It is generally well known that India is one of the few countries with both a current account deficit and a fiscal deficit. However, the extent of deterioration in both is a matter of deep concern. According to the Reserve Bank of India's recent data on balance of payments (BOP), the current account deficit (CAD) rose to 4.3 per cent of the GDP during the third quarter (October-December 2011) of last year, sharply higher than the 2.3 per cent during the same period in the previous year. The sharp spike might have come as a surprise, but there was enough evidence of the deteriorating trend. Indeed, the Prime Minister's Economic Advisory Council which projected the CAD to be around 3.6 per cent by March 31, is just one of the many official forecasters which had anticipated a deterioration in the current account of the BOP. There is an expectation that a jump in the earnings from invisibles during the last quarter would help in moderating the CAD. Even so, its “comfort” levels — variously estimated at between 2.5 and 3 per cent — appear to be as elusive as ever. More ominously, during the third quarter, for the first time since 2008-09, capital inflows were not sufficient to bridge the current account deficit necessitating a drawdown of foreign exchange reserves by nearly $13 billion.
India's fiscal deficit projections have gone haywire with the government revising last year's budget estimate to 5.9 per cent from 4.6. The recent budget hopes to bring it down to 5.1 per cent by March 2013, a level which is still considered very high. The co-existence of a large fiscal deficit with the CAD has invited comparisons with the period preceding the 1991 crisis, when the twin-deficits apparently presaged bad times ahead. Such comparisons can be very superficial however. By any yardstick, the Indian economy is in a much better shape today. However it is good to realise that the co-existence of the two deficits has made the economy more vulnerable to external shocks. For instance, high petroleum prices have inflated the import bill and contributed to merchandise trade deficit besides straining the fiscal situation. Policymakers face quite a challenge in minimising the deleterious consequences of the twin deficits. The RBI might be reluctant to cut interest rates if it is not satisfied with the progress of fiscal consolidation. As recent data indicate, foreign capital flows might be even less forthcoming, given the twin-deficits. All these, in turn, will have wide ranging implications for the macro economy, including exchange rate policy.