How the CAD impacts ordinary Indians
The common person cannot be faulted for believing that the balance of payments is not of concern to the public at large. Unfortunately, the balance of payments impinges on the welfare of the common person.
The Balance of Payments Simplified
The balance of payments current account receipts are composed of exports of goods and services and other receipts which do not create a liability for India, such as remittances by Indian workers abroad and India's earnings on its assets held abroad. Current payments are for imports of goods and services and what the rest of the world earns on investments in India. When current payments exceed current receipts, there is a balance of payments current account deficit (CAD). The CAD is financed by capital inflows net of outflows. Capital receipts consist of foreign direct investment (FDI), portfolio investments (such as foreign institutional investors in the stock market), external commercial borrowing, official external assistance and trade credit. Capital payments include assets held abroad by India and repatriation of capital from India by the rest of the world.
There is the conundrum posed in first year economics examinations: If the balance of payments always balances, why is it necessary to make it balance? This is because the current account deficit has to be matched by a capital account surplus (including the drawdown of forex reserves). In other words, we have to find the capital inflows to finance the CAD. The CAD is the gap between investments and savings and if there is difficulty in financing the CAD, either savings have to be stepped up or investment curtailed.
Safe Level for the CAD
One of the conventional measures of a safe level for the CAD is the CAD-Gross Domestic Product (GDP) ratio. As a broad approximation, the Rangarajan Committee (1991-92) set out a safe level of the CAD-GDP ratio at 2.0 per cent. To the extent India's interface with the international economy increases, the safe level of the CAD could be slightly higher, say 2.5-3.0 per cent of GDP.
Why is a High CAD of Concern?
In India, in recent years, the CAD-GDP ratio has been increasing, and in 2012-13, tentative estimates are that that the ratio could be as high as 5.5 per cent, which would translate to an absolute CAD of US $ 100-110 billion. In 2012-13, about 25 per cent of the financing of the CAD would be via FDI and other long-term flows, which are generally stable. The balance 75 per cent is accounted for by portfolio investment, external commercial borrowing and trade credit, all of which are reputedly unstable.
The total external debt in December 2012 amounted to US$ 376 billion and the forex reserves provide a cover of 79 per cent of the external debt. An alarming feature is that 43 per cent of the external debt matures within one year.
The total external liabilities (i.e. debt and equity) of India, as on December 2012, amounted to US $ 724 billion (gross) and the net of our international assets our liabilities are US $ 282 billion. Since the bulk of the claims on India are volatile capital flows, the slightest discomfort of foreign investors could trigger a massive capital outflow, which would put the country in the throes of a major foreign exchange crisis. It is in this context that rectification of the high CAD is the topmost policy priority.
Repercussions of a High CAD
The overall approach in recent years has been to power up investments through incentives, with the hope that savings would automatically rise and reduce the CAD. We seem to be following adventurist policies of a large fiscal deficit, a progressively soft monetary policy and a macho approach to holding up the US $-` exchange. Predictably, this has resulted in a high inflation rate. The Industrial Workers' Consumer Price Index (CPI) has crossed 12 per cent and the combined rural-urban CPI is close to 11 per cent. Official price indices, the world over, understate the actual inflation rate. If the CAD becomes difficult to finance, it would trigger a large capital outflow, putting the country in a severe bind. In such a situation, the common person will be afflicted by a zooming inflation.
How to Contain the CAD?
To contain the CAD, multi-pronged measures are required:
(a) The RBI should be allowed to sharply reverse monetary policy by increasing interest rates and reserve requirements and curtail RBI accommodation. This will entail increases in interest rates on deposits, lending and securities.
(b) The fiscal deficit is far too large (equal to one-third of total government expenditure). A Supplementary Budget is needed by July 2013 to cut expenditure, by say 5 per cent and raise tax revenues. The concern for the common person is that in any fiscal tightening, it is social sector expenditures which are invariably cut.
(c) We have to give up our macho approach of holding on to a strong exchange rate. The exchange rate should be allowed to depreciate in line with the medium-term inflation rate differential between India and the major industrial countries. This correction will require the present rate of US $1=Rs 54 to depreciate to say US $1=Rs 70. Most officials and analysts would no doubt be outraged by this suggestion, but unless this is done, imports will progressively wipe out Indian micro, small and medium industries and further widen the CAD.
Will Policy Adjustment Actually Take Place?
A realistic assessment is that the authorities will not countenance any of the above-mentioned measures. In the upshot, inflation will accelerate and savers, particularly senior citizens, would see a reduction in their incomes. Unfortunately, any adjustment would come only under external pressure. One prays one is totally wrong and that decisive action would bring down inflation and the CAD in the next twelve months.
Please Note: This article was first published in The Free Press Journal
on April 08, 2013. Syndicated.
This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.
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