We can’t celebrate India’s small current account deficit: Here’s why

A decade ago, India was one of the ‘fragile five’ economies, with excessive reliance on foreign capital to sustain growth. Its high vulnerability to foreign capital flight and sudden stops had caused excessive foreign exchange volatility as the current account deficit hit nearly 5% of gross domestic product (GDP) in 2012-13. Much water has flowed under the bridge since then.

The current account deficit has narrowed to around 1% of GDP in recent years, and occasionally even lower. Notably, India posted a rare $5.7 billion current account surplus in the first quarter of 2024, the largest since early 2004 in a non-crisis year. While this is good on an external-stability gauge, such low deficit levels have a flip side.

Also read: Why a current account deficit is good for India

From a national accounting perspective, the current account deficit-to-GDP ratio is the difference between domestic saving and investment rates. It is the amount of foreign capital needed to meet the economy’s investment demand. Therefore, a current account deficit adds to the net external liabilities of the economy.

A healthy and sustainable amount of debt is good for growth. Therefore, a current account deficit is neither a curse nor a blessing—only its adequacy as a ratio of GDP is important. And as is the case with any kind of recurrent debt, its sustainability is key.

The standard public debt sustainability framework, when applied to the current account deficit, yields a sustainable level of 2–2.5% of GDP. Even if India’s current account deficit were 2% of GDP, its external stability will not be hurt and net external liabilities would remain stable as a share of GDP.

With the deficit almost 1 percentage point below the sustainable level, there is an opportunity forgone in terms of a potentially higher investment rate. But who exactly is forgoing this opportunity?

The trends among three key economic agents—the general government, households and firms—show firms are to blame. The general government is a net borrower, but its negative savings-investment (SI) gap is now improving from pandemic lows, thanks to fiscal-deficit consolidation alongside a massive capital expenditure programme. 

While its SI gap is still below the pre-pandemic level, further improvement is likely. In other words, the government is rightly creating space for other sectors to increase their investments.

Also read: India’s FDI decline seems easier to explain than reverse

Households are net savers in India, and their SI gap is now reducing, given their focus on building assets such as housing amid limited income growth and rising debt.

Companies used to be net borrowers, but have gradually turned into net savers over the last decade. Their SI gap used to be around -2% of GDP, but has gradually risen into positive territory.

It may not just be a pandemic-related aberration that companies in India are not undertaking enough capital expenditure. There are structural and cyclical reasons to consider, such as the strong rise of the services sector.

Over the last decade, India has added close to $1.7 trillion to its nominal GDP, 52% of which came from the services sector, compared to 11% from manufacturing. Services are far less capital intensive, as they do not require heavy machinery and large factories . Thus, the capital intensity of Indian growth has fallen in tandem.

Even cyclically, the post-pandemic demand for services, both domestic and external, has been much stronger than for manufacturing. There has been a significant growth dividend from the rise of e-commerce, tourism, fintech and global capability centres in recent years.

A booming services sector also leads to a concentration of the economic surplus. The backward linkages of this sector happen to be relatively weak. For each additional dollar worth of output by it, only 30 cents reflects the inputs it absorbs from other sectors in the economy. For the manufacturing sector, in contrast, this proportion is much higher at 73 cents.

Two other intertwined issues behind lacklustre business capital expenditure are the post-pandemic weakness in low-end manufacturing and excess foreign capacity, which has resulted in stiff competition.

Industrial production data shows sectors (mostly low-tech) that account for 15% of manufacturing output have still not reclaimed their pre-pandemic output. In some of these, such as leather and apparel, production is still down by more a fifth from their pre-pandemic levels.

Excess capacity, such as in China, could also be restraining manufacturing-sector capex. India’s trade deficit with China has widened to around $100 billion, with $40 billion added over the last three years. 

Also read: India’s trade to improve amid easing global challenges: Economic Survey

This coincides with the yuan depreciating on a real effective basis due to relatively low inflation in China and a weakening exchange rate. Chinese goods have become cheaper, especially in low-tech categories.

To sum up, a complex demand problem underlies India’s weak business capital expenditure, which has kept the current account deficit much below the sustainable level. There is no single solution, but the need for a higher investment rate is undebatable. India’s capital stock per capita is lower than that of its peer economies.