Need for Stable Capital Flows

Context:

As per the latest data released by the RBI, the current account deficit (CAD) widened to 4.4 per cent of GDP in the second quarter of 2022-23, down from 2.2 per cent in the preceding quarter.

Relevance:

GS Paper 3: Indian Economy and issues relating to planning, mobilisation of resources, growth, development and employment.

Dimensions of the Article:

1. What is the Current Account Deficit?
2. What is Balance of Payments?
3. Widening Current Account Deficit:
4. Is the current account deficit a cause for concern?
5. Countercyclical nature of India’s CAD
6. Service exports in India
7. Way Forward
8. Conclusion

What is the Current Account Deficit?

• A current account deficit occurs when the total value of goods and services a country imports exceeds the total value of goods and services it exports.
• The balance of exports and imports of goods is referred to as the trade balance. Trade Balance is a part of ‘Current Account Balance’.
• According to an earlier report of 2021, High Oil Imports, High Gold Imports are the major driving force, widening the CAD.

What is Balance of Payments?

• BoP of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a specific period, usually one year.
• Purposes of Calculation of BoP:
  • Provides information about a country’s financial and economic situation.
  • Can be used to evaluate whether the value of a country’s currency is appreciating or depreciating.
  • Assists the government in making budgetary and trade policy decisions.
  • Provides crucial data for analysing and comprehending the economic dealings of a country with other countries.

Components of the Balance of payments (BOP)

• Current account: It includes the financial transactions dealing with the export and import of goods, services, unilateral transfers, investment income etc.
• Capital account: It includes the financial transactions dealing with assets such as foreign direct investment, foreign portfolio investment, foreign loans etc.
• Official reserve transactions: It conducted by the central bank in case of the BOP deficit or BOP surplus.
• Errors and omissions: It is the element of BOP (other than the current account and the capital account) which refers to the balancing items reflecting the inability to record all the international financial transactions.

Widening Current Account Deficit:

• The quarterly statistics of the RBI shows the widening current account deficit. This marks a reversal from an unusual surplus of 0.9 per cent of GDP in 2020-21.
• The third quarter of the current financial year may witness a fall in the CAD due to widening merchandise trade deficit.

Is the current account deficit a cause for concern?

• There is no one single answer to this question as India’s CADs have both desirable and undesirable components.
• Capital flows are pro-cyclical and react negatively to contractionary monetary policy by the Fed.
• Desirable deficits are mainly due to:
  • Rising investment
  • Portfolio choices
  • Demographics of the country
• Undesirable deficits are mainly due to: They reflect bigger problems such as poor export competitiveness and are financed by unstable financing.
• However, large and persistent CADs can be undesirable. This can expose India to the risks associated with its financing.
• Volatile capital inflows:
  • If CADs are financed by stable capital inflows, such as FDI inflows, they are desirable as they are less prone to capital flight.
  • However, if deficits are financed by volatile capital flows such as portfolio flows, there may be a cause of concern.
  • Portfolio flows are capricious and more susceptible to reversals in case of any global financial shock.
• FDI inflows in India are week in the current financial year.
• Stable capital flows are desirable as they allow debtor countries, such as India, to utilise and allocate them into sectors that may yield long-term productive gains and foster higher economic growth.

Countercyclical nature of India’s CAD:

• Recent research suggests that the country’s CAD rises when output falls rather than when demand rises. This indicates the dominance of external shocks.
  • For instance, if oil prices rise, and as oil is an input in the production process, it raises the cost of production and leads to a fall in economic growth.
  • This is the case where CADs rise with falling growth due to both the inelasticity of oil import demand as well as its major share in India’s total imports.
• Imported inflation:
  • Further rate hike by the US Fed may lead to capital outflows leading to additional exchange rate market pressures.
  • This can escalate the challenges in the present situation. A weaker currency coupled with unbalanced CAD can lead to imported inflation.

Service exports in India:

• India’s services exports grew at 23.5 per cent in 2021-22.
• An increase in the remittances and services exports have provided a counter-balance to rising merchandise trade deficits.
• Both have exhibited remarkable stability.

Way Forward:

• As a medium term measure, policymakers need to arrest the negative spillovers from the slowdown in global trade on merchandise exports.
• Policy measures must focus on structural reforms to facilitate exports  and improve trade competitiveness.
• India must sign free trade agreements maintain trade balance.

Conclusion:

• India is currently facing the twin-deficit problem of high fiscal and CADs.
• Uncertainty caused by the raising fears about a global slowdown can make an aggressive fiscal consolidate ineffective.
• India must focus on maintaining a comfortable external environment by ensuring stable financing, along with using exchange rates as a shock absorber to weather the adverse global economic situation.

-Source: The Indian Express