The current account deficit has emerged as the biggest risk for the Indian economy, replacing worries about an impending fiscal crisis.
India needs about $80 billion of foreign capital to fund its record current account gap, one reason why the government has gone out of its way to woo foreign investors since July. The recent series of meetings that finance minister P. Chidambaram had with global investors in Asia and Europe were an attempt to ensure that India does not trip into a balance of payments problem, when foreign exchange reserves will have to be put to work to defend the rupee.
The conference call that Reserve Bank of India governor D. Subbarao had with economists a day after the announcement of the monetary policy on 29 January offered further proof that the external situation is a major worry. Many of the questions dealt with it. Subbarao said in one of his answers that future interest rate cuts will not depend on the inflation trajectory alone. The size of the current account deficit will also be considered. That statement should temper some of the more unrealistic expectations of deep rate cuts in the coming months.
Meanwhile, former RBI governor Y.V. Reddy has put forth an intriguing idea in his forthcoming book on Indian economic policy, which was excerpted in Mint on Monday. Reddy argues that India should aim for a zero current account deficit over an economic cycle, so that India has the space to absorb shocks in bad years.
This contrasts with the traditional assumption among Indian policy makers that a current account deficit of around 2.5% of gross domestic product can be sustained. High-growth countries have good reason to run modest current account deficits, since they can invest more than they save.
The current account deficit is the excess of domestic investment over domestic savings. The only sustainable way to reduce this gap in the long run, without cutting back on investments, is to raise the savings rate. It is now well recognized that the savings rate—especially financial savings of the household sector—has been falling because returns have not kept pace with inflation.
Reddy argues that we need policies that are friendlier towards savers. The policy establishment understands this. What is less appreciated is that higher real interest rates are part of the answer.
So it is quite likely that the pace of interest rate cuts will be slower than the pace at which inflation comes down in the coming months (if it does at all).