Over the last two years, the Reserve Bank has been drawing attention to the widening current account deficit (CAD) in our BoP. The risks to our BoP have increased both in the global and domestic context: first, following the global financial crisis trade volumes have slumped and capital flows have become volatile; second, slowing domestic growth coupled with a large fiscal deficit alongside a high CAD poses twin deficit risks.

India’s BoP came under stress in 2008-09 reflecting the impact of global financial crisis. As capital inflows plummeted, India had to draw down its foreign currency assets by US $ 20 billion during 2008-09. Stress since the collapse of Lehman Brothers largely emanated from decline in India’s merchandise exports and deceleration in growth in services exports.

Though there was some improvement during 2010-11 on the back of a strong pick-up in exports mainly led by diversification of trade in terms of composition as well as direction, it proved to be short-lived.

BoP again came under stress during 2011-12 as slowdown in advanced economies spilled over to emerging and developing economies (EDEs), and there was sharp increase in oil and gold imports.

RISING VUlnerability

With the gradual external liberalisation of Indian economy, not only the size of balance of payments (BoP) has increased manifold, but the pattern of current and capital account has changed.

Even though the reform process has strengthened resilience of India’s external sector, at the same time vulnerabilities arise with greater exposure of the economy to the rest of world through liberalised trade and investment environment.

India’s current account particularly remains vulnerable to developments in the trade account. It is evident from the size of trade deficit growing from 0.5 per cent of GDP during 1951-55 to 8.7 per cent during 2007-12. In 2011-12, the current account deficit has widened to a record 4.2 per cent of GDP (See Chart) . Over the years, current account derived some resilience from surplus generated by invisibles, particularly software exports and private transfers, but trade deficit continues to dictate the overall trend in the current account.

Whenever trade account worsens reflecting downswings in the global business cycle or rise in international oil prices, the current account also comes under stress as is evident in the present context.

Going forward, since India’s linkage with the world economy, in terms of trade and finance, is likely to grow further, it is important that resilience in its trade account is built up mainly by promoting productivity based export competitiveness and improving domestic fundamentals that are supportive of least costly non-debt creating flows, particularly foreign direct investment (FDI). In this context, I make a few suggestions.

Unsustainable CAD

First, the current level of CAD is far above the level sustainable for India. As per estimates, at a nominal growth rate of about 13 per cent, the sustainable current account to GDP ratio is 2.3 per cent. Reserve Bank’s own research shows that economy can sustain CAD of about 2.5 per cent of GDP under a scenario of slower growth. A slowing global economy and protracted high levels of unemployment in advanced economies make it difficult to boost services exports in the short run. If the slowdown continues, it could also have an adverse impact on inward remittances. Hence, there is a need to reduce imports and boost merchandise exports to bring the CAD to sustainable levels.

Second, structural policy measures are needed to reduce vulnerability emanating from high oil and gold imports. While oil has been a major component of India’s imports, the sharp increase in demand for gold has put an additional pressure. During 2008-09 to 2011-12, on average, the net gold imports stood at about 2 per cent of GDP, almost double the level recorded during 2004-05 to 2007-08.

Thus, during the same period, CAD-GDP ratio, excluding net gold imports, would seem less problematic at 1.1 per cent. In addition to the traditional motive of gold demand for jewellery, gold seems to have become a safe investment asset and a hedge against inflation as is observed in other advanced economies. Its dematerialisation like any other financial product can reduce its physical imports.

Furthermore, inflation-indexed bonds could also be another option to offer investors the inflation linked returns and detract them from gold investments. In the case of oil, we need to become more energy efficient to reduce our dependence on oil imports.

Stepping up of production of electricity could reduce oil demand from backup generation systems. Moreover, the domestic pricing of oil should be aligned further to the international prices to rationalise oil consumption.

Third, current policies towards further diversification of India’s export basket, both destination and products, needs to be stepped up. Indian exporters need to accelerate efforts to move up in the value chain at the global level.

Fourth, given the global uncertainties and volatility in capital flows, the resilience of capital account needs to be further enhanced by encouraging FDI inflows.

To conclude, the Indian economy is much more open and globalised now than ever before. The periodic pressures on BoP have been addressed through policy changes. While the BoP has again come under stress since 2011-12 as emphasised by Governor D. Subbarao, the situation is not as serious as it was in 1991.

This is because the structure of the economy has changed in a fundamental way with flexible exchange rate and greater depth in financial markets, besides much larger foreign exchange reserves than those in 1991. However, there is a need to bring the CAD to sustainable levels in the short run and over the medium-term to accelerate efforts towards structural reforms that help boosting our competitiveness, raise growth potential and bring in more stable flows into the economy.

(The author is Executive Director, RBI.)

(Excerpts from speech at Kalinga Institute of Industrial Technology, Bhubaneswar)

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