For the current fiscal year, our obsession has been with growth, interest rates, fiscal deficit and movement on policy and reforms. Economists and policymakers have fiddled around with numbers linking each of these variables with one another and justified either reason for action or inaction. Even the Reserve Bank of India (RBI) has at times brought out studies which conclude that high interest rates have not really militated against growth.
For a while, the finance minister and the RBI passed the buck to one another. Finally, the government has done something on the policy front and it also seems serious about controlling the fiscal deficit. It is, therefore, not surprising that the recent cut in interest rates and cash reserve ratio (CRR) looked almost inevitable. But this has brought in limited euphoria as it is prima facie hard to believe that this move will be a game-changer, with the RBI putting in a lots of caveats.
The emphasis has suddenly turned to the current account deficit (CAD) which now seems to be a major consideration for future monetary policy action. Why should this be so?
The CAD is one part of our balance of payments which takes in all receipts and expenses that are of a short-term nature. The other is the capital account, which has long term inflows and outflows of which foreign direct investment (FDI), foreign institutional investment (FII) and external commercial borrowings (ECBs) and other borrowings are major components.
The major components of the current account are transactions in trade, services, remittances and software receipts. This account has been widening in the wrong direction and the government is quite helpless about it. Exports cannot be raised in case the global economy is in a slowdown phase. With a negative growth being registered so far, it looks unlikely that we could register a growth rate of even 10 percent this year.
Imports are increasing because of the oil bill and some heightened demand for gold. The government has raised the duty on gold to control its consumption. Beyond this, nothing can be done as the trade account is free. The export-import policies seek to give incentives to various sectors, but demand is the issue here.
Remittances and software receipts are determined by the state of growth in the developed world. With the US and euro region struggling, the inflows from these sources are also under pressure and are unable to make up for the widening trade deficit. Therefore, the CAD has increased to 5.4 percent of GDP for the second quarter of this fiscal.
This number is dangerous because the prudent norm is 4 percent of GDP. When we had our crisis in 1991, this number was breached. However, this time there is not too much concern because of the capital account, which has provided a lot of support to the balance of payments. This has ensured that the ultimate external account is stable, as seen by the forex reserves remaining largely range-bound. This is also one reason why the exchange rate has been in the range of Rs 53-56 against the US dollar which would not have been the case if looked at from the point of view of only the CAD. But this is not exactly good news for the RBI which is now looking at such support with some apprehension when formulating monetary policy.
Let us see why there should be some caution on this front. First, when the RBI is lowering interest rates in the face of a CAD, there would be a tendency for demand to increase which will also necessitate import of raw materials and capital goods. This will exacerbate the trade deficit and the CAD. Therefore, any series of interest rate cuts have to be well calibrated to eschew such volatility.
Second, lower rates could distract FII funds away from the debt market. In the current financial year, there has been a tendency for FIIs to flow into debt rather than equity given the state of global markets. Therefore, on the one hand, their access to the corporate debt market, infrastructure debt funds and government bonds has been increased, while, on the other, we could be putting brakes in terms of lower returns.
Presently, funds are flowing because returns are relatively higher here with global interest rates being lower. Therefore, easy monetary policy could be counterproductive from this perspective.
While these are present concerns, the CAD also poses a challenge for the economy because when it is supported by the capital account, there are other issues which arise.
First, the FII flows are of a volatile nature and can leave the country at any point of time. Such movement of funds can be destabilising as the exchange rate gets hit and liquidity is taken out of the system. This is a problem for the RBI once again. A right balance has to be struck to ensure that we get the dollars without jeopardising monetary policy.
Second, companies have been given greater access to ECBs which are still attractive given the interest rate differential. There are two issues here. One is that the FCCBs (foreign currency convertible bonds) have in the past left a bad taste in the mouth for companies which have had to redeem bonds in the absence of buoyant stock markets for equity conversion. Moreover, the external debt of the country has been rising and crossed the $ 350 billion mark. The external debt is now higher than our forex reserves, which is not a comfortable position to be in considering that up to 2010-11, it was the other way round.
Given these dynamics, it is not surprising that the CAD has become an important influence on our policy framework. The budget will work towards enabling more capital flows, while the RBI has to constantly monitor the ramifications for its own policy. Therefore, while the conventional tradeoff of growth and inflation will be the primary factors, the RBI will perforce have to keep an eye on developments on the CAD front too as the central bank has the last word on not just interest rates and liquidity but also exchange rates. The fact that these variables are all interlinked makes the story even more challenging.
The author is Chief Economist, CARE ratings. Views are personal
Updated Date: Dec 20, 2014 15:41 PM