Linking fiscal deficit with the CAD is incorrect and misleading. Ideally, India should encourage more FDI to narrow the gap
Going by the obsession of both RBI and now the finance ministry, attention has been deflected from the fiscal account deficit (FAD) and interest rates to the current account deficit (CAD). We have probably now assumed that growth has bottomed out and can only improve from here and that inflation is something over which we have no control. With the usual tossing of issues of interest rates and growth stimulus between the RBI and the ministry of finance becoming passé, the CAD has caught everyone’s attention. At times, we have gone overboard to also say that the fiscal account deficit (FAD) is responsible for the CAD. Are we missing something somewhere?The CAD is actually one aspect of the economy over which no one has any control and is largely market-driven. It happens exogenously and neither RBI nor the government is responsible for the number. As the government is not really involved in most of the components of the external account (except for loans from IMF, etc), tracing the problem to the fiscal side is questionable.The two components are the trade deficit and the invisibles account. Exports increase or decrease due to demand or competitive conditions. The commerce ministry can provide sops to exporters, but if they have to push forward their product, the price and quality matter. The rupee has been under pressure and should have given an impetus. But that has not worked with the global economy in a tailspin. The fiscal deficit does not matter here.The same is the case with imports. As mentioned by the FM, the imports nemesis is the COG bill—coal, oil and gold. The government is not spending on these items, but the public is. Therefore, the government does not come into the picture as has been alleged. The best the government can do is to raise duty rates or restrict quantitative imports—which it is loath to do given that we have agreed to the rules of WTO, which accepts tariffs but discourages quotas. There have been measures taken to curb the import of gold by making it expensive, which has worked at the margin. Fiscal spending again does not directly affect the trade deficit. The subsidy provided on fuel products only protects sections of society from the price changes and does not add on its own to the demand for oil.A thought worth considering is to have quotas for gold imports and also restrict the end-use of forex taken under the R2 lakh allowance. While it is true that a black market will emerge, it will not involve official forex reserves and hence this could be one way of drawing out black money from the system as these transactions would have to be off the official channels—both dollars and gold.The other component, invisibles, again does not feature the government anywhere in its spending. The receipts come from remittances and earnings of IT companies, which, linked with the global fortunes, have no government intervention. Therefore, linking the FAD with the CAD is incorrect and misleading. The two are distinct entities and while theoretically the CAD is the difference between savings and investment, where government dis-saving on account of high spending lowers the savings rate, none of the transactions per se actually affect the CAD significantly. The theoretical formulation of this linkage is more an ex-post identity.This also means that RBI also can do little to influence any of these components and, like the government, can only amend policies to encourage countervailing flows to make up for the widening CAD. As the current account has been opened up for all practical purposes, there is little scope for having any restrictive conditions here. Our recognition that the CAD is a problem is noteworthy, which has been reiterated by the FM in the Budget speech. The solution is more in the area of opening up the windows to capital flows. But this has to be viewed with caution. Quite clearly, if the CAD widens and we want to protect our forex reserves and thereby the exchange rate so that RBI does not have to intervene regularly to steady the rupee, foreign investment has to be welcomed in a big way. We are tending to focus more on investment through the portfolio route, but the only concern is that their enlarged limits in government securities market and the other debt segments actually shakes the stance we have taken so far that our debt levels may be high—the government’s in particular—but is being internally financed. The possibility now is that this component will increase as we gradually draw in more such funds. Ideally the concentration should be on FDI, but quite a few of our policies relating to FDI in retail, insurance and pensions are still stuck in an intellectual imbroglio. The other step taken by RBI in allowing more scope for ECBs is commendable but leads to an increase in our external debt, which is now well above our forex reserves at over $350 billion. Therefore, while we do need to have proactive policies to counter the CAD, which is the only way out, these other considerations, should be kept in mind as we go along. Also, this dependency does tend to make policies rather skewed towards such investment in order not to offend such flows. To that extent, the government loses some degrees of freedom when it comes to policy formulation. Last year, the announcement on GAAR had a severe backlash with an outflow of dollars leading to the rupee taking a major hit, which was reversed only after clarifications were made and the policy was withdrawn to be deferred for a later date. The CAD issue needs to be understood in the right perspective and we should not bark up the wrong tree for a solution. The situation is different from 1991-92 when the capital account existed only in the form of loans from governments and multilateral agencies. While policies relating to capital flows should be revised and liberalised, the downside risks need to also be kept in mind. This also means that we need not seriously consider capital account convertibility for some more time.
