The Current account has structural weaknesses; dipping into reserves or raising fresh dollars may not help.
As the global situation turns precarious with high uncertainty about world trade besides rising oil prices, tighter financial conditions and retreating portfolio capital from emerging markets, the rupee stands out as one of the most vulnerable currencies. RBI has expended close to $19 billion to stave off downward pressures in the year-to-date, but still ended up with an almost 8% fall in the rupee’s value against the dollar. Estimates of `70-71 to the dollar are doing the rounds, while analysts debate over the likely measures authorities might take to bridge the external financing shortfall for a widening current account and short-term liabilities due later in the year.
However, even as policymakers may find ways to bridge the gaps, the rupee will continue to drift down the weak street. This is because of structural weakening of each component of the current account, including long-term solid supports such as software exports and foreign remittances—a development particular to the current decade.
The accompanying graphic presents a long profile of net current account receipts or key exports, with the coloured rows showing the decade averages. First, consider the mainstays—software exports and remittances—that had continuously offset deficits in the merchandise trade balance in the decade to FY12. India, then, benefitted from secularly strong growth in these components, with a respective average of 24.4% and 16.3% each year. But, software export growth has dropped to just one-eighth of that figure in the current decade, or at a 3% annual average, affected by structural shifts in key export markets and the inability of domestic industry to move up the value chain.
Remittances, the other current account pillar outside the goods’ trade, have fared even worse. Growth over 2012-2017 all but disappeared, with it growing at an average of 0.1% annually. There has been a shift to far lower levels here as well, and that is not hidden by the 11.3% growth in FY18 which came on top of two steep, yearly declines. A significant chunk comes from Gulf countries, so remittances do move with oil prices. However, remittances from this region had slowed even before oil prices plunged in FY15. While some cyclical recovery could be expected with recent recovery in oil prices, remittances from advanced economies could fall structurally following more visa restrictions for onshore workers and their spouses.
It is clear that both these components are plateauing out. The fundamental weakening of these two columns of the current account adds to the longer deterioration of the merchandise trade balance—a story known all too well and an aggravating situation that India has been unable to address no matter where global demand may be. But, now, with eroding support of software exports and remittances, a more strained current account deficit needs to be balanced by improvements in the trade balance alone!
What are the prospects for that? Merchandise export trends are discouraging: traditional exports such as textiles and gems & jewellery are slowing down despite numerous measures to address supply-side constraints, such as better infrastructure, more flexible labour regulations, GST and so on. Why is that? Can newer or dynamic sectors, such as engineering goods and chemicals offset the losses from the decline in conventional exports? What are the respective elasticities regarding foreign demand and real exchange rate changes?
Consider the situation from a traditional-dynamic exports perspective. The traditional exports component aggregates all textile categories, gems and jewellery, leather and leather products, ceramic products and glassware, jute, carpets and handicrafts. Dynamic exports include manufactured product categories of drugs/pharma, organic and inorganic chemicals, engineering goods, electronic goods, plastics and linoleum. For the purpose of this discussion, natural resource exports such as iron ore, minerals, petroleum, other commodities and primary products such as agriculture /allied categories are not considered here.
Six-year data to FY18 shows a sharp plunge in both. If the dynamic sector export growth dropped below one-fifth of the 21.5% annual average of the preceding decade, or 4.7% in 2012-18, traditional exports fared even worse as its annual growth collapsed to 0.4% in the past six years compared to a robust 14% averaged during 2001-02 to 2011-12. Surely, these drops are material, visibly manifested in the widening of the merchandise trade balance, especially in the last few years. The critical question is that which of these two sectors can shoulder the increased burden from the levelling off of software exports and remittances, and offset a further weakening of the current account?
The faults in the current account are structural—only that these were masked by the oil price collapse in FY15. With oil prices rebounding since, the fundamental fragility of each current account component is getting exposed. With export prospects also threatened by heating trade wars, the CAD could slip out of control sooner than later.
Continuously dipping into forex reserves to stabilise the rupee, therefore, could turn out to be counterproductive much sooner because external debt servicing indicators would deteriorate faster in that case. Many would look towards a capital account financing boost—stronger FDI flows would certainly help, but, we have just seen how net FDI inflows dipped in FY18 with an acceleration in outward FDI flows. Raising FPI debt-investment limits, mobilising forex through costly NRI deposits or floating a sovereign bond will not help much either—such measures post-2013’s taper tantrum proved short-lived, failing to address the basic weaknesses in the current account. Those weaknesses could resurface soon, repeatedly bearing down upon the currency.
Several economists have pointed out that a weak currency will not necessarily boost exports given the negative elasticities of India’s export basket; on the contrary, it will deliver an inflation shock and damage several unhedged corporate balance sheets. But, one must note that if the current account deficit were to deteriorate to 2.5% of GDP, or more, in the forthcoming quarters, we will also see many such economists clamouring for brutally tighter monetary and fiscal policies to compress domestic demand and slow down imports. For, this is how these quick fixes work, where growth becomes the immediate casualty.
It is understandable that imported inflation fears and the inability to sufficiently push corporates to hedge forex exposures has forced RBI in the past to resort to such quick fixes. However, RBI must appreciate that given the structural weaknesses in the current account flagged above, stabilising the rupee by compressing demand this time around could mean large output sacrifices.
The monetary policy committee (MPC), that has patted itself for stabilising inflation, should also reflect if its decision was good policy; that of letting an overvalued rupee sustain for such a long time, and letting RBI figure out if the rupee is heavily misaligned vis-a-vis its (so-called) fundamentals and, then, aligning its monetary policy stance to carefully manage an orderly adjustment in the medium-term.