Higher rates, weaker rupee can restore India’s trade balance

India’s external balances are facing pressure from everything that is going on around the world: elevated commodity prices, high inflation, monetary policy tightening and slowing growth. India’s current account deficit likely widened to about 5% of gross domestic product (GDP) in the quarter ended September on the back of elevated oil imports and slowing export volumes. This is double the 2.5% level that is considered sustainable.

Every external deficit also has a domestic angle to it. A simple macroeconomic identity shows that the current account deficit is the difference between investment and the saving rate. Intuitively, when investment outpaces saving, external resources fill the gap.

So, is investment rising quickly? Perhaps not. Even though some investment indicators are rising, this does not signal the start of a new capital expenditure cycle. Measures of new investment intentions remain weak. Rather, it is replacement capex spending—bundled up wear-and-tear of the pandemic period.

Which brings us to saving. We believe that India’s saving rate has fallen, and that lies at the heart of the current account deficit widening to unsustainable levels. Saving comes in three parts: public sector, private household, and private corporate saving.

Public sector borrowing is higher today than in the pre-pandemic period. Household financial saving rose during the lockdown period, but fell sharply thereafter to below pre-pandemic levels. Lower bank deposits drove much of the fall, and the deposit-to-GDP ratio has fallen further in fiscal 2022-23, contributing to the sharp widening of the current account deficit. What can be done to raise the saving rate?

Policy rate hikes can help raise private sector saving in at least three ways. One, if rate hikes make households believe that inflation will fall over time, they may postpone some consumption. Two, higher rates can disincentivize household borrowing. Three, higher deposit rates will increase the opportunity cost of money, thereby incentivizing saving.

But it is not all so simple. There is another offsetting impact of higher interest rates. To the extent they slow growth and incomes, they could lower what is left for households to save.

There is a similar dilemma when trying to increase public saving. If fiscal consolidation is led by expenditure cuts, it will be negative for GDP growth and incomes. Already we are seeing the narrowing of state deficits being led largely by weak expenditure, particularly weak state capex.

This is where another tool could help: the rupee. Letting the currency depreciate gradually would likely make exports more competitive, lending a helping hand to India’s GDP growth. Exports, particularly high-tech exports, have been an impressive driver of economy’s post-pandemic recovery. Nurturing the sector during volatile times is likely to be a good idea. And, what is special about forex depreciation is that it is supportive of growth while reducing imports. By simultaneously making exports competitive and imports expensive, it tends to lower the trade deficit over time.

From this perspective, a combination of higher rates and a weaker rupee is likely to be the optimal response to the ongoing storm, in our view.

The Reserve Bank of India (RBI) started hiking rates in May 2022. By end-September, it had raised the repo rate by 190 basis points. The rupee remained fairly stable for much of this time, led by RBI’s forex sales. It was only in September that RBI moved to a two-pronged strategy of higher rates and a weaker rupee. As such, we think India is now in the midst of an optimal policy response.

The challenge will be to continue on that path. Real deposit rates are still negative and the trade-weighted real effective exchange rate (REER) has not weakened at all since May.

When will the current account deficit fall from 5% to the sustainable 2.5% level? Several different scenarios could play out. We employ four sensitivities—the impact of rate hikes on GDP growth, the impact of GDP growth on imports, and the real exchange rate elasticity of both exports and imports—to work out the possibilities.

If RBI delivers another 50 basis points repo rate hike (taking it to 6.4%) and the REER weakens by about 5%, the sensitivities suggest that, all else remaining unchanged, the current account deficit can narrow from 5% of GDP to about 3.5%. This means that about 60% of the adjustment could be achieved. The remaining 40% could happen if the global environment changes (for instance, if commodity prices fall quickly).

In a separate scenario, larger rate hikes (about 60 basis points more than our forecast, taking the repo rate to 7%) and a larger REER adjustment (of about 10%) could achieve 100% of the current account deficit adjustment.

These scenarios are indicative and admittedly come with large error bands in a highly volatile global setting. But they offer a sense of how important the two-pronged strategy of higher rates and a weaker rupee is in terms of restoring India’s balances.

Pranjul Bhandari is chief India economist at HSBC.