Ashima Goyal

Behind the current account gap

ASHIMA GOYAL | Updated on March 12, 2018

Lower inflation and a better menu of savings instruments can revive financial savings.

Rising CAD levels are linked to sustained inflation, which eroded financial savings by more than the fall in investment.

India’s current account deficit (CAD) rose to a record 6.7 percent of GDP in the last quarter of 2012. That clearly is unsustainable. But an effective cure must address the roots of the problem, for which a correct diagnosis is essential.

Let us look at the various possible explanations for such a rise in the CAD.

EXCESS DEMAND

Excess demand cannot be responsible for the higher CAD, when GDP growth has fallen to sub-six per cent levels and industry is actually faced with a problem of excess capacity.

At the same time, there is the issue of high fiscal deficit (FD), which could be raising demand. But then, the Government, pushed by fears of rating downgrades, has also made a serious effort to reduce the FD.

In the last quarter of 2012, growth in government consumption fell to 1.9 per cent, from 8 per cent in the preceding quarter, while that for community, social and personal services as a whole fell from 7.5 to 5.4 per cent.

If the fall in the FD reduced growth but not the CAD, it implies government expenditure creates demand largely for non-tradable goods, not for imported goods. Excess demand may be a problem only in agriculture, where supply rigidities prevent expansion to keep up with rising demand for food. There is also speculation-based argument, which says that if interest rates do not adequately compensate for or are even set below inflation rates, the resulting low/negative real interest rates encourage borrowings and imports. It, then, leads to a higher CAD.

But that argument is not credible either, given that credit growth has been low in the recent period. In any case, India’s CAD has never been high in high-growth periods, when one would expect higher domestic demand raising net imports.

If domestic absorption or aggregate demand is not responsible for the CAD, the problem could perhaps, then, lie in imports being cheap and exports not profitable enough. In that case, shouldn’t a depreciation in the rupee help?

EXCHANGE RATES

This argument, again, has limits. The CAD was only around one per cent of GDP during India’s high growth period in the mid-2000s, when the rupee was actually appreciating. After the steep depreciation following the 2008 global financial crisis, the CAD rose to about 3 percent of GDP and stayed there until 2011.

Then, as the rupee fell against the dollar, from Rs 44 in July 2011 to Rs 54-55 levels, the CAD went up to over 3 percent. Despite substantial real depreciation, export growth slowed more than import growth. To that extent, the cheaper rupee only worsened the CAD, implying that import and export demand are largely inelastic to exchange rate movements.

CAPITAL FLOWS

Another explanation points to capital flows, wherein it is said that higher capital flows lead to higher CADs, since the balance of payments must add up to zero. But this argument falls into the classic Immaculate Transfer doctrine trap. True, the capital and the current account must equal the change in reserves, but that does not mean one is directly causing the other. CAD outcomes are the result of various other macroeconomic adjustments, including in foreign exchange reserves, output, exchange and interest rates. But whatever these adjustments were, capital inflows definitely did not cause the current widening of the CAD. On the contrary, just when the CAD widened in 2011, there were capital outflows that made it difficult to finance the CAD.

EXTERNAL SHOCKS

A more promising explanation for rising CAD levels could be linked to supply shocks that have sustained high inflation over 2007-13, alongside lower growth. These, by impacting real incomes and generating low real returns, reduced financial savings in the economy.

The multiple cost shocks began with the spiralling of global food and oil prices in 2008. Their slow release through the system, given dysfunctional administered price regimes, kept inflation high. Capital outflows-driven rupee depreciation sustained these shocks, even when international commodity prices softened.

The CAD, by definition, equals domestic investment minus savings. While investments fall during slowdowns, if savings fall even more, the CAD widens. Savings are the sum of financial savings that largely fund investments involving goods that are tradable, as opposed to physical savings that are invested more in non-traded goods, such as in real estate. So a fall in financial savings would have a greater impact on the CAD.

The estimates of physical savings in the household sector are identical to those of investment in the unorganised sector. The latter is measured as a residual, after deducting the respective shares of the corporate sector and of the Government. It follows, then, that if the rest of investment exceeds financial savings, it will have to be financed by foreign savings that is, by running a CAD.

In 2011-12, the CAD rose to 4.2 per cent of GDP, from 2.7 per cent the previous year – i.e. by 1.5 percentage points. Investment fell from 36.8 to 35 per cent, or by 1.8 percentage points, while savings fell more, from 34 to 30.8 per cent, or by 3.2 percentage points. The widening of the CAD has to equal the excess of the fall in savings over the fall in investment – which is what it works out here.

Within savings itself, the largest fall was in the household financial savings component, by 2.4 percentage points. This, together with a 0.7 percentage points fall in the corporate savings-GDP ratio, almost covers the rise in CAD and fall in investment. The increase in household physical savings by 1.2 percentage points, in fact, almost made up for the fall in public sector savings of 1.3 percentage points – both of which largely impact non-traded goods.

These financial aspects were reflected on the trade side. Inelastic demand for oil, in the absence of local price pass-through, and for gold, given the absence of other inflation hedges, widened the CAD. If imports of oil and gold are subtracted from the trade deficit, the country actually recorded a trade surplus.

POLICY ACTION

What all this highlights is the inadequacies of the policy of freer import competition without building export capacity, leading to import growth exceeding that of exports. An example of this is India’s per container trade costs, which are more than twice the East Asia average. The intensification of the European crisis lowered export demand, just as domestic supply bottlenecks raised coal imports.It follows, the real story is sectoral. Aggregate policy instruments such as interest and exchange rates are constrained by their opposite effects on savings and investment in the case of the first, and export demand and import costs in respect of the second. The correct policy response requires concerted supply-side action to reduce costs, along with a dismantling of the administered pricing regime.

Lower inflation and a better menu of savings instruments can revive financial savings. Better export capacity must be matched by a diversification of export destinations.

(The author is Professor of Economics, Indira Gandhi Institute for Development Research.)

Published on April 16, 2013

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