In his Budget statement, finance minister Pranab Mukherjee expressed worry over the widening current account deficit (CAD) and, more particularly, the composition of the capital flows financing such deficit. This is one aspect of economic management that needs a closer study. The view taken on CAD and its financing will have a direct bearing on the conduct of fiscal and monetary policy in the medium term.
Of late, RBI too has been expressing concern about how environment sensitive policies of the government could lead to a deceleration of foreign investment flows into critical sectors of the economy such as mining, steel making, etc. This, in turn, could make the financing of CAD more difficult.
Commerce secretary Rahul Khullar has prepared a medium-term strategy paper in which he projects the trajectory of India?s foreign trade over the next three years. If the economy is to grow at 8.5-9%, the paper suggests that India?s trade deficit will widen from the current 7.2% of GDP to around 13% of GDP by 2013-14.
If the trade deficit indeed goes up to 13% of GDP in the next three years, the question is how this is going to be financed. What sort of current account and capital flows will finance this?
The near doubling of trade deficit, as projected by Khullar, means India may have to live with a higher CAD of 6% of GDP in the near future!
Here is how the arithmetic works. India?s net invisible inflows are projected at around $85 billion this year and this is about 5% of GDP. The government has roughly projected that this could grow to about $115 billion over the next three years. So the net invisible inflows, mainly constituted by remittances by Indians from abroad, could go up to about 7% of GDP.
With the trade deficit at 13% of GDP and net invisible inflows at 7% of GDP, one gets a CAD of 6% by 2014.
Rahul Khullar says in his paper that a ?trade deficit of 13% of GDP is clearly cause for serious concern. Services earnings will most certainly grow over the next few years. However, it is unlikely that even their growth can sustain the ballooning trade deficit of 13% of GDP?.
It is this problem that Pranab Mukherjee emphasised when he expressed worry over how a widening CAD will be financed in the future. Of late, RBI too has been? worrying about the growing CAD.
The risk posed by a widening CAD in a high growth, import-guzzling economy depends on whether you can finance it in a sustainable way. The composition of the net capital inflows financing the CAD, at present, is skewed more towards foreign portfolio investments, which come in the stock markets.
FDI inflows actually decelerated in 2010 by over 15%, from $28 billion in 2009. In comparison, net FII inflows into India peaked at $28 billion in 2010. In fact, India received nearly a third of all portfolio investments coming into emerging markets in 2010. A lot of the FII flows into India could be hot money and, therefore, short-term in nature.
So when the finance minister showed concern about the composition of the capital flows financing the growing CAD, he probably meant there was a need to open up the economy further to attract a lot more stable FDI flows. Only then can India finance its growing negative trade balance.
Globalisation cannot be a halfway house. Either you are in it fully or you are not. The difficulty in policymaking is, at times, it might appear alright to not engage more with the global system as a conservative strategy of derisking the economy. This strategy was adopted for the financial sector before the global meltdown.
However, at other times, greater engagement with the global economy is what leads to derisking. A classic example of such derisking is the way Reliance Industries sold a part of its stake to British Petroleum for over $7 billion to bring better technology for enhancing gas production in the K-G basin. Apart from derisking RIL?s balance sheet, it also derisks the country?s balancesheet.
Besides the use of FDI for financing trade deficit, higher gas production will reduce the future outflow of foreign exchange for energy imports. Stable FDI flows are similarly needed to derisk other sectors such as banking, insurance, retail, etc. The Tata Group showed higher revenue growth from their overseas operations than from India in 2010. This is also a form of derisking that comes from greater engagement with the global economy.
The RIL group traditionally had a more nationalistic approach and was loath to giving a decisive stake to foreign companies in any of their operations. This has changed over the past few years as the group attempts to scale up globally.
National policy must also be designed to enable such derisking of the economy, especially from an external sector perspective. If India is going to be a massive net importer of energy and other commodities, it will have to find some way of earning foreign exchange.?Or else we will end up staring at a 1991-type foreign exchange crisis, even with a robust GDP growth of 8% to 9%.
Prior to the East Asian crisis of 1997, the South Korean government actively discouraged FDI in several sectors dominated by the patriotic Korean Chaebols. After the 1997 financial crisis, the Chaebols were forced to attract stable FDI flows by selling substantial stakes in their companies without losing control. There is a lesson for India in the Korean experience.
?mk.venu@expressindia.com
