Is India’s rising Current Account Deficit a concern?

I was analysing the balance of payments report released by RBI for Apr-Jun 2010.

I plotted the Current Account Deficit as a % of GDP for some previous quarters. Here is how it looks like:

  CAD as a % of GDP
Q1 07-08 2.5
Q2 07-08 1.9
Q3 07-08 1.7
Q4 07-08 0.3
Q1 08-09 3.1
Q2 08-09 4.4
Q3 08-09 4.6
Q4 08-09 1.7
Q4 09-10 1.7
Q4 09-10 3.1
Q4 09-10 3.6
Q4 09-10 3.7
Q1 10-11 3.9

CAD as a % of GDP has again started to widen after a dip in the crisis.  It had declined to 1.7% levels as  this crisis struck but has increased to touch 3.9% levels as crisis has eased and activity has begun on export-import front.  The figure is lower than 4.6% levels reached in Q3 2008-09 but is slowly reaching the pre-crisis levels.

Managing high CAD with short-term capital flows is always a dangerous strategy. Capital flows received by India are usually in form of FII and ECB which can dry up anytime. We saw this problem in this crisis as well. Overall BoP was in deficit in 2008-09 as capital flows could not cover the current account deficit.

And then this rising CAD along with high short-term external debt have been one of the main reasons for previous crisis in emerging market economies.  RBI also released the External Debt report and it shows that share of short-term in external debt has been rising. It is still very low at 21.2% in  Jun-10 but has risen from 18.3% in Jun-09.

Another problem area is that India also has high fiscal deficits. It is in the league of a few nations which have both high fiscal and current account deficits. Economists call it twin deficit problem. In this the government needs both domestic savings to manage fiscal deficit and foreign savings to manage its current account deficit. In case of a shortfall in any of the two, a crisis situation can develop. It indicates economy is living with  high profligacy means. Both Greece and US suffered (see this paper by Menzie Chinn on US twin deficits) from twin deficit problems. So one cannot ignore the consequences of the twin deficits anymore.

Situation is manageable in India so far. Even if capital flows dry up,  we have adequate forex reserves to manage the high CAD. Fiscal deficit is being managed as domestic savings have been high. There were concerns when two massive borrowing programs were launced in 2009-10 and 2010-11 over Rs 4.5 lakh crore. But the bonds were subscribed pretty easily in the end. Government has also promised to lower the fiscal deficit levels. Next year target is 5.5% of GDP, but thanks to payments from 3G and WIMAX, deficit could be lower than 5.5% of GDP.

But we cannot take these for granted. Let us take the case of Korea in this crisis. Despite having adequate forex reserves, it was forced to tie up with Fed for meeting shortfall in dollar liquidity. And then cases of fiscal deficits going awry are common place. The problem with recent crises is that once expectations set in, it becomes a case of self-fulfilling prophecy. So a country may be having sound macroeconomic fundamentals but it could still be in a crisis. Hence, there is always a need to keep a watch on the debt/deficit indicators. 

Not of concern now, but needs to be watched.

4 Responses to “Is India’s rising Current Account Deficit a concern?”

  1. harun Says:

    A very good article which gives valuable insight on the true state of the economy.What baffles me to date is the rupee to the dollar,how can we have a inflation of 8% ,petrol at 52 ,sugar at 34 and a dollar at 44.50.Sounds ridiculous.But its even shocking to hear people on TV claim that the dollar will trade between 43 to 44.How is that possible when the CAD is as high as 3.6 of the GDP.To me the correct price of the rupee to the dollar is 45 to 45.50.The parity must reflect the buying capacity of the rupee.

  2. RBI’s second quarter review of monetary policy 2010-11- an analysis « Mostly Economics Says:

    […] deficit (CAD) continues to widen. It says CAD upto 3% of GDP is considered as safe. In Q1 2010-11, CAD reached 3.9% of GDP. Lower than high of 4.6% of GDP in Q3 2008-09, it is higher than comfort […]

  3. sbhatnagar Says:

    A very good and informative article Amol…Thanks

  4. James Says:

    India practises what the Federal Reserve does and terms Quantitve Easing…printing money out of thin which explain’s why India, with such a small economy for its population size has such huge problems with inflation. India is the biggest lemon being oversold to this world!

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