Analysis of India's Current Account Deficit

India: Rise of the Elephant ?

Assessing India’s Current Account and Macroeconomic Vulnerabilities

Submitted by Radhika Kapoor

IPS 2016

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Table of Contents

Introduction ...................................................................................................................................... 3 I. Overview of India’s Current Account (CA) and other Macroeconomic Indicators ..................... 5 II. Analyzing the Current Account Deficit ..................................................................................... 9

A. Domestic Perspective based on National Income Accounts ................................................... 9

B. International Perspective based on Trade Flows in Goods and Services:.............................. 19

C. International Perspective based on Global Capital Markets: ................................................ 25 III. Current Account Deficit – Assessing Vulnerabilities .............................................................. 30 IV. Conclusion and Policy Recommendations .............................................................................. 34 Bibliography ................................................................................................................................... 36

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Introduction

India is the second largest country in the world in terms of population and seventh largest in

terms of geographical area. Post its independence from British colonization in 1947, India

adopted a mixed economy model with a major role for state in industrial production and an

emphasis on import substitution. While both public and private sectors coexisted, a central role

was assigned to the state’s planning machinery for resource allocation across sectors. The stated

primary objectives of the planning process were economic growth, social justice and self-

reliance (Indira Gandhi Institute of Development Research, 2006). However, this model put

India at a disadvantage in the post war expansion in international trade and investment flows, as

the GDP (Gross Domestic Product) growth in the country remained at about 3-4 per cent per

annum for several decades. In the wake of a fiscal and balance of payment crisis in 1991, the

country undertook a wide range of economic and structural reforms to gradually open up the

financial account to allow for international investment. The model was better known as India’s

Liberalization, Privatization and Globalization (LPG) model of economic reform. Reforms such

as de-regulation of industries with the abolition of ‘licence raj’, elimination of import quotas,

reduction in import tarrifs, permitting foreign holdings in several industries, and gradual

liberalization of the financial sector were undertaken to boost the growth in the economy. The

country also maintains a unified market determined managed float exchange rate regime since

1993. India is now the world’s tenth largest economy by nominal GDP , is poised to become a

USD two trillion economy in 2014 (IMF World Economic Outlook, 2014).

India’s GDP was growing at an average of 8.3% from 2003-2010, propelling it out of the

global financial crisis in 2008-09. However, after having achieved 10.3% GDP growth in 2010,

India’s growth slowed down drastically to below 5% in 2012 and 2013. The balance of payments

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situation also worsened in these years, with the CA (Current Account) deficit widening to 4.92%

of GDP in 2012, fiscal deficit of 8% in 2011, public debt of 67% of GDP in 2011 and 2012, high

inflation of 9.3% in 2012, and a nominal depreciation in exchange rate all of which are atypical

among emerging markets. Combined with these were problems such as stalled infrastructure

growth, supply bottlenecks, delayed project approval and implementation, heightened political

uncertainty and policy paralysis(IMF Staff, 2013). These factors caused foreign direct

investment (FDI) fall by 21%, according to the Ministry of Commerce and Industry (Wall Street

Journal, 2013). In 2014, the country witnessed a major change in political leadership and voted

to power the opposition party BJP (Bhartiya Janta Party) with an outright majority—282 of the

543 elected seats in Parliament’s lower house (The Economist, 2014). The new Prime Minister,

Mr. Narendra Modi, a pro-business proponent, has revived investor confidence in the country.

The International Monetary Fund (IMF) in October 2014 raised its medium-term assessment of

the Indian economy, and said that the post-election recovery of confidence in India provides an

opportunity for the country to embark on much-needed structural reforms in areas such as

education, labour and markets to improve competitiveness and productivity (Mishra, 2014).

However, the question remains “What must India do to get back on its ambitious growth

trajectory?”

With this as the context, this paper aims to assess and discuss the CA and the underlying

macroeconomic vulnerabilities of India as it prepares itself to traverse a more sustainable path of

growth. Section I provides an overview of current account of India, highlighting the broad

trends. Section II analyzes the CA from 3 broad perspectives to understand the causes of the

deficit, followed by Section III which describes the vulnerabilities and their underlying reasons

and effects. Section IV is the concluding section with results and policy recommendations for

India to sustain a high growth trajectory and sustain its CA deficit.

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I. Overview of India’s Current Account (CA) and other Macroeconomic Indicators

1. India’s current account deficit widened from 0% of GDP to 4.92% in 2007 of GDP in

2012, getting investor community across the globe concerned. While India’s average

current account deficit for the period

2005-2013 was 2.3%, the current

account deficit for the year 2012

was abnormally high at 4.92%,

which for developing and

EMC(Emerging Market Countries)

as a rule of thumb must not exceed

3-4% of GDP. Investors felt that

India was vulnerable to investor pull out since the risk capacities of the community as a

whole had declined post the recession. The unsustainable current account deficit levels in

2012 led to the much expected sharp reversal of the current account in 2013 to - 2.62%

(Chart1)

2. Balance of payment pressures intensified for India during the years 2012 and 2013

because of both external shocks (tightened global liquidity) and domestic

macroeconomic vulnerabilities. India was faced with significant portfolio debt outflows,

and depreciating pressures on currency, equity, and bond markets. Investor concerns were

amplified by India’s persistently-high inflation, weakening growth prospects, large current

account and fiscal deficits, and domestic political uncertainty. (IMF Staff Report, 2014)

3. Following the slowdown induced by the global financial crisis in 2008-09 when the

nominal GDP growth slumped to 3.9% of GDP , the Indian economy responded

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Chart 3. Growth Trends in BRICS Nations from 2005-2013

strongly to fiscal and monetary stimulus and achieved a growth rate of 8.6 per cent and

9.3 per cent respectively in 2009-10 and 2010-11. However, India’s GDP growth as a

whole has been declining consistently since 2011 to an existing level of 4.5% in 2013 (Chart

2). The growth figures in the recent

few years are dismal considering

that the country was growing at an

average rate of 8.3% from 2003 to

2010. Part of the domestic

slowdown is obviously the outcome

of a sluggish global recovery.

