India’s external economy, for long considered to be the one bright spot in the entire macro economy, has been repeatedly coming under stress recently. While still not a cause for alarm, the latest balance of payments (BoP) data released by the Reserve Bank of India on Friday is deeply disquieting. The current account deficit (CAD) — the sum of the balance of trade and “invisibles” including earnings from software exports and workers’ remittances — has risen to the highest ever level of 4.5 per cent of GDP, or $21.7 billion, during the fourth quarter of fiscal 2011-12. This is sharply higher than the 1.3 per cent recorded over the same period in the previous year. That in turn has pushed up the CAD for the whole year to $78.2 billion, or 4.2 per cent of GDP, which is again a record. Any hope of containing the CAD to within reasonable levels depends on global commodity prices as well as economic activity in India. Although falling petroleum prices have afforded a measure of relief, the depreciating rupee has neutralised some of the gains. The economic slowdown, though an undesirable feature from the growth perspective, can also moderate the CAD by limiting the import bill relating to capital and intermediate goods.
The falling rupee can discourage imports and, over the medium term, at least, boost export competitiveness, consequently shrinking the CAD. That has not happened so far because some imports, notably petroleum, are inelastic. Also, exporters have not derived the full benefit of the rupee depreciation mainly because of lower demand from the principal markets of the European Union and the U.S. Obviously, for policy makers, the real challenge is to fund the CAD on a sustainable basis. In sharp focus is the fact that the widest ever CAD has kept India’s BoP in negative territory for the second quarter in a row, forcing the RBI to dip into its foreign exchange reserves. Once again, the BoP data highlights the huge risks in depending on volatile portfolio capital flows. A related development contributing to the economy’s vulnerability is the high level of external debt, especially of the short-term variety. Key vulnerability indicators like the debt-GDP ratio and debt-service ratio deteriorated during last year. However, despite being aware of the serious pitfalls, the government and the RBI have shown a penchant for short-termism. Recent relaxation of rules relating to external commercial borrowings and greater incentives for non-resident Indians and foreigners to invest in government paper can all be justified only on the ground of expediency. Such steps go against the grain of prudent policies that have stood the economy in good stead, until recently.