Gold as a convenient villain

It is now official—the widening current account deficit (CAD) is a major source of concern for policymakers. In his budget speech, finance minister P. Chidambaram flagged CAD as his “greater worry”. Last month, the Reserve Bank India (RBI) governor warned this deficit could reach record levels. Figures available for the first half of the current fiscal year show that CAD indeed increased rapidly. As against 4.2% of gross domestic product (GDP) recorded at the end of the last fiscal, in the second quarter of this year CAD reached 5.4%. There are indications that in fiscal 2012-13, this trend could worsen. The third quarter recorded a 19% increase in CAD over the corresponding period last year, resulting from a combination of a 3% decline in exports and a 6% increase in imports.

The burgeoning CAD has generally evoked two kinds of responses. The first relates to financing of the deficit. The finance minister has indicated that “this year and perhaps next year too, we have to find over $75 billion to finance CAD”. Usually, three sources of financing—foreign direct investment, short-term financing sources such as foreign institutional investors, and external commercial borrowing are as seen as the options. Both the magnitude of funding and the sources that they come from raise a range of piquant issues including their impact on the overall external debt. These are in the nature of second-order problems which policymakers should be mindful of.

The second response to the increasing CAD is to look at ways to curb the import bill. While in the past, increasing dependence on external sources for crude oil was seen as the major factor contributing to the rising import bill, in more recent years it is the increase in gold imports. The rapid increase in gold imports, particularly in the aftermath of the financial downturn, is a key factor that needs to be examined seriously. In 2007-08, the share of gold in India’s total imports was about 4%. But within the next two years, it had increased to nearly 10%. As the following years showed, imports by the largest consumer of gold registered a structural break from past trends. The reason for the growing imports was not merely India’s so-called cultural affinity with the yellow metal: it was a clear indication that India could not remain insulated from the commodity speculation that followed declining investor confidence in equities and other instruments.

It thus appears that controlling imports of gold to rein in CAD is as difficult a task as curbing imports of crude oil. These commodities are structurally inter-linked with different sectors of the economy. Yet another factor that militates against steps aimed at discouraging imports of gold is that this fuels smuggling. The government coffers will be poorer as a consequence.

In this context, policymakers should be aware that over the past decade, the Indian economy has become significantly more import-intensive. In 2001, country’s import-to-GDP ratio was 10.6%, which increased to 25% in 2011. While India had a continuously rising trend of imports-to-GDP ratio, some emerging economies such as Brazil and Indonesia have managed to lower theirs, particularly after 2008. In contrast, Indian exports have grown much more slowly, from 9.2% to just around 16%.

It is amply clear that the relatively indifferent performance of exports has a considerable role to play in the perilous state of the current account. Further, exports from India have lagged behind because of inappropriate policy support. Fiscal incentives have been seen as the primary factor for driving exports. While such measures can be of some help in the short-run, an incentive-led system cannot ensure sustained increases in exports.

Another significant factor contributing to the sluggishness in exports is the policy framework that has guided the country’s trade liberalization effort. This framework relied exclusively on lowering border protection to impart efficiency in the domestic economy. The logic that the trade liberalization agenda followed was simple: once exposed to competition domestic enterprises would enhance their efficiency, thus finding their place in the international market. In other words, the assumption was that efficiency will be automatically transmitted to enterprises and rigidities existing in the domestic economy will no longer matter.

Hindsight tells us that India’s tryst with globalization should have been accompanied by two broad sets of initiatives. First, concerted efforts are needed to improve shop-floor efficiency through the focused use of advanced technologies. This requires adoption of innovation systems both at the national level and at the enterprise level. The impetus for these needs to be provided by the network of scientific institutions existing around the country. A second set of initiatives is needed to radically improve infrastructure as well as the institutions supporting businesses engaged in foreign trade. Improving conditions for doing business which, according to the World Bank, have not taken place in the past several years. These need to be accorded a high priority.

Biswajit Dhar is director general at Research and Information System for Developing Countries, New Delhi.