Current-account or trade deficit?
Rakesh Singh
The Reserve Bank report on currency and finance has expressed concern over the rising revenue deficit, widening trade deficit and industrial slowdown.But it believes that despite the widening trade deficit, the current account deficit narrowed to $3,730 million (i.e., 1 per cent of GDP) from $5,889 million (1.8 per cent of GDP). This is a good sign as it is below the manageable level. The importance of current account deficit (CAD) as an indicator to sustainable external payments has acquired importance in financial capitalism. Trade no longer integrates economies, it is the amount of financial flows between nations that determines the degree of the economy's openness. But in the volatile financial scenario what would be a sustainable level of a CAD? According to the committee on capital account convertibility "In view of the growing degree of integration of the Indian economy with the rest of the world. It needs to be recognised that the CAD should vary in the context of opening of the economy. The size
of the CAD which can be sustained without encountering external constraints is thus a function of the degree of the economy's openness which can be defined in terms of the ratio of current receipts to GDP. The size of this ratio is the crucial determinant of the ability of the economy to make current payments and meet the servicing of the economy to make current payments and meet the servicing of external debts. As the CR to GDP ratio rises, it would be possible for the economy to expand the CAD ratio without rendering the external debt unsustainable." What would be the sustainable level of CAD for the Indian economy? The RBI report says that with the rate of domestic saving at 25-26 per cent and capital output ratio around four per cent a CAD of two per cent of GDP is required to ensure an investment rate of 28 per cent which would sustain a growth rate of around seven per cent. Though the CAD in our country has remained below the requirement of external financing of the economy. The optimal size of the
CAD needs to assessed in terms of contribution of current receipts to GDP. If one looks at the figures in this report, one can conclude that the degree of openness of the economy as measured by the ratio of current receipts to GDP at 15.6 per cent in 1996-97 could allow for a CAD of upto two per cent of GDP without encountering problems in debt servicing. The debt-GDP ratio has been on a declining trend since 1992-93 and debt servicing absorbed around a quarter of the current receipt. Current account consists of two heads merchandise trade and invisibles. Of the two, merchandise trade comprising exports and imports of goods is easier to understand. Invisibles comprise current international payments for items other than merchandise exports or imports like travel, transportation, interest and dividend payments etc. It has been pointed out by the RBI report that the decline in the current account was mainly due to the sharp increase in surplus under the invisibles account. Even though the trade deficit
deteriorated the CAD improved because of the surplus on the invisible account. Is this a healthy trend as far for the economy? Is the level of CAD important? Is the trade deficit more important than the CAD?Mihir Rakshit, an eminent economist, is of the opinion that often there is overemphasis in emerging macroeconomic literature on the level of CADs. No doubt most developing countries run CAD in their balance of payments and attract external resources to supplement their domestic savings for higher growth rates. But it is useful to remember that there are three ways in which large inflow of capital can undermine the balance of payment viability in the long run. First, if the borrowing from abroad is used to finance domestic consumption than investment. Even if the capital inflow adds to the productive capital formation, widespread inefficiency of the investable resources may make their returns too low to repay foreign creditors. Third, what is important is not the productivity of investment in physical
terms, but addition to foreign exchange earnings in relation to requirement for servicing external debt. Thus it is not enough to add to the productive capacity of the economy unless that can be converted into extra foreign exchange earnings. Hence the need to ensure that export growth of the country will be enough to discharge the interest and repayment obligations on account of foreign borrowings." (ICRA bulletin of money and finance) while analysing the the currency debacle Rakshit finds that export growth should be able to service external borrowing and even the additional equity flow. Most recent evidence gathered suggests that are of the leading indicators of a currency crisis is a deterioration of the trade balance and not the current account balance which contrary to the expectation, does not receive much support as being a useful indicator of a currency crisis. In this context it is a matter of great concern that Indian trade deficit in 1996-97 increased to $12.4 billion as against $11.4 billion in
1996-97. Export import ratio, an indicator of the extent to which export can finance imports declined marginally to 88.1 per cent during April to October 1997 from 89.3 per cent during April-October 1996. As a consequence there was a widening of the trade deficit. This could on its own may be sending out the wrong signals to currency speculators. Thus to be happy about a low CAD may be paving way for a serious crisis as trade deficit widens. Something needs to be done to arrest this deficit ballooning along with a consistent macro-fiscal and exchange rate policy to keep currency speculators at a bay. The author is a professor at the NMIMS, Mumbai.
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
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