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Fear the external sector

Fear the external sector
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First Published: Fri, May 06 2011. 01 15 AM IST
Updated: Sat, Jul 02 2011. 03 01 PM IST
Reserve Bank of India governor D. Subbarao’s policy statement on Tuesday said India’s current account deficit (CAD) in fiscal 2011 would be better than that of the previous year. At a projected 2.5% of gross domestic product on the heels of robust growth in exports over the last few months, India’s vulnerability in the external sector seems to have receded. In reality, though, this is an illusion. If anything, India appears more vulnerable than it has in a while.
There are critical known unknowns that threaten to significantly widen CAD over the next couple of years. The price of crude, for example. Oil imports make up about one-third of the total and there is little the government can do except pray.
Economic recovery in developed markets is fragile. Their health is crucial to India’s exports. Though exports grew by an impressive 46.6% in the last quarter of fiscal 2011, policymakers know this rate of growth is unsustainable.
These are vulnerabilities beyond the control of policymakers. The external sector, however, can be partially insulated from vulnerabilities by getting on with reforms.
A more rational pricing of retail petroleum products is the first place to start. The growing difference between the actual cost and domestic pricing suppresses the role of pricing as a signalling mechanism for consumers. When oil is underpriced, there is no incentive to alter habits or spur innovation in fuel efficiency. Simultaneously, it poses a risk to CAD.
The harder reform, perhaps, is to improve manufacturing competitiveness. There has been a structural shift in the nature of India’s international trade. Manufacturing exports in engineering and chemicals have been the drivers of export growth. That trend is set to intensify. By government estimates, engineering, chemicals and electronics will make up 39% of exports by 2014 from 31% now.
Last year, the real effective exchange rate (REER) rose largely on account of inflationary conditions in the economy. The six- country REER increased by 12.7%, eating into the competitiveness of exporters. The most critical sector of exports needs a better domestic environment to keep growing fast.
High costs in domestic manufacturing also tend to keep import growth high. Industrial inputs make up around 55% of imports and have been inching up lately. Domestic competitiveness can only help.
Increasingly, CAD is being bridged by volatile portfolio flows. Net foreign direct investment dropped last fiscal. It might help if policymakers asked themselves the extent to which their opaque dealings and confusing signals contributed to a drop in the most stable inflow available.
India needs to get its act together to partially offset its vulnerabilities in the external sector. Else, be afraid. Very afraid.
Can policymakers undertake the required reforms? Tell us at views@livemint.com
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First Published: Fri, May 06 2011. 01 15 AM IST
More Topics: Ourviews | RBI | D. Subbarao | CAD | Oil imports |