, which consumes a quarter of the world’s oil, high petrol prices have already caused a cutback in consumption and a slump in sales of fuel-guzzling cars, and this has finally cooled oil prices. With cooling oil prices, India’s current account deficit is likely to be modest.

Second, our invisibles inflow will accelerate sharply in December, when the India Millennium Deposits of NRIs, raised in 2000, will be repaid. Experience from the Resurgent India Bonds shows that the bulk of IMD redemptions will be converted into rupees, not repatriated in dollars. So, of the $ 8 billion of IMD redemptions, I expect around $ 6 billion to be converted to rupees. This will show up in RBI data as an additional inflow of invisibles.

Third, the FII money flowing into stock markets is not hot money. Short-term loans are hot money: they have to repaid at face value. But if FIIs try to exit, their very attempt to sell will drive down prices so fast that exiting will be more costly than staying on. That is why they stayed on in India during the Asian financial crisis. FIIs dominate the Indian market, and when they sell, there are precious few other buyers. Their sale of a mere $280 million worth of stock in October sent the Sensex crashing 1,000 percentage points. Can FIIs possibly sell stock worth tens of billions of dollars? Only at prices close to zero.

Now, panics do happen, and fresh inflows could end. But our forex reserves are more than enough to take care of sudden pauses in FII inflows. Our real problem remains that our forex reserves are too high. That makes India utterly unlike any country hit by the Asian financial crisis.