Global growth fell from an annual average of 4.8 percent during 2003-07 to an average of 2.9

percent during the subsequent 5-year period (2008-12). (IMF Working Paper, 2014)

4. While the GDP growth in the BRICS (Brazil Russia India China and South Africa)

nations was mostly upward trending till 2007, all the BRICS nations suffered an

economic slowdown during the global financial crisis of 2007-08. India and China’s

growth dipped first in 2008 followed by that of Russia, Brazil and South Africa. By the

end of 2010, most BRICS countries recovered from the recession but had lower GDP growth

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than before owing to sluggish global growth. (Chart 3) Today, China’s growth is highest

among those who are a part of BRICS, followed by that of India.

5. India’s persistently growing inflation levels from 3.8% in 2003-04 to 10.9% in 2013-14

suggested weaker macroeconomic fundamentals (Chart 4). High inflation could be partly

attributed to supply side inflation. Food inflation due to higher international commodity

prices of certain pulses and proteins was feeding into wages, increase in oil prices were

increasing input costs across the table, depreciation of the Indian rupee, among others were

all contributing to the increase in inflation. Further, during the phase of large and increasing

capital flows – from 3% of GDP in 2005 to 7.6% of GDP in 2007 (Table 3) in the country –

the Reserve Bank deployed a range of instruments to manage these capital flows, including

sterilized interventions. However, the growth in foreign capital during the period was

mirrored in growing inflation (6.4% in 2007).

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Table 3. Balance of Payments

Source: IMF Staff report (2013-14) and RBI

6. Tight monetary policy, with nominal as well as real lending rates increases, especially

beginning early 2012, slowed the pace of investment activity and economic activity as

expected, while controlling inflation. While expansionary monetary policy supported

growth during 2008-10, tight monetary stance post 2010 to control inflation (12% in 2010)

contributed to the slowdown in the subsequent years.

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II. Analyzing the Current Account Deficit

India’s Current Account (CA) has remained in deficit during the period 2005-2013 with an

average deficit of 2.3% of GDP, the exception to which was 2007, where the CA balance was

approximately 0% of GDP (Chart 1). 2007 onwards the CA deficit has been widening. The CAD

(Current Account Deficit) broadened to an unsustainable level in 2012 at 4.92% of GDP, which

as per the rule of thumb for the EMCs and developing countries would see a reversal beyond 3-

4% of GDP. As expected, the reversal happened in 2013, and CA deficit narrowed down to 2.3%

of GDP. It is important to analyze CA balance in this economy can be understood using the

following three perspectives:

A. Domestic Perspective based on National Income Accounts

1.1 Current Account deficit is driven largely by the fall in domestic savings from 2005 to

2013, since the investment levels remained largely unchanged during the period. Gross

national savings in India have fallen 3% of GDP over the period 2005-2013 from 33.4% to

30.4%, while the total investment in 2013 remained at 34.8% of GDP which is approximately

same as 2005 levels of 34.7% of GDP. This fall in savings is a result of many factors such as

fall in public sector savings to half from 2.4% in 2005 to 1.2% in 2013, fall in corporate

private savings by 0.4% from 7.5% to 7.1% and fall in household savings of 1.6% from 23.5

% in 2005 to 21.9% in 2013. (Table 4)

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1.2 Corporate profitability suffered due to higher nominal interest rates, which resulted in

corporate savings falling by 2.3% of GDP from 2007 to 2012, while corporate

investment decreased by an alarming 8.1% of GDP during this period (Chart 5).

Corporate savings fell from 9.4 percent of GDP in 2007-08 to 7.1 percent in 2012-13, while

corporate investment fell even more

from 17.3 percent of GDP to 9.2

percent (Table 1). Since 2007,

corporate investments have been

falling far more than corporate

savings due to policy bottlenecks -

such as obtaining environmental permissions, fuel linkages, or carrying out land acquisition -

led to stalling of a number of large projects, which may in turn have discouraged new

investment (Government of India, 2013).

1.3 Negative real deposit rates, along with the growth slowdown, seem to have contributed

to the decline in household financial savings accompanied by a switch towards savings

in physical assets (gold and property). Financial savings (gross) of households fell from

15.5 percent of GDP in 2007-08 to 10.8 percent in 2012-13, reflecting decline in the major

constituents – bank deposits, life insurance funds, and shares and debentures (Table 4) (IMF

Working Paper, 2014)

1.4 India experienced the crowding out of the private sector due to large increase in fiscal

deficit, huge government borrowing requirements and negative real interest rates

(Chart 6) during the period 2008-13, undermining growth in the private sector

investments, increase in their savings. This can be seen from the Table 4, where the

household financial savings available for the private corporate sector decreased from 6.3% of

Chart 5

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Table 4. Savings and Investment (Source: IMF staff report and RBI)

GDP in 2005 to 1.7% of GDP in 2008, while decreasing further up to 0.2% of GDP in 2012.

This was another reason for very low levels of GDP growth 2011 onwards.

