Current Account Deficit: Short-Term Fixes For Structural Weakness?

All five measures announced by the government are on the capital flows side, aimed at financing the CAD, not diminishing it.

Gantry cranes move shipping containers at the Jawaharlal Nehru Port,  in Navi Mumbai, Maharashtra, on Dec. 16, 2017. (Photographer: Dhiraj Singh/Bloomberg)
Gantry cranes move shipping containers at the Jawaharlal Nehru Port, in Navi Mumbai, Maharashtra, on Dec. 16, 2017. (Photographer: Dhiraj Singh/Bloomberg)

As the rupee plunged and India’s current account deficit rose from the level of 0.4 percent of gross domestic product achieved in the January-March quarter of 2016-17 to breach the 2 percent mark in the April-June quarter of 2018-19, the government held a series of high-level meetings on Sept. 14. and Sept. 15 and announced five steps to ‘rein in the current account deficit’. The government also announced an intention to curb ‘non-essential’ imports. Will these measures really be effective? If not, what options does India have?

To understand the nature of the current account deficit, we need to see what is happening to our trade in goods and services. More importantly, we need to understand how a country’s primary income and remittances are moving to upset or create a balance.

Trade In Goods And Services

India’s exports have been growing over the last year. In 2017-18, India’s exports have grown by over 10 percent over 2016-17. In April-June 2018, India’s exports rose by 14 percent over the same quarter in the previous year.

The import basket can be segregated into oil, gold, and non-oil-non-gold. A key factor in the recent spurt in the trade deficit has been the growing oil import bill following the rise in international crude prices. In the past, another key contributor was Indians’ obsession for gold, nearly all of which is imported. However, in the current mix of imports, a repeat of past moves to restrict gold imports may be misplaced.

India has been importing less gold in absolute terms year-on-year since 2015.

However, since the CAD itself was declining, the proportion of gold imports as a percentage of CAD rose to 191.6 percent in 2016-17.

In 2017, the imports of gold in absolute terms increased by 22 percent. Much of this increase was due to an inadvertent error following the introduction of the Goods and Service Tax on July 1, 2017. Prior to GST, India imposed a 10 percent duty on gold imports from countries other than those with which it had signed free trade agreements. To prevent duty-free imports from FTA countries, India had imposed a countervailing duty of 12.5 percent on gold imports from these countries, such as South Korea. However, the imposition of the GST led to a scrapping of all local taxes including the countervailing duty.

As a result, between July 1, 2017, and Aug. 3, 2017, gold imports from South Korea jumped to $338.6 million. Contrast this to the value of gold imports in 2016-17 from South Korea, which stood at $70.46 million.

The government finally restricted gold imports from South Korea on Aug. 25, 2017. That accounts for why gold imports in 2017-18 were higher than in the previous years. Currently, while gold imports are substantial, accounting for 53 percent or $8.44 billion of our CAD in April-June 2018, as such gold imports have actually fallen from 75 percent or $11.27 billion of our CAD in April-June 2017.

Merchandise imports in 2017-18 have also increased on account of higher non-oil, non-gold imports—coal, machinery and capital goods—which actually point to a reviving economy.

Service exports, especially software service exports, have bridged much of the CAD over several years, without which, the deficit would have been even higher. However, one critical weakness in our service exports is the lack of diversification.

  • Software service exports account for more than 41 percent of the total service exports, while sectors such as business services, as also personal, cultural and recreational services have been in deficit.
  • More than 90 percent of even these software service exports are largely restricted to only three markets: United States of America, United Kingdom, and European Union.

Clearly, the basket of service exports, as also destinations will need to be expanded to neutralise the risks associated with shrinking external demand.

Stronger Capital Goods Imports Adding To India’s Current Account Deficit Woes

Capital Flows Can Pressure The CAD Too

A country’s current account is not just determined by its imports and exports. Income flows, both primary and secondary, may also lead to a surplus or deficit on the current account. While remittances (secondary flows of income) into India have been positive and high, deficits have been created by the interest and dividends that India has had to pay out on flows of capital on its financial account, namely foreign direct investment, foreign portfolio flows and loans, such as external commercial borrowings. Interest and dividends on such foreign inflows are also part of the CAD.

Interest and dividends on FDI, portfolio flows, and other investments received from foreigners has accounted for 43 percent of the CAD in April-June 2018.

The Government’s Stance

The government has announced five measures. These include:

  1. a review of the mandatory currency hedging requirement for infrastructure loans,
  2. permitting manufacturing sector entities to avail of external commercial borrowings up to $50 million with a minimum maturity of one year,
  3. a review of the debt investment limits for foreign portfolio investors,
  4. exempting the withholding tax for masala bonds, and
  5. removal of restrictions on Indian banks’ market making of masala bonds.

What is the likely impact of the measures announced to control the CAD?

All five measures are currently on the capital flows or financial account side.

Of these, measures such as review of debt investment limits for FPIs, easier rules for manufacturing entities to raise funds overseas are aimed at increasing the supply of dollars. On the other hand, exempting the withholding tax for masala bonds and review of mandatory currency hedging for infrastructure loans are measures aimed at reducing the demand for dollars.

These are short-term measures, aimed at helping in financing the CAD, not diminishing the CAD per se.

India’s Options

Reining in the current account deficit will require looking at the shortage in availability of foreign exchange in India as a structural weakness. Measures to eliminate the shortage will need to focus not just on curbing imports, but also growing exports by diversifying the product offerings, as also the market mix for such exports. Oil imports can be curbed only through making India self-sufficient in energy. At the same time, the focus should be on improving India as a destination for FDI flows, so as to reduce the dependence on hot money portfolio flows.

A lack of realistic assessment of the problem would lead to knee-jerk reactions and temporary ‘solutions’, which will not stand the test of time.

Tulsi Jayakumar is a professor of economics and the chairperson of family managed business studies at the SP Jain Institute of Management & Research, Mumbai. Views are personal.

The views expressed here are those of the author’s and do not necessarily represent the views of Bloomberg Quint or its editorial team.