INDIA AND THE WORLD

The Problems

1. India’s current account deficit – how much more it imports than it exports – is very sensitive to the global price of crude oil. When oil is expensive, the CAD is too high for comfort; when it falls, the CAD can look manageable.

2. Indian producers are not particularly competitive – which means that even when you take oil and gold imports out of the picture, exports are growing far less than are imports.

3. Any CAD has to be paid for by capital inflows into the economy. For stability, these should be long-term flows like FDI – but India depends too much instead on short-term ‘hot money’.

4. When a country exports less than it imports, its currency depreciates – or loses value. But a lengthy and outsized depreciation of the rupee, while a natural consequence of a high CAD, would also stoke fears about macroeconomic instability.

De-Risking the External Sector

Sajjid Z. Chinoy

Abstract

The sharp decline in crude prices in late 2018 provided much-needed relief to India’s external sector. But we must remain cognizant of underlying fault lines. The pressure on India’s balance of payments through much of 2018 revealed: (i) India’s external balances remain very sensitive to sharp swings in global crude prices, creating ‘boom–bust’ cycles on the external sector precipitated by crude price movements; (ii) the underlying (non-oil, non-gold) current account balance has deteriorated sharply in recent years and is contributing to the pressures; and (iii) there still exists an uncomfortably high reliance on volatile capital flows to fund the current account deficit.

Consequently, the policy focus must be to narrow the CAD to more sustainable levels – even if crude prices were to re-accelerate – and to de-risk the external sector more generally. This would entail: (i) narrowing the consolidated fiscal deficit (since the recent increase in the CAD simply reflects an incipient investment recovery against the backdrop of high public dis-saving); (ii) improving the competitiveness of the tradable sector (through infrastructure, factor market reforms, improved viability of small and medium enterprises [SMEs]) to improve the non-oil, non-gold current account balance; (iii) creating an institutional framework to systematically hedge sharp crude price movements to help mitigate external sector and fiscal risks; and (iv) continue working on creating an enabling domestic environment (regulatory, tax, ease of doing business) to attract more stable capital inflows (such as FDI and passive bond flows) so that the CAD can be increasingly financed by such inflows and less by volatile or pro-cyclical flows.

Context and challenge

· For much of 2018, India’s external imbalances widened to levels that appeared unsustainable, particularly against an increasingly challenging global backdrop characterized by a continued normalization of financial conditions in some developed economies.

· India’s CAD widened to 2.7 per cent of GDP in the first half of 2018–19 versus 1.9 per cent of GDP the previous year, and was on track to being close to 3 per cent of GDP in the second half of the year if oil had continued averaging $75/barrel.

· The collapse in crude prices has provided much-needed relief on the external front. But this should not mask underlying pressures: India’s underlying (non-oil, non-gold) current account balance has deteriorated by almost 3 per cent of GDP in three years – suggestive of waning underlying competitiveness.

· On the capital account, the economy witnessed portfolio outflows for the first half of the (fiscal) year – precipitated by a tightening of global financial conditions – causing net capital inflows to slow significantly.

· The combination of a widening CAD and the sharp slowing of capital inflows meant the economy witnessed a meaningful BoP deficit in the first half.

· This resulted in a steady depletion of foreign exchange reserves and sustained rupee depreciation pressures. While some degree of rupee depreciation was an inevitable/optimal response to a negative terms of trade shock (emanating from higher crude prices), relentless and outsized rupee depreciation risks both: (i) engendering self-fulfilling pressures, and (ii) stoking financial and macroeconomic instability concerns.

What needs to be done?

While the sharp decline in crude oil prices recently has alleviated the stress, BoP pressures need to be addressed more fundamentally through a multipronged approach that: (i) reins in the CAD; (ii) reduces the susceptibility of the CAD to swings in global crude prices; (iii) improves the quality of capital inflows – such that a larger fraction of the CAD can be financed by stable flows; and (iv) continues augmenting foreign exchange reserves/buffers through bilateral and multilateral swap agreements.

Current account measures

A key policy imperative is to narrow the CAD to more sustainable levels. The experience over the last decade suggests a CAD in the range of 1.5–2.5 per cent of GDP can be financed predominantly by stable capital inflows (FDI and NRI deposits), thereby minimizing reliance on volatile or pro-cyclical sources of funding. Reining in the CAD would likely entail:

· Bringing down the consolidated fiscal deficit, which is still close to 6.5 per cent of GDP. At these levels, India’s consolidated fiscal deficit remains an outlier in the emerging market universe. While the Union government has been steadily reducing its deficit, state deficits have doubled in the last five years and thereby largely undone the Centre’s consolidation (see Figure 1). The CAD is simply the gap between investment and savings in the economy. The widening of the CAD therefore is simply reflecting an incipient pickup in domestic investment against the backdrop of high public dis-saving – in other words, a high consolidated fiscal deficit. Thus, the more the consolidated fiscal deficit can be brought down, the more the CAD can be compressed without having to reduce investment or private consumption (so as to boost private savings). To achieve this, therefore:

Figure 1: India’s underlying current account surplus (excluding oil and gold)

(four-quarter moving average, as a percentage of GDP)

Source: RBI, JP Morgan calculations

– The Centre must assiduously follow the fiscal path laid out by the FRBM Review Committee to reduce its deficit to 2.5 per cent of GDP by 2022–23.