1.5 India’s CAD throughout the time period (2008 to 2013) reflects the twin deficit

phenomenon (Fiscal and CA) (Chart 7). The CAD average during the period was 3.2% of

GDP while the average fiscal deficit was 8.4% of GDP. The fiscal deficit of 10% of GDP in

Chart 6: Deposit Rates (Source: IMF Working Paper 2014)

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2008 was a huge source of concern for the foreign investors investing in India’s growth story

due to which the net portfolio investment dropped by 54.6% in 2008 from the previous year

(Table 4). Similarly in 2009,

the net FDI (Foreign Direct

Investment) inflows fell 19%

from 2008 levels. The

widening of the fiscal deficit

in 2008 and 2009 was

reflective of the fiscal

stimulus spending of 5.3% and 5.2% of GDP respectively to counteract the recessionary

impact of the financial crisis. The fiscal stimulus also implied higher government

consumption coupled with higher import consumption of oil and gold (primarily). However,

this also led to inflationary pressures. It is evident that the CAD is fueled by fiscal deficit till

2008 where the average private saving investment balance from 2005 to 2008 is 4.6%;

however a fall in private savings from 2010 onwards with investment levels remaining pretty

much constant led to widening of the CAD till 2012. Overall, the private savings investment

gap (Sp-I) failed to offset fiscal dissavings. This resulted in the twin deficit phenomenon of

CAD and Fiscal deficits.

Year

Current

Account

Fiscal

Balance

(T-G)

Primary

Deficit Sp-I

Real

GDP ICOR Investment

Saving

2006

-

1.0%

-

5.1% 0.3% 4.1% 9.3 3.8% 35.7% 34.7%

2007 0.0%

-

4.0%

1.2% 4.0% 9.8 3.9% 38.1% 36.8%

2008

-

2.5%

-

8.3% 3.3% 5.8% 3.9 8.8% 34.3% 32.0%

Table 5. Fiscal Balance 2006-2013 (Source: Fiscal Monitor, World Bank, Global Finance, IMF)

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2009

-

1.9%

-

9.3% 4.5% 7.4% 8.5 4.3% 36.5% 33.7%

2010

-

3.2%

-

6.9% 2.4% 3.7% 10.3 3.6% 36.8% 34.2%

2011 -

3.3% -

7.6% 3.2% 4.3% 6.64 5.3% 35.0% 30.8%

2012

-

4.9%

-

7.5% 2.9% 2.6% 4.7 7.6% 35.6% 30.8%

2013

-

2.6%

-

6.9% 2.2% 4.3% 4.4 8.0% 35.0% 30.6%

1.6 Increasing ICOR (incremental capital output ratio) from 3.8 in 2006 to 8 in 2013

suggests lower productivity of investment (Table 5). Marginal productivity of capital was

therefore falling, specifically in the years 2008-09 and 2012-13. Global average of 3 is the

norm.

1.7 India has been following a cyclical fiscal policy over the period of 2006 to 2013 which

showcases its fiscal imprudence. In high growth times of 9.2% and 9.8% growth

respectively, the government was running dual deficits (primary and fiscal balance)

instead of saving for times of lower growth (Chart 8 and Table 5). The huge deficits

implied that the government was providing arguably a larger than necessary fiscal stimulus,

which manifested into inflation. Government expenditure increased 0.5% of GDP from

26.5% in 2006 to 27% in 2013, while the government revenues decreased 0.8% from 20.3%

to 19.5% of GDP. The quality of the fiscal stimulus, with its focus on revenue

expenditure/tax cuts and stagnant capital outlays, added to demand pressures. These demand

pressures were mirrored in high inflation; and, negative real deposit rates, on the back of high

inflation, contributed to higher gold imports and higher CAD. (Mohan, 2014) Primary

deficits were driving fiscal deficits, while interest rate payments, averaging at 4.5% ,

decreased from 4.8% in 2005 to 4.6% in 2013, with debt levels falling from 77.1% to 61.5%

over the time period (Table 5) . Twin deficit is worrisome as foreign capital flows are

financing the fiscal deficit and current government consumption. The greater the extent to

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which foreign capital flows fund current consumption spending rather than productive

investment, the greater the future economic burden of repaying foreign debt.

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1.8 An adverse consequence of the growth slowdown after the withdrawal of the stimulus

was lower-than-targeted tax and non-tax revenues, which worsened the fiscal condition

of the country with fiscal deficits ranging from 6.17% in 2006 to 10% in 2008,

moderating to 7.2% of GDP in 2013. This suggests that the government revenue is not

enough to offset the government expenditure, which is evident when we look at corporate tax

rates

over the

period

(Chart 9

and

Table 6),

which decreased from 36.87% in 2004 to 32.44% in 2012, rising finally to 34% in 2013-14

as the country was in dire straits and needed to exercise fiscal prudence.

Table 6: Fiscal Sector of India (% of GDP)

Source: IMF

2006 2007 2008 2009 2010 2011 2012 2013

Government

Expenditure 26.5 26.4 29.7 28.3 27.2 26.7 26.9 27.0

Government Revenue 20.3 22.0 19.7 18.5 18.8 18.7 19.5 19.8

Fiscal

Balance - 6.17% -4.4%

-

10.0%

-

9.8%

-

8.4%

-

8.0%

-

7.4%

-

7.2%

Primary Balance -1.3% 0.4% -5.3%

-5.2%

-4.2%

-3.7%

-3.1%

-2.6%

Interest

Payments -4.8% -4.8% -4.7%

-

4.6%

-

4.2%

-

4.2%

-

4.3%

-

4.6%

Govt.

