Policies disproportionately focused on the capital account; instability may surface from the current account side.
India’s macroeconomic stability has infused much confidence in the past one year. It has also bred satisfaction over the achievement. This particularly applies to the current account deficit (CAD) whose alarming expansions have periodically pulled down the rupee whenever foreign investors flee. Underlying this tendency is a fundamentally unstable dynamics, built up in more than one decade. It is marked by a trend-widening of the trade deficit, which betrays India’s insufficient generation of export receipts—at a pace matching its import bills; in other words, a steady loss of external competitiveness over time. Against this characteristic, can the current stable nature of the CAD be considered to persist or sustainable? Or is this borrowed or imported stabilisation? Answers to these questions must inform and guide macroeconomic policies, if only to exploit munificence for structural, long-term improvements in the external balances.
As a refresher, return to the lowest point touched by the CAD in October-December 2012. At -6.5% of GDP, this was a shocker caused by sharp contraction in exports while imports kept up their brisk pace. As export growth languished, a heavy clampdown on gold imports achieved a sharp compression of the CAD to -3.5% of GDP in the following quarter. Indeed, such was the pressure following capital outflow triggered by the US Federal Reserve Chairman’s ‘taper’ remark on May 22 that policymakers were driven to quell the rupee’s quivers by early disclosure of the improved CAD number! Export growth recovered reasonably in the next one year—an average 12% each quarter—while imports were kept on a tight leash with duties, etc., both of which restrained the CAD.
Thereafter, i.e. from July 2014, developments have been exceptionally favorable. Global oil prices plunged by half in six months; prices of other imported commodities and items fell too; export growth, which started to slow from August 2014, didn’t shrink steadily as much until this year; import growth has been subdued by both price effects and weak domestic demand; lower inflation resulted, releasing some monetary space; and the fiscal policy got a breather from hefty fuel subsidy payouts. Such has been the bounty that even a surplus on the current account was forecast by some.
None of this reflects any fundamental change in forces driving the current account balance however. If this is reassuringly narrow and respectable once again, it isn’t exactly as though its various components had become competitive, which is what imparts basic strength and sustainability. Rather, it is providence lowering import payments. Export receipts still fall short of meeting a ‘normal’ import bill; liabilities and outflows linked to foreign investments in India retain their upward climb. The largest and most significant component—merchandise trade balance—lies in the 7-8% region as share of GDP, altogether not so different from the pre-crisis years (2004-07) and but a short distance from its historical 10-11% peak. Worse still is the alarming deterioration in services exports, for long a mainstay of the current account balance. These are now in persistent decline, even at a time when its key market, the United States, shows a steady recovery.
Nothing has changed, except luck. But good fortune, as we know, can both rise and fall. As a thought, consider if the external gap would open up as before if oil prices were to strengthen and domestic demand bounced back? It is not inconceivable to imagine imports growing at their usual 15-20% pace, particularly as current policy efforts are aimed at reviving domestic investment that typically increases demand for capital and intermediate goods imports. How much would export growth match up to? Would the current account settings sustain in their present range in that case? Or would there be a current account reversal?
As well admit this external stability is temporary; it can quite quickly reverse direction if and when conditions change. This brings to fore the issue of structural repairs of external imbalances, which originate chiefly from the current account, or rather, trade side. Much of the external sector policy focus is upon the capital account, while there is less explicit recognition in public policy space of the country’s ever-widening trade deficit, which essentially reflects eroding competitiveness of its exports. Reasons as to why this is happening need seeking. Is an uncompetitive exchange rate that is responsible? Or are there domestic constraints that have eroded India’s exporting capacity? At a very basic level, the sources of competiveness or productivity gains/losses could lie in either prices, i.e. the exchange rate, or real changes in markets, institutions and infrastructures. Do we really know where exactly India has lost competitiveness?
So even as the favourable current account settings are comforting, policy efforts to recoup competitiveness and stimulate exports should be active. In this regard, the current pro-India investor fervour can be exploited by explicit seeking of foreign direct investments (FDI) flows into the tradable sector, instead of relaxing rules to boost FDI in real estate and construction sectors. Policy recognition that the sectoral composition of FDI matters for the trade balance is important: FDI in tradable sectors is proven to directly boost exporting capacity by productivity improvements through technology, learning and competition effects. But the benefits of FDI in nontradable sectors (defined as information, communication, finance, other services, construction and real estate) are not so clear-cut. Indeed, in some countries, these are found associated with reduction in export capacity and deteriorating the external balance as they diverted resources away from tradables to non-tradables and/or fed into import demand. The fact that nearly half (47%) of FDI flows into India to date is concentrated in nontradable sectors, many of which generate no forex earnings, while export-oriented FDI has constantly eluded the country does merit examination beyond overall FDI trends. What, for example, are the sectoral FDI linkages with the current account balance?
These are sobering thoughts at a time when impeccable external indicators assure resilience to financial instability threats from the situation in Greece and a possibly tighter US monetary policy further ahead. But tough questions must be posed precisely at times when a false sense of achievement endangers slippage into complacency. As long as current conditions, global and domestic, prevail, the current account will remain subdued. But the moment global demand and trade revives, international oil and other prices will jump up. There will be encouraging feedbacks into India’s own domestic economic cycle that will surely reflect in both capital and consumer goods’ imports, at higher prices, of course. How sure can we be that exports will match up then, given the declining competitiveness? The concern is that an ‘imported’ stability shouldn’t distract policy attention from contending with critical structural issues.
The author is a New Delhi-based macroeconomist