The increase in the current account deficit in the first quarter of 2009-10 by a little over 200% to $13.7 billion is a cause for anxiety in the short run, as it increases India’s vulnerability to external sector developments. It also makes the central bank’s job tougher. The increase in the deficit was more than offset through capital inflows in the first quarter, which continue unabated. The combination of these two factors makes India vulnerable to events such as a sudden reversal in inflows.

Today, unlike in an earlier era, the economy is cushioned to an extent from external sector volatility on account of the foreign exchange reserves India has ($265 billion on 24 September).

This raises the question as to why there is a flood of global capital into India, the all-important counterweight to an expanding current account deficit.

Illustration: Jayachandran / Mint

The first impact of the flood of capital has come through an appreciation of around 3% in the exchange rate of the rupee against the dollar over the last nine weeks.

This is not good news for exporters in the short run, but not necessarily bad news for the economy. Along with high economic growth has come high inflation since December, which has a more adverse impact on India’s export competitiveness than a nominal appreciation in the exchange rate.

In 2009-10, the six-currency trade-based real effective exchange rate appreciated 20%, way more than the less than 5% appreciation in 2007-08 when exporters were pouring into the finance ministry lobbying for sops.

The nominal appreciation in the rupee mitigates the impact of inflation and creates the platform for an increase in the economic growth rate.

Oil makes up around 30% of India’s imports and capital goods another 23%. Over half the imports go into sustaining economic activity and creating the building blocks of future growth. Moreover, the price of the average Indian basket of crude in the first quarter of 2010-11 at $78.2 per barrel was not too far from the highest average price over the last nine years—$82.7 per barrel in 2008-09.

Long term, the current expansion in the current account deficit may or may not have an impact, but in the short run the central bank needs to walk a tightrope between keeping an eye on the nominal exchange rate appreciation and pulling back inflation. More challenging than 2008, perhaps.

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