Gross Debt 77.1 74.0 74.5 72.5 67.5 66.8 66.6 61.5

Chart 9

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1.9 If India stabilizes the public debt at the 2012 levels of 61.5% of GDP, and grew at the

recent growth rate of 5.5%, then its fiscal deficit needs to be restricted to 3.36% of GDP

and government will need to run a positive primary balance of 1.28% of GDP (Table 7).

Fiscal deficit sustainability analysis underscores the urgent need for fiscal consolidation in

the country to maintain public debt levels at 61.5% of GDP. If India grows at average growth

rate of 7.3%, it will need to curtail its fiscal deficit to 4.47% of GDP, while maintaining a

positive government primary balance of 0.17%. While if it grows at 4.5%, it will need to run

a primary surplus of 1.84%. Only if the country grew at 9.8% will it have the opportunity to

run a fiscal deficit of 6%, while running a primary deficit of 1.37% of GDP (Table 7).

1.10 It is conclusive from the analysis that for all practical considerations, India does not

have any room for discretionary government spending for it to contain its exorbitant

debt levels and the vulnerabilities associated with it, with the pace at which it is

growing. Therefore, it needs to exercise fiscal prudence and constraint by incorporating

structural reforms for streamlining its existing expenditures and increasing its revenues.

Table 7: Fiscal Deficit Sustainability (2006 - 13) Source: Author’s Calculations

Growth

Scenarios

b (Target Public

Debt)

g (Growth

Rate)

d

(Fiscal Deficit)

= b*g

Interest

Payment

Governmen

t Primary Balance

(+ is deficit)

r= (interest

payment)/debt*100

Average

Growth Rate 61.5 7.3 4.47 4.64 -0.17 7.5%

Optimistic

Growth 61.5 9.8 6.01 4.64 1.37 7.5%

Recent Growth 61.5 5.5 3.36 4.64 -1.28 7.5%

Pessimistic

Growth 61.5 4.5 2.80 4.64 -1.84 7.5%

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Chart 11: External Debt and Composition (2001-12)

Source: RBI and Nagaraj, 2008

1.11 Gross government debt in

2008 was at an elevated

leverage level of 77.1% of

GDP, which decreased to

61.5% of GDP in 2013 which

however is still very high. The

debt levels are substantially

high when compared with those

in average Emerging Market

and Middle Income Economies ranging between 35 % and 40% of GDP. However, one sees

that with tightening of the government spending, the public debt levels have also declined,

even though a lot more needs to be done by the government to bring the debt levels to a more

sustainable level.

1.12 External debt to GDP increased from 16.8% in 2005 to 23.3% in 2013 but is still in

an acceptable range. External debt is largely held by non-residents. This suggests growing

reliance on external financing which is vulnerable to changes in market sentiment and on

investor’s risk and exposure appetite in the future. (Chart 11)

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Table 8. Debt and Reserves Source: RBI and IMF staff report

Chart 11. Gross International Reserves 2012 ( As a percentage of IMF reserve adequacy Matrix)

1.13 The ratio of foreign exchange reserves to total debt has gone down from 109% in

2005 to 69% in 2013 and that of short term debt to foreign exchange reserves has

increased from 12.9% in 2005 to 29.3% in 2013, signaling higher short term debt

accumulation over that of foreign exchange reserves over time. Foreign exchange

reserves are required for not only paying external debt but also for protecting the currency

from extreme volatility through RBI’s (Reserve Bank of India’s) direct intervention in the

foreign exchange markets. However, presently the ratio of short term debt to foreign

exchange reserves (29.3%) combined with the estimates of debt service ratio suggest reserve

adequacy (Table 8).

1.14 India has accumulated sufficient foreign

exchange reserves over time poised at 293 billion

US dollars in 2012 and has reserve adequacy

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with regards to payment of short term as well as external debt as well as protecting its

currency in the foreign exchange markets from volatility and shocks. The Table 8

showcases its ability to maintain existing debt levels with the existing foreign exchange

reserves that it has (Chart 13).

B. International Perspective based on Trade Flows in Goods and Services: This

perspective emphasizes the role of trade flows in goods and services as drivers of current

account balances.

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2.1 Large trade imbalance stemming from higher import of goods is the main driver

of the widening of the Current Account Deficit, while large inflows of

remittances followed by trade surpluses from services sector over the years help

in moderating the CAD. Trade deficit in goods and services has been widening from

3.3% of GDP to 7.3% of GDP in 2012. However, this trend showed a slight reversal

with a decline in the trade deficit to 4.9% of GDP in 2013 and therefore the current

account deficit also declined to 2.62% of GDP, while secondary income inflows were

poised at 3.9% of GDP. (Chart 14)

2.2 India is the largest remittances receiver in the world ($70 billion in 2013-14).

Remittance flows have surpassed both foreign aid flows and FDI flows to India,

underscoring the huge role of these flows in containing the current account

deficits of the country. Workers’ remittances, which have constituted around 3 to 4

percent of India’s GDP since FY 1999-2000, have provided considerable support to

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Chart 15

India’s balance of payments. The average net secondary income as a % of GDP is

3.5% over the period 2005 to 2013. It is interesting to note that remittances financed

about 45 percent of the merchandise trade deficit between FY 2005/06 and FY

2008/09 (Afram, 2012). Since the remittances are a primary factor of the secondary

income balances, one can look at the secondary income balance to understand the

scale of the inflow (Chart 14 and Table 9). A large number of Indian households

(around 4.5 percent) receive remittances. According to the RBI, more than half of

these remittances are utilized for family maintenance that is, to meet the requirements

of migrant’s families regarding food, education, health, and other needs) while the

rest are either deposited in bank accounts (20 percent) or invested in land, property,

and securities (7 percent). (Afram, 2012).

