Don’t worry about CAD

There has been a lot of concern over how India’s unsustainable current account deficit (CAD) has increased at a time when the US Fed has signalled its willingness to normalise its unconventional policy actions instituted since 2009.

To be fair, the record high CAD/GDP ratio of 4.8 per cent in 2012-13 is undoubtedly untenable. After the recent remedial steps taken by the policymakers, consensus estimates for CAD for 2013-14 have seen a correction to sub-4 per cent levels of GDP — which is approximately $70-75 billion.

Just as unanticipated ballooning of CAD shocked us in 2012-13, the extent of correction in 2013-14 could surprise us pleasantly.

Economic history is rife with instances of rapid current account adjustments from unsustainable levels.

Self-correcting methods

Internal mechanism : The improvement in current account comes through a slowdown in domestic demand growth and, in turn, import growth. This is preceded by widening deficit , due to buoyant domestic demand.

External mechanism : In this case, improvement in the current account improvement is made possible by rapid depreciation in the exchange rate in favour of the country’s competitiveness, favouring an increase in net exports. External adjustment seems to be preceded by sluggish economic growth, possibly because these economies face withering competitiveness.

Over the last two years, India has witnessed the emergence of both internal and external factors.

GDP growth fell sharply from 9.3 per cent in 2010-11 to 5 per cent in 2012-13. Over the last two years, growth in private consumption more than halved to 4 per cent in 2012-13 and investment growth turned flat from 14 per cent growth in 2010-11. Over the last one year, the government deficit has also corrected by 0.8 per cent of GDP.

On the exchange rate side, the rupee has depreciated by a massive 24 per cent and 20 per cent over the last two years on nominal and real trade weighted basis, respectively.

Recent evidence confirms more of the same. The rupee lost close to 6 per cent against the dollar in August 2013 and the Q1 FY14 GDP data showed growth momentum slipping below 4.5 per cent for the first time in 17 quarters. However, the measures announced by the RBI since the last week of August (including the dollar swap window for OMCs, easing terms for NRI deposits, increase in banks’ foreign currency borrowing limits) have helped the rupee to partially reverse its losses while curbing volatility in the currency.

Rupee and recovery

Empirical evidence points towards long and lagged impact of (usually about six-eight quarters) exchange rate on trade balance. However, the same could play over a shorter horizon if accompanied by an improvement in global demand for exports. Although emerging market economies are witnessing a mid-cycle correction in their respective growth momentum, key developed economies are showing signs of recovery.

A strong possibility of tapering of quantitative easing (QE) by the US Fed in the near term confirms the central bank’s assessment of sustained recovery prospects in the US.

The combination of Abenomics and unprecedented QE by the BoJ has turned around the fortunes of the Japanese economy. Besides brighter prospects for the US and Japan (which together constitutes 23.1 per cent of India’s export basket), the negative sentiment associated with Euro Zone and China (which together constitutes 21.3 per cent of the India’s export basket) has also subsided. The improvement in growth prospects for key countries has already started to impact services exports, which have grown at the robust rate of 35.6 per cent Y-o-Y in Q1 FY14 compared to a contraction of 2.4 per cent Y-o-Y seen during Q1 FY13. It is no surprise that the BSE IT Index has gained 38 per cent this year, while the benchmark Sensex is up a meagre 2 per cent in 2013 so far.

The concurrent impact of the rupee depreciation on remittances, which is most important, often gets ignored. As per the World Bank, India has been the largest recipient of remittances in the world for the last five consecutive years. In 2012, total remittance inflow of $69 billion accounted for 13 per cent of such flows worldwide. Remittances are extremely important in lowering the pressure on CAD as they finance close to one-third of the merchandise trade deficit.

For a Gold Bank

Current policy measures have started bearing fruit.

While the current macro backdrop is in favour of an adjustment in India’s current account deficit, recent steps taken by the policymakers with respect to administrative restrictions on gold imports — the second largest item of import — has already begun to have an impact. For the year as whole, gold imports are expected to decline by about $8-10 billion.

While some of these measures could eventually get reversed once normalcy returns, it is important to impart structural stability to CAD with respect to gold imports. In this context, the policymakers can explore the possibility of setting up an apex body — The Gold Bank — which can procure and retain gold abroad through offshore foreign currency borrowing.

Using this gold-backed backing, the scheduled commercial banks can offer a Gold Deposit Account to retail customers, which can represent notional units of gold and provide gold price return in weight terms. This will not only promote financialisation of incremental demand for gold, but also incentivise the deferment of the need for importing physical gold.

The fuel price reforms instituted since January 2013 has improved price elasticity and led to a decline in volume of LPG and high-speed diesel imports. In addition, a one-time steep adjustment in diesel price can be announced to curb the recent impact of increase in under-recoveries.

Additionally, the option of importing oil from Iran, which will involve payment in rupees, is being evaluated. This could result in a potential saving of around $9 billion in 2013-14. Amid ongoing adjustments in growth and exchange rate, the Government has prudently stuck to the path of fiscal consolidation.

After successfully reigning in fiscal deficit at 4.9 per cent, below the revised estimate of 5.2 per cent in 2012-13, the Finance Minister has drawn a credible red line at this year’s fiscal deficit target of 4.8 per cent of GDP.

This will further facilitate the expected correction in India’s CAD. A sharp correction in CAD by approximately 2 per cent of GDP can push the overall deficit close to $50 billion, much lower than the consensus expectation of $70-75 billion. Seemingly, CAD is now looking like yesterday’s problem.

(The author is President, Assocham and MD and CEO, YES Bank.)

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