The current account deficit (CAD) and high dependence on foreign institutional investors (FII) to bridge this gap has emerged as major risk to growth, with direct negative impact on exchange and interest rates. The linkage to commodity price fluctuations and FII appetite for Indian assets has made Indian economy (and markets) more vulnerable to external forces. When the going becomes tough, authorities do not have control over the adverse impact.
It is obvious that economies that run current account surplus and low inflation maintain sustainable economic growth. The impact of CAD on the Indian system is permanent export of capital (for consumption), replaced by temporary short term (hot money) inflows from FIIs, with insignificant contribution from foreign direct investments (FDI).
It is wishful thinking at this stage to plan for bridging the entire CAD with FDI flows. The other two alternatives are a significant boost in exports to maintain CAD at manageable level, or invoicing the foreign trade (imports) in rupees to reduce dollar demand in on-shore foreign exchange market.
It is not easy to invoice India’s foreign trade in rupees, in the absence of full capital account convertibility and internationalisation of the Indian currency. This will mean passage of exchange rate risk management to foreign seller (in case of imports) and buyer (in case of exports). In the absence of transparent and liquid off-shore rupee market, foreign entities may not prefer to take this risk. If hedging activity is conducted in an unregulated off-shore NDF platform, the impact is neutral on exchange rate, given the strong linkage between off-shore NDF and on-shore OTC/ETF platforms.
The decision on invoicing in a particular currency depends on the outlook on the exchange rate; when sentiment is weak on rupee, an overseas seller will not like to have a sale invoice in rupees while the overseas buyer will prefer a foreign currency invoice. This stresses the need to build confidence among overseas entities to invoice in rupees with Indian companies.
The need of the hour is to encourage importers, rather than exporters, to invoice in rupees which would reduce the trade gap in dollar terms. The idea is to cut dollar demand in the domestic on-shore foreign exchange market to ensure rupee exchange rate stability with a gradual appreciation bias. The dynamics of the Indian economy are complex, with conflicts between growth and inflation, CAD and rupee exchange rate, and growth and fiscal deficit. The authorities can at best do a balancing act, in the absence of bandwidth to support growth through monetary policy actions.
(The author is Executive Director, Lakshmi Vilas Bank.)