Going by the obsession of both RBI and now the finance ministry, attention has been deflected from the fiscal account deficit (FAD) and interest rates to the current account deficit (CAD). We have probably now assumed that growth has bottomed out and can only improve from here and that inflation is something over which we have no control. With the usual tossing of issues of interest rates and growth stimulus between the RBI and the ministry of finance becoming passé, the CAD has caught everyone’s attention. At times, we have gone overboard to also say that the fiscal account deficit (FAD) is responsible for the CAD. Are we missing something somewhere?The CAD is actually one aspect of the economy over which no one has any control and is largely market-driven. It happens exogenously and neither RBI nor the government is responsible for the number. As the government is not really involved in most of the components of the external account (except for loans from IMF, etc), tracing the problem to the fiscal side is questionable.The two components are the trade deficit and the invisibles account. Exports increase or decrease due to demand or competitive conditions. The commerce ministry can provide sops to exporters, but if they have to push forward their product, the price and quality matter. The rupee has been under pressure and should have given an impetus. But that has not worked with the global economy in a tailspin. The fiscal deficit does not matter here.The same is the case with imports. As mentioned by the FM, the imports nemesis is the COG bill—coal, oil and gold. The government is not spending on these items, but the public is. Therefore, the government does not come into the picture as has been alleged. The best the government can do is to raise duty rates or restrict quantitative imports—which it is loath to do given that we have agreed to the rules of WTO, which accepts tariffs but discourages quotas. There have been measures taken to curb the import of gold by making it expensive, which has worked at the margin. Fiscal spending again does not directly affect the trade deficit. The subsidy provided on fuel products only protects sections of society from the price changes and does not add on its own to the demand for oil.A thought worth considering is to have quotas for gold imports and also restrict the end-use of forex taken under the R2 lakh allowance. While it is true that a black market will emerge, it will not involve official forex reserves and hence this could be one way of drawing out black money from the system as these transactions would have to be off the official channels—both dollars and gold.The other component, invisibles, again does not feature the government anywhere in its spending. The receipts come from remittances and earnings of IT companies, which, linked with the global fortunes, have no government intervention. Therefore, linking the FAD with the CAD is incorrect and misleading. The two are distinct entities and while theoretically the CAD is the difference between savings and investment, where government dis-saving on account of high spending lowers the savings rate, none of the transactions per se actually affect the CAD significantly. The theoretical formulation of this linkage is more an ex-post identity.This also means that RBI also can do little to influence any of these components and, like the government, can only amend policies to encourage countervailing flows to make up for the widening CAD. As the current account has been opened up for all practical purposes, there is little scope for having any restrictive conditions here. Our recognition that the CAD is a problem is noteworthy, which has been reiterated by the FM in the Budget speech. The solution is more in the area of opening up the windows to capital flows. But this has to be viewed with caution. Quite clearly, if the CAD widens and we want to protect our forex reserves and thereby the exchange rate so that RBI does not have to intervene regularly to steady the rupee, foreign investment has to be welcomed in a big way. We are tending to focus more on investment through the portfolio route, but the only concern is that their enlarged limits in government securities market and the other debt segments actually shakes the stance we have taken so far that our debt levels may be high—the government’s in particular—but is being internally financed. The possibility now is that this component will increase as we gradually draw in more such funds. Ideally the concentration should be on FDI, but quite a few of our policies relating to FDI in retail, insurance and pensions are still stuck in an intellectual imbroglio. The other step taken by RBI in allowing more scope for ECBs is commendable but leads to an increase in our external debt, which is now well above our forex reserves at over $350 billion. Therefore, while we do need to have proactive policies to counter the CAD, which is the only way out, these other considerations, should be kept in mind as we go along. Also, this dependency does tend to make policies rather skewed towards such investment in order not to offend such flows. To that extent, the government loses some degrees of freedom when it comes to policy formulation. Last year, the announcement on GAAR had a severe backlash with an outflow of dollars leading to the rupee taking a major hit, which was reversed only after clarifications were made and the policy was withdrawn to be deferred for a later date. The CAD issue needs to be understood in the right perspective and we should not bark up the wrong tree for a solution. The situation is different from 1991-92 when the capital account existed only in the form of loans from governments and multilateral agencies. While policies relating to capital flows should be revised and liberalised, the downside risks need to also be kept in mind. This also means that we need not seriously consider capital account convertibility for some more time.
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