India has for some time now been facing the so-called twin deficit problem. A high fiscal deficit and a high current account deficit are a threat to economic stability—which is the main reason why international credit rating agencies have brought the country’s debt close to junk status.
The fiscal problem is likely to be a sticky one, especially if the economic slowdown continues and if a weak coalition government tries to boost spending to win electoral goodwill. Thankfully, there is better news on the external front, despite the fact that we had a balance of payments deficit in the quarter ended September—the first such deficit in three years.
But matters seem to be on the mend now.
The current account deficit seems set to shrink despite the huge tumble in export earnings. Part of this steep fall is because of the recent drop in global oil prices. Meanwhile, capital flows continue to be vibrant despite the huge withdrawal of money from the domestic stock market by foreign financial institutions, or FIIs.
But equally interesting is the change in the composition of these capital flows. FIIs pulled out an estimated $15.02 billion in 2008-09, according to data released this week by the Reserve Bank of India, or RBI. The scale and rapidity of this withdrawal after September did unsettle the money and foreign exchange markets—short-term interest rates crossed 20% and the rupee tumbled to an all-time low of 52 against the dollar.
But other types of capital inflows have been strong, especially foreign direct investment, or FDI. RBI provisionally estimates that India got a net inflow of $33.61 billion through FDI. Overseas Indians, too, sent a lot more money back home, thanks to the financial near-collapse in the West and higher interest rates in India.
Money from overseas Indians is volatile and can flow out very easily, as it did in 1990 and 1991 when India came close to defaulting on its global debts. But a greater dependence on FDI rather than FII money will make the financing of the current account deficit more stable.
A shrinking current account deficit and stable capital flows should help the rupee move up against the dollar.
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