Table 9. Net Secondary Income as a % of GDP

Net Secondary

Income (% of GDP)

2005 2006 2007 2008 2009 2010 2011 2012 2013 Average

2.8% 3.0% 3.0% 4.5% 3.8% 3.3% 3.5% 3.9% 3.9% 3.5%

2.3 India’s trade deficit is primarily driven by imports of primarily goods such as crude oil

and gold, which dominate 30% and 11% of the import bill of the country respectively

(OEC India, 2014) (Chart 15). As can be seen from the Chart 14, India imports a higher value

of goods than it exports, this trade imbalance is leading to a widening CAD. India imports the

following commodities: Crude

Petroleum (30%), Gold (11%),

Coal Briquettes (3.5%), Diamonds

(3.3%), and Petroleum Gas

(2.8%), while it exports the

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following products: Refined Petroleum (19%), Jewellery (6.5%), Packaged Medicaments

(4.0%), Rice (2.2%), and Cars (1.8%). Crude prices were increasing exponentially 2002

onwards till 2008 from 20 USD/bbl to 140 USD/bbl, post which there was a drastic drop in

the prices in the early 2009 during the great depression to 40 USD/bbl. However, since 2009,

it has been around the range of 100-120 USD/bbl (Figure). The period between 2002-2008

the government subsidized the oil prices, to ease inflationary pressures on its citizens,

however, this increased the CA deficit since the incomplete pass-through of high

international crude prices to

domestic petroleum prices

dampened the expenditure

adjustment effect, which could

have reduced oil imports and

hence reduce the pressure on the

CAD. Similarly, India’s

obsession with gold has made it pay a heavy price with gold prices on a surge since 2005 to

2012 (Chart 16), and Indian rupee depreciating, the current account deficit was widening.

The country had imposed an import tax on metals such as silver and gold to discourage the

imports as well as gain revenues from them. However, this measure has also led to a surge in

smuggling of the precious metals (Jamasmie, 2014). Together oil and gold imports make up

an estimated 70 percent of the country’s trade deficit. (CNBC, 2012) Therefore, curbing the

imports and demands of these commodities is a successful strategy to contain inflationary

expectations caused by the stimulus package and its subsequent withdrawal.

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2.4 Share of the services sector in the GDP

is growing progressively over the time

from 53% in 2005 to 57% in 2013,

whereas the manufacturing sector going

down marginally from 19% of GDP in

2005 to 18% of GDP in 2013 and

agriculture sector contribution going

down substantially from 15% GDP in 2005 to 13% of GDP in 2013 (Chart 17 and

Table 10). The services sector has benefitted substantially by the rapid nominal

depreciation of the Indian rupee from Rs. 44.1/US $ in 2005 to Rs. 58.6/US $ in 2013.

However, it is essential to study the real effective exchange rates in order to establish that

the nominal depreciation led to export competitiveness.

Industry Type 2005 2006 2007 2008 2009 2010 2011 2012 2013

Exports of goods and services

(% of GDP) 19.3 21.1 20.4 23.6 20.0 22.0 23.9 24.0 24.8

Services, etc., value added (%

of GDP) 53.1 52.9 52.7 53.9 54.5 54.6 54.9 56.3 57.0

Agriculture, value added (% of

GDP) 18.81 18.29 18.26 17.78 17.74 18.21 17.86 17.52 18.20

Table 10. Share of goods, service and agriculture as a % of GDP Source: World Bank

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Chart 18. Real Effective Exchange Rate (REER) (2004-05=100) Source: IMF Working Paper 2014

2.5 While for the period 2005-2013, Indian rupee is broadly experiencing nominal

depreciation, there are marked spells of real appreciation due to very high inflation

levels which deter its export competitiveness. Further analysis of the REER (Real Effective

Exchange Rates) index 2008 from RBI suggests a minor real appreciation (given 2004-05 as

the base year with index

100). However, the

estimates from IMF, BIS

and OEC suggest that the

country has been

experiencing real

appreciation since 2008 to

2012, which would

reduce its export

competitiveness (Chart 18). If one was to take a conservative estimate from all these

estimations, it is certain that there were two broad spells of real appreciation, one in 2009-

2010 and one in 2010-11. This deterioration in the competitiveness is visible in the widening

of non-oil non-gold trade deficits from 1% of GDP in 2005 to 2.7% of GDP in 2008, a time

when a huge fiscal stimulus was being given to the country to come out of global recession.

Further in the other spell of real appreciation during 2010-11, non-oil non-gold trade deficit

deterioration from 1.5% to 1.8% in 2012 & 2013 which further widened the Current Account

deficit to 4.92% of GDP in 2012. However, the analysis is almost certain that the most

critical task of the RBI (Reserve Bank of India) in the near future would be controlling

inflation, containing RER appreciation pressures while encouraging growth in the economy.

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2.6 India’s RBI is following a contractionary monetary policy to curb inflation from March

2010 onwards when the inflation in the country peaked at 12.1% by increasing both

repo and reverse repo rates to levels of 8% and 7% respectively in 2013. India witnessed

negative real interest rate in 2010, which has dis-incentivized savers, thereby triggering a

sharp movement of household savings (70% of overall savings) from financial assets to

physical assets (such as gold). The proportion of household savings invested in financial

assets has reduced from around 50% in 2007-08 to around 30% in 2012-13 (LiveMint, 2014).

The real interest rates in 2012 and 2013 were maintained at 3.1% levels, as compared with

7% levels in 2007. The increasing repo and reverse repo rates is indicative of the inflation

reduction strategies and depreciation pressure countering strategies on the rupee.

