Mumbai: The second quarter of 2012-13 saw a current account deficit of 5.4% of the country’s gross domestic product (GDP). The third quarter is likely to see a current account deficit of around 6% of GDP. And just to remind everybody, the deficit was 3% of GDP in 1990-91, the year of the country’s worst balance of payments crisis. This year’s budget is being prepared under the lowering shadow of a record current account deficit.
Why is that important? Well, the Reserve Bank of India (RBI) believes the country’s sustainable current account deficit is 2.5% of GDP. It’s far above that level now, and the massive gap has to be financed through capital inflows, which makes the Indian economy completely dependent on the kindness of foreigners. Any loss of confidence in India’s growth prospects, any lessening of global risk appetite, and fund flows to the country’s markets could start drying up, dragging down the rupee and leading to a stampede for the exits. The price of imports will rise, inflation will go up, growth will slow, companies that have borrowed abroad will totter, and we could see a vicious backlash. It’s a huge risk, as rating agency Moody’s Investors Service recently underlined. And don’t forget that we have the general election in 2014, so political uncertainty is likely to weigh on inflows. The finance minister has only a small window of opportunity. He must make the most of it.
That means managing the current account deficit has to be at the centre of the budget. The strategy has to be two-pronged—taking steps to reduce the current account deficit on the one hand, and ensuring that the confidence of international investors in the Indian economy is boosted on the other, so that capital inflows to cover the deficit are adequate.
The current account deficit is the gap between domestic savings and investment. But the problem is that the current account deficit is high at a time when investment is very low, which means that increasing investment, which is needed to boost growth, runs the risk of inflating the external deficit. A high current account deficit at a time of low growth also indicates that the problem is structural in nature. The finance minister can do little, in the short term, to remove the supply bottlenecks that have led to higher imports, such as a shortage of coal, the increased use of diesel, or the mess in iron ore. He can do little about oil prices or oil imports in the short term without affecting growth.
What can he do then? He could take measures to increase domestic savings. Shrinking the fiscal deficit is one way of doing that. That will also increase the leeway for RBI to cut interest rates. But if the deficit is cut by reducing subsidies, it will lead to higher administrative prices, increasing inflation. Higher tax receipts cannot be taken for granted, because the reasons holding back growth are supply-side bottlenecks that will take time to resolve and the recovery is likely to be slow as a result. He could, however, go in for a tax on the very rich. Cutting non-Plan expenditure is essential, but unfortunately a large part of the Centre’s expenses are more or less fixed. In short, while it’s absolutely necessary to reduce the fiscal deficit and the finance minister has already indicated he’ll aim for it to be 4.8% of GDP in 2013-14, a large part of the improvement will have to come from non-tax receipts, such as divestments.
It is not just the government that needs to save more—the financial savings of households have gone down from 12% of GDP in fiscal 2010 to 8% of GDP in fiscal 2012. This trend has to be reversed, by giving more incentives to people to save in financial instruments. The finance minister must give sops for exports, which will improve the trade deficit. He could also increase the import duty on gold. And he could lay out the timeline for the implementation of the goods and services tax.
What can the finance minister do to ensure that capital inflows remain robust? One, he could announce measures that would help the capital markets, which would support his divestment agenda and allow foreign institutional investors’ funds to flow into debt markets, lowering interest rates. He must try and get domestic investors back into the markets. And secondly, he could outline in his speech his agenda for further reforms, such as the pension and insurance Bills, freeing up foreign direct investment further, and making the tax code more investment friendly. Finally, the markets will not take kindly to more populism.
Ultimately, credible supply-side structural reforms, not all of which can be addressed by the budget, are needed to restore confidence in the economy. Will the finance minister do his bit? This is after all the last full budget before the 2014 election and there will be pressure on him to play to the political gallery. The hope is that the government has in recent months taken several reformist steps, albeit only after it was pushed to the wall by the threat of a ratings downgrade. That threat persists and the reforms momentum needs to be carried forward in the budget. If it isn’t, it won’t be long before the slowdown snowballs into a crisis.