Why India needs stable capital flows

In Context

• As per the RBI’s quarterly statistics, the current account deficit (CAD) widened to 4.4 per cent of GDP in the second quarter of 2022-23, down from 2.2 per cent in the preceding quarter.

About the “Current Account”

• A nation’s Current Account maintains a record of the country’s transactions with other nations. It comprises the following components:
  • trade of goods and services,
  • net earnings on overseas investments and net transfer of payments over a period of time, such as remittances
• This account goes into a deficit when money sent outward exceeds that coming inward.
• Calculation:
  • It is measured as a percentage of GDP.
    • Trade gap = Exports – Imports.
    • Current Account = Trade gap + Net current transfers + Net income abroad.

About Current Account Deficit (CAD)

• Meaning:
  • When the value of the goods and services that a country imports exceeds the value of the products it exports, it is called the current account deficit. 
• Twin deficits:
  • CAD and the fiscal deficit together make up the twin deficits – the enemies of the stock market and investors. 
• Different from the Balance of Trade:
  • It is slightly different from the Balance of Trade, which measures only the gap in earnings and expenditure on exports and imports of goods and services. 
  • Whereas, the current account also factors in the payments from domestic capital deployed overseas. 
    • For example, rental income from an Indian owning a house in the UK would be computed in the Current Account, but not in the Balance of Trade.
• Significance:
  • Country’s trade and transactions:
    • If the current account – the country’s trade and transactions with other countries – shows surplus, that indicates money is flowing into the country, boosting the foreign exchange reserves and the value of rupee against the dollar. 
    • These are factors that will have ramifications on the economy and the stock markets as well as on returns on investments by people.
  • Indicator of Economy:
    • CAD may be a positive or negative indicator for an economy depending upon why it is running a deficit. 
      • Foreign capital is seen to have been used to finance investments in many economies. 
      • It may help a debtor nation in the short-term, but it may worry in the long-term as investors begin raising concerns over adequate return on their investments.

Characteristic features of India’s CAD

• India’s CADs have both desirable and undesirable components: 
  • A desirable deficit is a natural reflection of rising investment, portfolio choices and the demographics of the country. 
  • However, large and persistent CADs can be undesirable if they reflect bigger problems such as poor export competitiveness and are financed by unstable financing.
• The countercyclical nature of India’s CAD is a matter of concern: 
  • Research suggests that the country’s CAD rises when output falls rather than when demand rises, indicating the dominance of external shocks. 
    • For instance, if oil prices rise, and as oil is an input in the production process, it raises the cost of production and leads to a fall in economic growth. 
    • In this case, CADs rise with falling growth due to both the inelasticity of oil import demand as well as its major share in India’s total imports.
• Risks associated with financing:
  • Large and persistent CADs expose India to the risks associated with its financing. 
  • Economic theory suggests that if CADs can be financed by stable capital inflows, such as FDI inflows, they are desirable as they are less prone to capital flight. 
  • However, if deficits are financed by volatile capital flows such as portfolio flows, there may be a cause of concern. 
    • Portfolio flows are capricious and more susceptible to reversals in case of any global financial shock. Hence, the composition of financing is crucial. 
  • Current example:
    • While FDI inflows were enough to finance the deficit in 2021-22, these inflows have been weak in the current fiscal year. 
    • FDI and portfolio inflows each only financed about 18 percent of CADs in the second quarter of 2022-23. So, there is a financing issue. 
• Counter-balancing Remittances:
  • Remittances and services exports have provided a counter-balance to rising merchandise trade deficits.
  • While capital flows are pro-cyclical and react negatively to contractionary monetary policy by the Fed, remittances have exhibited remarkable stability.

Suggestions & way ahead

• Controlling negative spillovers from global changes:
  • Over the medium term, policymakers need to arrest the negative spillovers from the slowdown in global trade on merchandise exports. 
  • Further rate hikes by the US Fed may lead to capital outflows leading to additional exchange rate market pressures. 
    • This could be challenging in the current situation as a weaker currency, coupled with a sticky import basket will lead to imported inflation. 
• Making exports competitive:
  • Policy measures thus must facilitate exports by focusing on structural reforms to improve trade competitiveness, alongside which the government must sign free trade agreements.
• Ensuring stable financing:
  • India is currently facing the twin-deficit problem of high fiscal and CADs. 
  • While aggressive fiscal consolidation may be undesirable in the face of rising fears about a global slowdown, a comfortable external environment can be maintained by ensuring stable financing, along with using exchange rates as a shock absorber to weather the adverse global economic situation.