2.7 While most BRICS countries suffered major declines in their exports as a % of GDP

post the recession period of 2008-2009, India’s exports increased to 25% of GDP from

around 19% of GDP (Chart 19).

It is important to note that the

Indian economy is less integrated

with global economy despite

adopting the framework principles

of liberalization, globalization and

privatization way back in 1991, as

it has been gradually opening up

its capital account over the years in a very cautious way.

C. International Perspective based on Global Capital Markets: The international

perspective based on global capital markets emphasizes the role of global financial flows

26

as the driver of current account balances. Therefore, this perspective focuses on the

financial account of the balance of payments.

3.1 FDI in India is encouraged through a dual route: a progressively expanding

automatic route and a case-by-case route. Portfolio investments, which have been

progressively liberalized, are restricted to select players, particularly approved

institutional investors and the NRIs. Indian companies are also permitted to access

international markets through GDRs/ADRs, subject to approval. Foreign investment in

the form of Indian joint ventures abroad is also permitted through both automatic and

case-by-case routes. Restrictions on outflows involving Indian corporate, banks and those

who earn foreign exchange (e.g. exporters) have also been liberalized over time, subject

to certain prudential guidelines (Jadhav, 2003).

Box 1 identifies sector specific limits of FDI in India to provide a larger perspective on the

FDI policies of the state (Source: RBI and Indian news sources).

Box 1: Sector Specific Limits of Foreign Investment in India

Sector FDI

Cap/Equity

Entry

Route

Other

Conditions

A. Agriculture

1. Floriculture, Horticulture, Development of Seeds, Animal Husbandry, Pisciculture, Aquaculture, Cultivation of vegetables & mushrooms and services related to agro and allied sectors.

2. Tea sector, including plantation

100% 100%

Automatic FIPB

(FDI is not allowed in any other agricultural sector /activity)

B. Industry 1. Mining covering exploration and mining of

diamonds & precious stones; gold, silver and minerals. 2. Coal and lignite mining for captive consumption by

power projects, and iron & steel, cement production.

3. Mining and mineral separation of titanium bearing minerals

100% 100% 100%

Automatic

Automatic

FIPB

27

Chart 20

C. Manufacturing 1. Alcohol- Distillation & Brewing 2. Coffee & Rubber processing & Warehousing.

100% 100%

Automatic Automatic

3. Defense production 49% FIPB

4. Hazardous chemicals and isocyanates 5. Industrial explosives -Manufacture 6. Drugs and Pharmaceuticals 7. Power including generation (except Atomic

energy); transmission, distribution and power trading. 8. Railways 9. Roads and Highways

100%

100%

100%

100%

100%

100%

Automatic

Automatic

Automatic

Automatic

(FDI is not permitted for generation, transmission & distribution of electricity produced in atomic power

plant/atomic energy since private investment in this activity is prohibited and reserved for public sector.)

D. Services 1. Civil aviation (Greenfield projects and Existing

projects)

100%

Automatic

E. Retail

1. Single Brand Retail 2. Multi Brand Retail

100% 51%

F. Private Insurance 100%

3.2 India’s financial account shows debt inflows increasing while FDI and portfolio flows

still playing a large role. In 2012, FDI

inflows only financed a quarter of the

current account deficit, while they

generally exceeded the CAD before

2007-08. Debt flows, particularly in the

form of non-resident Indian (NRI)

deposits increased from 0.3% of GDP

in 2005 to 0.8% of GDP in 2012. Short term debt is also increasing substantially over the

years. Similarly, external commercial borrowings (by Indian corporations) increased

28

significantly since 2008. Net portfolio flows have been very volatile in the past and more

recently in response to global financial market volatility (IMF Country Report, 2014).

Portfolio flows were 1.5% of GDP in 2005, increasing to 2.2% in 2007, while again coming

down to 1% in 2008 and rising back to 2.4% in 2009. In 2012, the portfolio flows comprise

1.5% of GDP. Financial flows from FDI were consistent at 0.5% of GDP till 2007, post

which there is a surge of inflows in the period of recession (2008) (Chart 21), where India

was considered a safe haven for investment since it was one of the few countries least

affected by recession and with strong growth prospects. Therefore, 2007 and 2008 were the

most significant years in terms of high capital inflows in the country, which built substantial

foreign exchange reserves. Chart 20 shows India’s composition of liabilities with respect to

other countries.

3.3 FDI inflows in the

country are distributed

in a variety of sectors,

primarily –

manufacturing, real

estate activities,

construction, financial

services, business

services, and

communication services (Chart 22). While manufacturing sector is the biggest recipient of

the FDI inflows, it is evident that the key services industries like communication, financial

and information technology have benefited immensely from the FDI inflows in the country,

leading to an increased share of services in the country. Further, there is also much needed

29

investment into the infrastructure of the country. However, the FDI inflows in the country are

not comparable to those of other comparable economies like China and therefore, the country

must look for ways to make the investor climate more conducive towards attracting higher

FDIs in a broad range of industries for strengthening its growth prospects in the future.

