Macro economists are increasingly worried about India’s twin deficits—fiscal and current account. Overall, rating agencies seem more concerned about the fiscal deficit than the external deficit and have cautioned that India may face a downgrade of its sovereign rating unless the former is reduced. One is somewhat surprised that they do not seem to be equally, if not more, concerned about the galloping deficit on the current account. In any case, the record of rating agencies on anticipating, leave alone predicting, balance of payments crises has not been very reassuring. To give one example, the widening current account deficits in East Asia were, broadly speaking, ignored until the crisis erupted in 1997.
To my mind, the fiscal deficit should be less of a concern than the external deficit. For one thing, the rate of growth of nominal gross domestic product (GDP) has been much higher than the rise in government debt. (However, some caution is due here as well for GDP data on expenditure basis points to stagnant nominal GDP from Q1 to Q2 of 2012-13.) Further, the debt-to-GDP ratio is hardly alarming. In any case, as the French philosopher Voltaire cautioned, “Any state that borrows from its own people is no poorer for it.” The corollary being that a state needs to be far more concerned about its external indebtedness.
Thanks to its huge, growing, external deficit, India’s net International Investment Position has been deteriorating rapidly. Recent data shows this number, negative as it is, jumped from $224 billion at the end of June to $272 billion by the end of September. Put plainly, this is the amount we owe to the rest of the world on a net basis, i.e. after taking credit for our reserves and investments abroad. This will keep growing as the deficit on current account shows no signs of abating. Policymakers seem to have placed their faith in the old adage of continuing to dance until the music goes on. The problem, of course, is that someday the music of excessive reliance on external funding will stop. The fact that the deficit has been financed so far by capital inflows, thanks to the herd instinct of investors and global interest rates, should not make us complacent. As economist Rudiger Dornbusch said in the context of the euro zone, any “crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought”.
In my view, the external deficit is a reflection more of the uncompetitiveness of the exchange rate. The governor of the Reserve Bank of India (RBI), D. Subbarao, said as much when he delivered the 46th A.D. Shroff Memorial lecture on 20 November: “Deficit economies…need to depend for growth more on external demand which calls for a real depreciation of their currencies.” Instead, we seem to be continuing to depend on a market-determined exchange rate, rather than achieving “real depreciation” as Subbarao propounded.
Recent reports suggest that RBI has been selling dollars to halt the rupee’s fall. This apart, the trade-weighted exchange rate index calculated by the central bank, is not a good measure of the competitiveness of the tradable sector. A more logical measure would be to invoice currencies, or even just the dollar, given that more than 80% of our external transactions are invoiced in the US currency. By my estimate—taking 2001-02 as the base, the wholesale price index in India and the consumer price index in the US as measures of inflation—the nominal rate needed to be somewhere close to Rs.70 per dollar by the end of March 2012, for the real rate to be where it was 10 years back.
Instead of correcting the exchange rate and following a policy aimed at a viable external account and promoting growth and jobs, we seem to be considering increasing the import duty on gold. This will do little to cure the basic problem. It is worth remembering that until the crisis of 1991 there were no gold imports, at least officially, and yet the crisis occurred. Gold is, at least partially, a financial asset and the normal demand and supply curves in economics textbooks too often do not apply to financial assets. If price rises are supposed to reduce demand, then there is a far stronger case to remove all subsidies on petroleum products.
One excuse trotted out for falling exports is the state of the global economy. Yet, it is worth noting that in the same global economy Chinese exports keep growing. Net negative exports not only reduce growth and output but also much-needed jobs, particularly in labour-intensive businesses.
The other side of what I am advocating—a depreciation of the rupee in real terms and removal of subsidies—will lead to a jump in the inflation rate. It is, however, better to swallow that pill rather than wait for a crisis to occur leading to our having to take the bitter medicine of deflationary macroeconomic policies imposed by external creditors. And, as in all crises, the burden of adjustment falls unduly on the shoulders of those least able to bear it.
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A.V. Rajwade is a risk management and author.