I see a number of reports these days that express concern about the sharp rise in India's current account deficit (the summary of trade flows of goods and services including remittances from Indian migrant workers abroad). Most of these reports call for active policy initiatives to bring the deficit down to more "sustainable" levels.
A number of them recommend tighter monetary policy, possibly a series of hikes in key interest rates, to harness growth and compress imports. I honestly don't know what to make of these prognoses.
In my scheme of things, a widening current account deficit when foreign currency reserves are exceptionally high should actually be a good thing for a growing economy. So I keep wondering what the fuss is all about.
Let's look at some of the facts. It seems certain that in this fiscal we are likely to run up the largest current account deficit in recent history. It is also true that our foreign exchange reserves are much more than adequate to fund this deficit.
Under the most conservative assumptions for inflows like export earnings and remittances and the most aggressive assumptions import payment outflows, a current account deficit of $20-22 billion is likely for 2005-06. With the current level of reserves of $136 billion, we should be able to fund six of these deficits and still have some dollars left.
To get a better handle on this issue, it might make sense to figure out the genesis of this rising current account deficit. Basic macroeconomics tells us that the current account deficit equals the excess of domestic investment over savings plus the government deficit. This is a "truism" that comes out of manipulating some pretty basic equations that describe the economy, which means they must hold under all circumstances.
Since the government deficit is unlikely to have ballooned much over last year's level (I would believe that the consolidated Centre-state deficit would have reduced a bit this year), the key driver for a rise in the current account would have to be a rise in investment.
In short, the rising current account deficit is telling us that the economy is bang in the middle of an investment recovery and domestic savings are insufficient to fund it. We are thus dipping into our fund of reserves to do so. We would perhaps need fewer dollars to fund this recovery if commodities like oil had been cheaper. High oil prices have simply increased the size of the draft of the deficit.
There are a couple of things about this investment recovery that I would like to emphasise. For one, a significant fraction of new investments coming on stream are being funded through foreign direct investments. Over the last couple of years, India's corporate debt has become attractive in international markets and a fair number of companies are tapping global markets to fund their capacity expansion programmes.
The bottom line is that some of this expansion in the current account is "self-financing" if you look at it from a macro perspective. While up-tick in the investment cycle is leading to outflows on the current account, this is being compensated by capital flows that support this investment.
In fact, despite the sharp rise in the current account deficit and outflows on this count, reported foreign exchange reserves have actually grown this year by about a billion dollars. This number is relatively small because the RBI has incurred huge "paper" (valuation) losses on its non-dollar asset holdings in its reserve portfolios. This has been the result of the dollar's appreciation against other currencies. In the first quarter of this fiscal alone, these valuation losses added up to over $4 billion.
If the reported foreign exchange reserves are adjusted by this quantum of paper losses, the actual growth in reserves, which represents the surplus of inflows over outflows, is a good deal more. Even going by most conservative estimates, the surplus would have to be at least $5 billion.
Let me do some more "back-of-the envelope" calculations. The first quarter of the fiscal (the only bit of data available for this year) shows a current account deficit of $6.2 billion.
Let me assume that for the first half the deficit was $13 billion. If actual reserves went up by $5 billion in this period, then gross capital flows into the economy would have to add to $18 billion to yield this surplus. Of this, only about $3.5 billion would incidentally be portfolio investments.
The bottom line is that we haven't yet dipped into our pool of reserves to fund growth despite going through a singularly rough year on the trade front. This is an indication of the strength of the capital account and should give the forex market some comfort.
In any case, even if capital flows were to slow down temporarily, dipping into reserves to keep our growth engine going might not be a bad idea at all. As long as growth is on track, capital flow will follow.
Thus, there are two sets of policy in the face of this rise in deficit. The first is to go weak at the knees and try and compress imports as much as possible by trying to harness economic growth.
An obvious way to do this is to go in for a series of rate hikes, which drag demand down. The second is to brazen it out and let the current account slip a little and make sure that the growth engine keeps ticking. I just hope that the dogma of "sustainable" current accounts won't lead our policy makers to choose the first option.
The author is chief economist, ABN Amro. The views here are personal.
