Column : India’s large and troubling CAD

India’s current account deficit (CAD) in the July-September quarter turned out to be far worse than anticipated, a record 5.4% of GDP. Even during the quarters following the sharp depreciation of the rupee since August 2011, the deficit had remained between 3.9% and 4.5% of GDP. (The quarters post the financial crisis of 2008 are not valid comparators since the prices of commodities, particularly crude, had come down sharply.)

Which parts of the accounts were the major culprits? Stepping back, a bit facetiously, note that some part of the worsening was due to the rupee depreciation. Valuing the balances at the average rupee level of the corresponding second quarter of a year ago (R45.8 to a dollar), rather than the actual average (R55.1 to a dollar), the deficit would have been 4.5% of GDP, although this would have remained disconcertingly high. Facetious and not very convincing, since the rupee’s depreciation is actually an endogenous signal of the deterioration of the CAD.

But this is not the way the current and capital account flows are supposed to work. Theoretically, the weaker rupee should have been an incentive to switch from imports to domestic substitutes and for exports to have increased by becoming more competitive (see chart for co-movements). Why are many of the underlying assumptions of this hypothesis turning out to be flawed? While the currency changes have indeed had an effect, the effects have been varied and inconsistent,

... contd.