'Is the current-account deficit growing too big?', The Economic Times, 10 January 2006, by invitation.
Whether a current deficit in the balance of payments viable and whether it is desirable are separate issues. Note that sustained deficits are not necessarily desirable, as we can see from the United States where a deficit of 6 percent of GDP, fuelled by a consumption binge, shows no sign of imploding. Sustaining a deficit is theoretically possible, but only at a progressively higher rate of interest. Normally, the question to ask is whether the activity that is being financed through borrowing is profitable and necessary. In the context of the balance of payments, though, there is also the question of whether the activity is likely togenerate foreign exchange in the future. I shall return to this as it is of the essence. But I have thus far ignored risk. Once lender’s risk enters the picture, the question of viability cannot be disposed off so simply. Lenders remain ever alert to the credit worthiness of their clients. As this diminishes they call in their loans and this precipitates a balance-of-payments crisis. And speculative attacks are not necessarily mounted by steely-eyed bankers alone. We learned to our dismay that they may also be mounted by own our cousins overseas. I am referring to the rapid withdrawal of their deposits by NRIs in July 1991. Of course, railing at the act as treachery would only reveal us as sentimental. Just as the schoolboy’s street cred is defined by the number of marbles in his pocket, a country’s only protection against ‘the market’ is the reserves of its central bank. These are no longer in its vaults, however. They remain invested mostly in US government debt. India’s reserves on December 30, 2005 stood at US $ 143.1 bn. The RBI’s press release of that day also informs us that it is the sixth largest stock of reserves in the world. But then we are also a large country, and the reserves position can fluctuate. We find that by January 7 the reserves had slipped to US $ 137 billion. Nevertheless, they remain large in relation to the current account deficit. For April-September 2005 the latter amounts to US $ 12.9. So you get the picture. What of the reserves in relation to debt? We have numbers only for the medium term here rather then for the absolute present, and they do not evoke pessimism. On March 31, 2005 the foreign exchange reserves of the RBI provided cover of around 110 percent of total external debt outstanding and a ratio of short-term debt to total debt at 6 percent was about the lowest in the developing world. So, the three-percent-of-GDP figure for the current-account deficit per se is a red herring. In mid-1991, when the deficit-GDP ratio had registered this level, the foreign-exchange reserves stood at US $ 1.1 billion. This must give us some perspective. That is, while in 1991 a speculative attack was perfectly rational (though treacherous!), today it would not be. This is reflected in the ten-fold increase in portfolio investment in April-September 2005, exactly as the current account had not only turned red after three years of showing a surplus but was moving rapidly on. As fair weather friends portfolio investors can be trusted to assess your credit worthiness.
As I have stated, a sustainable deficit need not mean that it is desirable to maintain it. We would need to look at it contents. While the merchandise deficit over April-September 2005 has been led mainly by non-oil imports including capital goods, reflecting strong manufacturing growth, POL imports along with that of gold and silver are not far behind. This is our Achilles Heel, and pandered to by policy. Political pricing of oil means that domestic consumption is not dampened in the face of spiralling international prices. Finally, we need to see how the deficit is financed. An increasingly important share of the capital inflows, now making a re-appearance after the late eighties when it had figured prominently, is commercial borrowing. During April-September 2005 this item amounted to 2.8 billion, exceeding FDI inflow. It needs to be watched very carefully. External commercial borrowing had a role in precipitating the East Asian crisis where international banks had first made incredible lending decisions.
The following passage was not in the published version of the article:
So should the competitiveness of India’s exports be raised via policy? Sure. As we are more or less committed to the rupee floating, at least for current account transactions, there is not much scope for use of the exchange-rate mechanism.However, two specific interventions may be considered. Firstly, the cost of capital is high in India in relation to the rest of the world. This immediately affects the competitiveness of India’s exporters. Historically, the real cost of capital has been near zero in much of East Asia. Indian manufcturign has been at a disadvantage by comparison. Secondly, the entire supporting structures for exports need to be scrutinised. This includes both physical infrastructure and procedures in India’s ports. I had had to take a double take before fathoming the comment “Colombo is India’s best port!” made by a student in my class who had been a merchant seaman.