India’s burgeoning trade deficit is posing a challenge to the country’s macroeconomic stability, and making itself felt in the weakness of the rupee. In October, the deficit swelled to a record $21 billion as exports shrank and imports rose. Although the widening trade gap can be partly explained by sluggish global demand that is depressing exports, what is worrying is that non-oil imports are not declining despite slowing economic growth. In October, non-oil imports rose 1.73%. Some economists see the increase in non-oil imports as an outcome of domestic supply-side constraints; supply isn’t enough to meet demand even in a slowing economy. This should worry policymakers. As chances of any revival of demand in the global economy remain dim, higher imports, along with growing appetite for short-term foreign fund inflows to finance the deficit, could rapidly snowball into an external shock in the event of a sudden stop to the inflows or a surge in global financial market volatility.
What is disheartening is that despite numerous warning signals on the external front throughout this year, instead of either checking demand by reducing government spending or acting to remove supply-side hurdles, the government has so far chosen to lighten controls on the capital account to attract fund inflows to prop up the currency. There is nothing wrong with opening up the capital account per se but doing so with the idea of propping up the currency is certainly not ideal, and it has not worked. The Indian rupee, after strengthening for a couple of months, is once again under pressure. The currency appreciated from Rs.57 per US dollar in June to Rs.52 to per dollar in October, but has once again slipped to the 55 mark. It lost over 1% on Monday, the day the trade data was released by the government. Volatility of such magnitude in the foreign exchange market adds to the uncertainty not only for businesses with overseas exposure, it also has an impact on inflation. A drop in the rupee’s value against the dollar increases imported inflation.
Clearly, stopgap measures are not helping. What India needs is serious efforts to remove the supply-side constraints and boost investments, which will not only contain the steady increase in non-oil imports, but also help curb inflation and push growth in the Indian economy. The problems that the Indian economy is facing today, on both the external and internal fronts, to a large extent are a consequence of internal mismanagement and the solutions have to be found within. Postponing decisions until a later day will only worsen the situation.
Will removing supply-side hurdles help contain the trade deficit?