3.4 Net capital inflows in most years from 2006-13 were sufficient to cover CAD and lead to

reserve accumulation, barring 2012 (Table 11)

Balance of

Payments

2005 2006 2007 2008 2009 2010 2011 2012 2013 Average

GDP (Current

US $ Millions)

834215 949117 1238700 1224097 1365372 1708459 1880100 1858745 1876797 1437289

GDP growth

rate

9.28 9.26 9.80 3.89 8.48 10.26 6.64 4.74 5.02 7.5

Current

Account

(Excludes

Reserves and

Related Items)

-

10,284

-9,299

-8,076

-30,972 -26,186 -

54,516

-

62,518

-91,471 -

49,226

-

38,061

Current

Account (% of

GDP)

-1.23% -0.98%

0.00%

-2.53% -1.92% -

3.19%

-3.33% -4.92% -

2.62%

-2.3%

Balance on

Goods

-

32,517

-42,803 -54,827 -92,675 -79,950 -

93,353

-

120,173

-

151,928

-

114,650

-

86,987

Balance on

Services

5,240 11,034 16,123 18,315 12,540 2,329 13,486 15,865 22,393 13,037

Balance on

Goods and

Services

-

27,276

-31,769 -38,703 -74,360 -67,410 -

91,023

-

106,686

-

136,063

-

92,257

- 73,950

Balance on

Primary

Income

-6,649 -6,245 -6,515 -5,364 -7,538 -

15,601

-

16,043

-20,842 -

21,783

-

11,843

Balance on

Secondary

Income

23,642 28,716 37,143 55,378 52,290 56,650 65,258 71,788 74,067 51,659

Balance on

Goods,

Services, and

Primary

Income

-

33,926

-38,015 -45,219 -79,724 -74,948 -

106,625

-

122,730

-

156,906

-

114,040

- 85,793

Net Good

Service and

Primary

Income as a %

of GDP

-4.1% -4.0% -3.7% -6.5% -5.5% -6.2% -6.5% -8.4% -6.1% -6%

Net Secondary

Income as a %

of GDP

2.8%

3.0%

3.0%

4.5%

3.8%

3.3%

3.5%

3.9%

3.9%

3.5%

Capital

Account

(Excludes

Reserves and

... ... ... ...

293

49

67

-597

961

155

Table 11. Balance of Payment (Source: IMF)

30

Related Items)

Balance on

Current and

Capital

Account

-

10,283.54

-

9,299.06

-

8,075.69

-

30,971.99

-

25,893.44

-

54,466.22

-

62,449.72

-

92,068.48

-

48,264.14

-

37,975

Financial

Account (% of

GDP)

3.0% 4.0% 7.6% 2.8% 3.1% 4.1% 3.2% 4.6% 3.2% 4.0%

Financial

Account

25,283.93 37,774.71 94,363.47 34,436.78 42,920.75 69,596.55 59,326.10 85,645.69 59,177.99 56,503

FDI (Net)

4,628.65 5,992229 8,201.63 24,149.75 19,485.79 11,428.79 23,890.66 15,442.45 26,388.08 15,512

Portfolio (Net)

12,144.11 9,545.72 33,016.30 14,985.22 17,756.86 36,875.47 2,664.81 29,285.24 6,857.99

18,126

Portfolio(Net)

% of GDP

1.5% 1.0% 2.7% 1.2% 1.3% 2.2% 0.1% 1.6% 0.4% 1.3%

III. Current Account Deficit – Assessing Vulnerabilities

1. Since the “Natural direction” of capital flows must be from developed to developing

countries, running a current account deficit is essential at this point in time for

India. However, the key question is to identify how much CAD the country can afford to

run before going into a balance of payment crisis. This can be analyzed using the CA

sustainability analysis.

2. Current Account sustainability analysis suggests that while there has been a recent

CAD reversal from 4.9% of GDP in 2012 to 2.6% in 2013, CAD needs to be further

contained to 1.09% of GDP with the recent levels of growth at 5.5% and external

debt at 20% of GDP (Table 12). However, should India achieve an optimistic growth

rate of 9.8% (average of the highest three years of growth), it can afford to run a CAD of

4.89% with external debt at 50% of GDP. While, with the average growth rate of 7.3%

(2005 to 2013), India can manage a CAD of only 1.45% with external debt at 20% of

GDP. However, if we were to analyze the recent and the most plausible growth

trajectory, with India’s growth poised at 5.5% of GDP, it would need to contain its CAD

from its present level of 2.6% (2012) to 1.09% of GDP, while maintaining external debt

31

at 20% of GDP. Further, if its growth were to suffer, it would have to contain the CAD

further to 2.27% of GDP while increasing its external debt to 50% of GDP (Table 12).

However, that will not be advisable since there are vulnerabilities associated with higher

levels of external debt funding.

3. Post 2010, growth in India has been declining from 6.6% in 2011 to 5% of GDP in

2013 due to a multitude of factors including high inflation, RER appreciation,

public debt, fiscal imprudence, high CA deficits, among others. Sustained poor

growth may stir fiscal and financial sector vulnerabilities. Further, slowdown in growth

compromises the ability of a country to service its IIP (international investment position)

and therefore, CAD must be maintained at sustainable levels in tandem with growth.

Growth Scenarios C/Y

(Current

Account Deficit/GDP)

G

(Growth Rate in %)

K*

(Equilibrium ratio of

country's liabilities held by international investors to

GDP (Y))

Average Growth Rate 0.73% 7.3 10%

1.45% 7.3 20%

2.18% 7.3 30%

2.90% 7.3 40%

3.63% 7.3 50%

Optimistic Growth 4.89% 9.8 50%

Recent Growth 0.55% 5.5 10%

1.09% 5.5 20%

1.64% 5.5 30%

2.19% 5.5 40%

2.73% 5.5 50%

Pessimistic Growth 2.27% 4.5 50%

Table 12. Current Account Sustainability Analysis (Author’s Calculations)

32

3 The currency with respect to the dollar is nominally depreciating, while high and

persistent inflation is leading to sustained spells of RER appreciation. Therefore,

inflation is the most important vulnerability to the system, which is leading to trade

imbalances, and widening of the current account as can be seen during the period 2008 to

2012 respectively.

