Financial Express, February 27, 2013

Current account deficit worries

 In recent weeks, the Governor of the Reserve Bank of India, Duvvuri Subbarao, has twice highlighted the nation’s current account deficit (CAD) as a cause for concern. The CAD is basically the difference between what is earned on selling goods and services to foreigners and what India pays for foreign goods and services, and it has recently hit record levels—over 5% of GDP. The CAD is typically offset by foreign capital coming into India. Why should a high CAD be a cause for worry? 

The RBI Governor highlighted several concerns. At the G20 Finance Ministers’ meeting, he said, “There are a number of risk factors for inflation. The most important is the current account deficit.” A few days earlier, he had stated, “We would not worry if the widening CAD is on account of the import of capital goods, but here it is high on account of the import of oil and gold. The other concern is the way we are financing it. We are financing our CAD through increasingly volatile flows. Instead, we should ideally be getting as much of FDI as possible to finance the CAD.”

What is the possible reasoning behind the Governor’s statements? It is useful to begin with some basic accounting. Macroeconomic balances imply that the CAD is equal to the difference between domestic savings and investment plus the government deficit. Hence, an increasing CAD can reflect a higher fiscal deficit, an increasing shortfall of domestic savings, or both. In India’s case, it has been both. Domestic private savings have fallen as a percentage of GDP, and the fiscal deficit has gone up. It is important to realise that the CAD is a symptom of more basic factors that deserve attention. A high CAD is not bad in itself: it just signals possible underlying problems.

The problems are poorly managed government spending and taxes, high inflation (and high inflation expectations), and a strong perception that government policies are unfavourable for future growth. The last is based on policy inaction as well as evidence of corruption. These problems deserve focus, not the CAD per se.

Turning to the RBI Governor’s statements, why should the CAD be a risk factor for inflation? If the economy were overheating, and pulling in foreign investment for that reason, this statement might make sense—again, the CAD would be a symptom not a cause. But that does not seem to be the problem, unless India’s potential growth rate has fallen more than policymakers admit. If foreigners were unwilling to finance the CAD, and the Indian rupee had to depreciate, pushing up the domestic price of inelastic imports such as oil, that could fuel inflation in the short run (though not in the long run, unless the RBI made a monetary accommodation). But interestingly, after a temporary pause, foreign investment into India has been strong.

Subbarao’s second point was that foreign investment is of the wrong kind, “volatile” portfolio flows instead of FDI. A related concern was that the CAD itself is of poor quality—fuelled by imports of gold and oil rather than capital goods. This leads back to poor inflation management (people are buying gold as an inflation hedge) and poor economic management (lack of an effective energy policy and lack of confidence for private industrial investment in India). His main point, though, seemed to be that portfolio flows are volatile and therefore bad.

To the extent that portfolio flows bring in foreign capital, they are as good as FDI—domestic firms receiving foreign portfolio flows may be encouraged or enabled to make real investments themselves. If this link is absent, it points again to poor domestic economic conditions. Foreign portfolio flows could be contributing to an asset bubble, but volatility seems to be a red herring. My ongoing research with Ila Patnaik and Ajay Shah suggests that such flows do not create wild swings in the domestic stock market, or harm domestic investors at the expense of foreigners. Separately, I have not seen concrete evidence that domestic stock market movements have much impact on India’s real economy.

In fact, any kind of equity investment involves risk sharing, and in that sense it is good for the recipient. At worst, foreigners exit and the currency depreciates: India can still pay its bills. Problems arise much more if the CAD is financed by borrowing on terms fixed in foreign currency, especially at short maturities—that can create a crisis. The real issue, therefore, is what is happening to India’s external debt stock, and its maturity composition. This is where RBI should be focusing, in addition to domestic monetary policy. Unnecessarily worrying about volatility of portfolio flows (or of the exchange rate) is just a distraction. Meanwhile, the biggest problems lie beyond RBI’s control: in the government’s management of revenue raising, spending, and the conditions for private sector investment. FDI is good, but so is domestic investment. The national government needs to do its job better. If it does, the CAD will take care of itself.