A lot has been said and written about India’s widening current account problem and the rupee’s weakness. With apologies to the reader, here is another. Let me start with the consensus narrative that goes something like this: The economy is recovering strongly (13.5% and 6.3% growth in the first two quarters of this fiscal year) despite strong global headwinds, namely Russia’s war and the associated surge in global commodity prices, the aggressive monetary tightening by the US Fed, and the strong dollar. Inflation, while still high, has begun to ebb. Fiscal deficit, buoyed by strong revenue growth, is on a consolidation path, and monetary policy has been tightened appropriately. The only material concern is the sharp widening of the current account deficit (CAD) due to high global oil (and other commodities) prices and strong non-oil import growth because of the recovery in domestic demand. The weakness in the rupee stems from the difficulty in funding the large CAD when global interest rates have shot up, and the dollar is at its strongest in decades. Substantial foreign exchange reserves have been expended in trying to moderate the volatility in the rupee, but the worst is behind us, and FX reserves remain adequate to withstand any disruptive moves. In the context of the trying global environment, this is as good as any Goldilocks storyline.
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Here is an alternative narrative. While impressive in its pace, the economic recovery, in level terms, remains significantly below that implied by the pre-pandemic growth trend. As such, it is incomplete, and the economic loss from the pandemic is likely to be large and permanent. More importantly, the pace of growth is set to slow sharply over the next two quarters. The government and RBI see growth this year averaging 6.5-7%. If, in the first two quarters of the fiscal year, the run rate has been 13.5% and 6.3%, then for the average to be 6.5-7%, the pace in the second half of the year must slow to 4-5%. It is not economics, just the tyranny of arithmetic! So, if in the next fiscal year, growth is expected above 6%, as consensus forecasts suggest, then it needs to rise by over 2 ppts over the run rate in the second half of this fiscal year. This year, global growth is heading towards 2.9-3%. Next year, it is slated to nearly halve to 1.7% as the US slows towards a recession and China begins to recover only in the second half. To expect India to deliver 2-ppts higher growth when the global economy slows 1.2 ppts will be challenging to say the least.
Turning to the CAD, instead of complicating the analysis with what happened to exports and imports, it’s more fruitful to think about it as a funding problem. An economy’s fiscal deficit must be funded either by borrowing from residents or foreigners. This is just an adding-up identity. The private sector’s excess of savings over investment (the savings-investment gap) is the part of the fiscal deficit that is funded by residents and the CAD is the part financed by foreigners. It does not matter whether the government directly borrows from non-residents or not. For example, the Indian government funds most of its needs domestically. But, by doing so, it forces the private sector to borrow abroad. What matters is how the country funds competing demands.
This year’s funding arithmetic stands something like this: Even after declining, the public sector (the Centre, state, and PSUs together) needs to borrow 10-10.5% of GDP, the excess savings of the private sector (after funding its investment needs) is 6.5-7% of GDP, such that 3-3.5% of GDP needs to be borrowed abroad, which is the resulting CAD. In comparison, during FY21—the pandemic year—the private sector’s excess savings was a whopping 14-14.5% of GDP, such that despite a much larger public sector deficit of 13-13.5% of GDP, instead of borrowing, India invested around 1% GDP abroad that resulted in a current account surplus of the same amount.
This way of looking at the issue avoids going down the rabbit hole of debating whether exports fell because of lower demand or an uncompetitive exchange rate, whether imports rose because of higher commodity prices or because rich Indians are splurging on foreign consumer goods, or whether India’s infrastructure build-up now requires more foreign capital equipment than before. Instead, this focuses on the problem’s root cause, namely, the sharp decline in India’s private savings (because private investment has languished, the narrowing of the savings-investment gap is because of falling savings). The rupee’s weakness is just the foreign investor’s way of saying that asset prices (both equity and bonds) in India are too expensive and therefore need to be compensated by a much cheaper currency. And with global markets not funding the CAD fully, RBI had to draw down the country’s public savings, i.e., its foreign exchange reserves.
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What caused private savings to fall? There is a myriad of reasons, but that’s for another day. That said, clearly, falling household and SME incomes must be a key cause. This trend is unlikely to reverse next year, and the government needs to substantially reduce next year’s deficit. If it doesn’t, then the CAD will rise further. In a world where global financial conditions will remain as tight or even tighten further (depending on where the US takes its policy rate), India will find it very hard to fund a wider CAD without cheapening its exchange rate or equity and bond valuations substantially (for bonds, this would imply a much higher yield and policy rate).
A tighter budget, higher interest rates, lower investment, and slower growth are what it will take to keep foreign borrowing (and inflation) contained. As the world slows and the US heads towards a recession, global markets will turn increasingly risk-averse. Hunkering down is the prudent way to navigate these challenges. India’s growth, too, will slow, and the temptation to ease fiscal and monetary policies in response will be high. But, good macro management, like parenting, requires knowing when to say no.
The author is Chief emerging markets economist, JP Morgan
Views are personal