4 Investment in the country is almost stagnant while the private savings are going down,

both of which are stresses that signal the country’s recent high current account deficits

may be a “bad” phenomenon rather than signs of a healthy economy. Further the ICOR

suggests lower productivity of investment and decrease in investment efficiency, which may

further exaggerate the vulnerabilities in the system.

5 Remittance (Secondary Income) inflow is approximately 3-4% of GDP year-on-year,

and absorbs substantial CA deficit levels of the country. However, any drastic

fluctuations in the remittances amount will lead to an unsustainable level of CAD, leading to

a balance of payment crisis.

6 Size, maturity and composition of capital flows are a vulnerability to the financial flows.

Capital flows are largely short term and dominated by portfolio investments, which are

substantially volatile. However, debt is growing in the capital flow composition with external

commercial borrowing, trade credits and NRI deposits increasing over time. If due to

external or internal shocks, the creditors refuse to roll over the short term obligations, India

could experience a financial sector crisis. Further, large borrowings from foreign sources like

the NRI investments in India add to the vulnerability of the domestic economy in case of a

massive selloff by non-residents in the local-currency bonds, affecting both the currency and

the broader economy.

33

7 Currency composition is a key vulnerability to CAD since the external debt levels have

been increasing from 16.8% in 2005 to 23.3% in 2013. Indebtedness towards creditors in a

foreign currency raises serious concerns on reserve adequacy. However, India is in a

comfortable position with regards to the reserves in the medium to short term.

8 Investors may become wary of financing larger fiscal deficits stemming from low

growth and government imprudence given public debt sustainability concerns. Investors

may also become anxious about continuing to lend to a fragile banking system in the context

of the financial sector vulnerabilities and the pressures poor growth places on bank balance

sheets such as rising NPLs in the system (Figure). Overall, given the deterioration of the

fiscal sector, fiscal policy is severely constrained as a policy tool during this period.

9 High sectoral exposure to infrastructure and commercial sector are both evident

vulnerabilities in the financial sector, as can be seen from the rising share in Bank

credits of these two sectors (Chart 23 and 24).

10 Private sector crowding out and decreasing corporate profitability is another marked

vulnerability in the system. Decreased household financial savings available for the private

corporate sector of about 0.2% of GDP in 2012 and negative interest rates are a vulnerability

containing the private sector. Further, structural issues such as policy and supply chain

bottlenecks are also dampening private sector growth. Given that exchange rate volatility is

driven by depreciation pressures, unhedged foreign currency exposure of large

corporations and banks must be contained.

Chart 23

Chart 24

34

IV. Conclusion and Policy Recommendations

India, one of the leading emerging market economies, is at a very important juncture where if

it observes fiscal discipline and prudence, controls for inflation, while implementing certain

structural reforms for empowering the private sector and strengthening the financial sector, it

will be poised for growth. The current account analysis suggests that the country had

unsustainable levels of current account deficit from 2011-12, were owing to poor

macroeconomic fundamentals such as trade deficits (oil and gold imports), high inflation,

RER appreciation, very high fiscal deficits (lower revenues and increasing expenditures) and

primary balance deficits, decreasing financial household savings, crowding out of the private

sector, stagnant investments as a % of GDP, high public debt, high non-performing loans and

dependency on short term and volatile capital inflows. On the positive side of India’s economic

story are high debt inflows, remittance inflows and NRI deposits, enhanced political certainty

with the new government, policy advances, FDI limit relaxations in a few sectors, tight

monetary policy by the RBI for controlling inflation, healthy foreign exchange reserves, less

external debt as a % of total debt and improving fiscal deficit situation. In conclusion, with

right policies in place, the country could see substantial development in the near future.

Policy Recommendations

1. Controlling inflation through tight monetary policy should be first priority. While

growth is important for the country, the current focus must be to curtail inflation so as

to have RER depreciation and subsequent increase in exports from India. This will have

a two pronged effect – relief to consumers with CPI (Consumer Price Index) and WPI

(Wholesale Price Index) decreasing, followed by narrowing of the trade deficit and CAD.

35

2. Fiscal deficits are at unsustainable levels and must be contained to further reduce the

high levels of public debt and reorient spending toward investment and social sectors .

Fiscal deficits can be reduced by the following two ways –

a) Increasing Government Revenues: The GST (Goods and Services Tax) reform has

been pending in the Indian parliament for ratification since 2009.This overhauling could

be the single largest tax reform aimed to improve tax administration and to simplify and

unify the complex system of taxation. The GST will be discussed in the winter session of

the parliament in 2014 and could help India gain more tax revenues.

b) Streamlining Government expenditures: There is an urgent need for Rationalizing

Fertilizer, Food and Fuel Subsidies and reform them to increase their effectiveness.

Transfer of subsidy through the AADHAR card (12 digit unique identification number

issued by the Unique Identification Authority of India on behalf of the Government of

India) is an effective means for directly reaching the targeted beneficiary. Since subsidies

are difficult to withdraw later on, one can also deliver the desired impact through direct

cash transfer in the Aadhar cards.

3. Structural Reforms geared towards empowering the private sector and increasing

employment: It is important for the private sector to lead the growth engine of the economy.

However, to do so by removing supply side policy bottlenecks, investing in infrastructure,

reforming labour laws to make supply more flexible and creating market friendly conditions

for businesses to operate will be critical in powering them to growth.

4. Reforming the banking sector by placing an upper limit on the number of NPLs (Non-

performing loans), keeping limits on sector lending exposure and mandating hedging

above a particular value of foreign currency, will all be important steps towards

strengthening the banking and financial sector

36

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