Why India Needs Stable Capital Flows
Context:
- The current account deficit (CAD) grew from 2.2% of GDP in the first quarter of 2022–23 to 4.4% in the second, according to the RBI’s quarterly statistics.
- In contrast, the extraordinary surplus in 2020–21 was 0.9% of GDP. The third quarter of the current fiscal year may see a drop in the CAD due to the widening of the merchandise trade imbalance.
- The global trade deficit fell to $37.73 billion in the third quarter of 2022–2023 from $49.1 billion in the second quarter. The most recent data show that due to a considerable increase in net services exports, the trade imbalance significantly dropped in January, falling to $1.27 billion.
Does the current account deficit pose a problem?
- Indian CADs contain both positive and negative components.
- A logical outcome of rising investment, portfolio choices, and country demographics is a planned deficit.
- High and persistent CADs, however, might not be preferred if they are supported by shaky finance and signal wider difficulties like low export competitiveness.
- Economists claim that the country’s CAD typically rises when output drops as opposed to when demand rises, highlighting the significance of external shocks.
- For instance, rising oil prices, which would occur if oil were employed as a production input, would raise production costs and impede economic progress. With the current situation’s inelastic demand for oil imports as well as its significant share of all of India’s imports, CADs rise in tandem with slowing growth.
Stable capital flows are preferred to narrow the CAD:
- India is exposed to the risks associated with its financing because to significant and ongoing CADs.
- As long as they can be financed by dependable capital inflows, such FDI inflows, CADs are preferred since they are less subject to capital flight.
- Yet, if deficits are financed by irregular capital movements, such as portfolio flows, there may be reason for concern. Portfolio changes are unpredictable and more likely to reverse during a global financial catastrophe.
- The structure of finance is crucial. However, they have proven insufficient for the current fiscal year, even if FDI inflows were enough to fill the deficit in 2021–2022.
- Only about 18% of CADs were funded by portfolio and FDI inflows in the second quarter of 2022–23.
- Thus, there is a financial issue. Since they allow debtor countries like India to utilise and allocate cash to industries with the potential to increase long-term productivity and economic growth, steady capital flows are favoured.
The CAD must be balanced by the use of services and remittance:
- Remittances and service exports have reduced rising merchandise trade deficits.
- India’s service exports climbed by 23.5% in 2021–2022. In the first half of 2022-2023 compared to the same time in the previous year, service exports rose by 32.7%.
- Moreover, remittances rose by 25% between April and September 2022, totaling $48 billion. Unlike to capital flows, which are pro-cyclical and have a negative response to the Fed’s contractionary monetary policy, remittances have demonstrated exceptional stability.
Policymakers should consider the medium-term economic situation:
- In the medium term, policymakers must halt the negative impacts of the slowdown in global trade on exports of products.
- A capital flight could occur if the US Fed raises rates further, which would put additional pressure on the exchange rate market.
- With the current state of the economy, this could be challenging because an unstable import basket and a depreciated currency will lead to imported inflation.
- As a result, government must simultaneously negotiate free trade agreements and focus policy activities on structural changes to boost trade competitiveness in order to enhance exports.
Conclusion:
- The two deficit concerns India is currently facing are high fiscal and CAD deficits.
- In light of mounting worries about a global recession, aggressive fiscal consolidation may not be ideal. But, by providing steady financing and using exchange rates as a shock absorber to navigate the hard global economic situation, a comfortable external environment can be preserved.
