Losing sight of the external sector

The current, and entirely justified, policy focus on reining in inflation has worryingly diverted attention away from other critical areas of the economy, such as the external sector. India's deft external sector management has ensured stability of the macroeconomy during the major global financial crises in recent years. In fact, India's measured approach to capital account convertibility has won all-round praise. The strategic changes introduced in the early 1990s covering trade, foreign investment, and the management of exchange rate and reserves have served the country well. Of late, however, some signs of weakness have shown up, and they need to be addressed. To be sure, there are huge positives. For instance, the recent export performance has been exemplary despite the global slowdown. Exports grew by 38 per cent to touch $246 billion in 2010-11. The momentum has continued into this year. With exports clocking a growth rate of 46 per cent in the first quarter, the government has raised the target to $300 billion for 2011-12. While imports too have been robust, the strong export growth has caused the trade deficit to narrow to $105 billion in 2010-11 from $116 billion in the year before.

On the negative side, the widening current account deficit that has led to greater dependence on riskier capital flows to finance it, and the dwindling foreign direct investment flows pose special challenges. Although the current account deficit has been contained at the prudential limit of 3 per cent of the GDP in 2010-11, invisible receipts have been coming down. From $91.6 billion in 2008-09, they have dropped to $79.99 billion in 2009-10 and the figure for the first nine months of 2010-11 was $63.18 billion. Equally worrying is the sharp fall in the non-debt-creating foreign direct investment from $34.17 billion in 2009-10 to $27 billion in 2010-11. Portfolio flows have declined marginally but the inflows by way of external commercial borrowings and foreign currency convertible bonds (FCCB) have increased dramatically. Official policy has been to encourage non-debt-creating flows since these investors are unlikely to pull out for short-term considerations. According to a recent UNCTAD report, India has fallen behind many countries among the world's top investment destinations. India's forex reserves are yet to return to the pre-crisis levels, while the current account deficit has more than doubled and the capital flows have become more volatile. None of these might pose immediate threats to the macroeconomy but they do reveal incipient weaknesses that cannot be ignored.

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