– State deficits must be reined in by changing the incentives under which state finances operate and better aligning incentives with desired outcomes. The 15th Finance Commission should perhaps consider: (i) designing their horizontal distribution formula to include incentives for states to be fiscally prudent; and (ii) suggest regulatory interventions to ensure state borrowing costs are correlated with underlying fiscal positions.

· Improving tradable sector competitiveness.

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Figure 2: India’s fiscal deficit (as a percentage of GDP)

Source: RBI

– Continue doubling down on infrastructure buildout (particularly transportation and port infrastructure) and continue with factor market reforms (land, labour, financial sector) to increase efficiencies, reduce costs and improve competitiveness of the tradable sector.¹ Perhaps these factor market reforms (land, labour) can first be tried in special export zones to reduce the political economy challenge.

– Improve the viability of the SME sector (a key labour-intensive, export and import-competing sector) and create an enabling environment (e.g., liberalizing labour laws) for SMEs to achieve scale economies.

– Address the tariff-inversion problem in several sectors by bringing down tariffs on intermediate imports in line with those on final goods.

– Formulate an overarching strategy to exploit the (quite large) untapped potential of agricultural exports by dismantling export controls and stockholding limits (Essential Commodities Act) that militate against scale economies.

– In this vein, policymaking must be nimble and stand ready to take advantage of Chinese tariffs on US agricultural products by quickly facilitating export of key agricultural products (cotton, soybean, maize) to China.

· Insulating the economy from sharp swings in crude prices by creating an institutional framework to systematically hedge crude prices.

– India’s heavy dependence on oil imports often results in boom–bust cycles on the BoP when crude prices swing around. For example, the CAD collapsed to 0.7 per cent of GDP in 2016–17 as crude prices fell and was then tracking close to 3 per cent of GDP in 2018 when crude prices bounced back up.

– Policymakers should smooth out this volatility by undertaking a systematic programme to hedge global crude prices, as some other economies have begun to do. This would significantly reduce external sector uncertainty and also impart more certainty to Budget projections. But doing so would entail creating a transparent and institutionalized framework to systematically hedge international crude prices so as to align bureaucratic incentives.

– Hedging crude prices is not meant to second-guess future market movements; instead it is meant to mitigate risk and avoid boom–bust cycles. The government effectively used excise duty changes to ensure equitable burden sharing between the public and private sector of the oil windfall. Hedging crude prices would ensure less uncertainty/volatility of the terms of trade shock.

– Separately, authorities must be complimented for deregulating pump prices; this must be persisted with, because the volume response to price changes serves as an automatic stabilizer for the CAD.

Capital account measures and augmenting foreign exchange reserves

· Apart from reining in and smoothing the CAD, efforts must be undertaken to attract more stable capital inflows so that any given CAD is increasingly financed by stable inflows and is not reliant on volatile and pro-cyclical capital flows (portfolio investment/trade credits/banking capital).

– Regulatory, tax, ease-of-doing business policies must combine to create a more enabling environment to attract more FDI, such that FDI flows are financing a progressively larger fraction of any CAD. Seventy per cent of the growth in China’s exports to the United States in the last decade came from US firms manufacturing in China.

– Policymakers must also gradually prepare the groundwork to enter a global bond index, so the economy can eventually become the recipient of more ‘passive’ debt inflows that are more sticky and less sensitive to changes in global sentiment.

· Firms that are not naturally hedged must be induced/incentivized/mandated to hedge any foreign currency borrowings so as to avoid any systemic buildup of financial vulnerabilities, apart from not constraining the exchange rate as a policy instrument.

· Policymakers must continue entering into more bilateral and multilateral swap engagements to boost ‘effective’ foreign exchange reserves and augment the economy’s buffers.

The Solutions

1. The government will have to commit to reducing its fiscal deficit – and to pushing states to reduce theirs. When the government spends more than it earns, it pushes up the CAD as well.

2. The tradable sector – both exporters and those Indian producers who compete with imports – has to become more competitive, so exports grow faster than imports and the CAD decreases. This would need more and better infrastructure, more flexible land and labour laws, and a focus on growing agricultural exports.

3. As long as India is a big oil importer, it will not be totally insulated from higher oil prices. But if there were better ways to reduce the uncertainty caused by sudden shifts in the oil price, you could at least ensure there was less instability. Institutions that allow companies and the government to hedge against changes in oil prices need to be built.

4. Another source of stability would be attracting long-term capital flows, such as FDI. This would again need the government to make investing in India look genuinely attractive.

¹See Pranjul Bhandari’s note, ‘Slow Pace of Infrastructure Buildout’, in this volume for a fuller discussion on the infrastructure sector prospects and constraints; and the note by Gita Gopinath and Amartya Lahiri, ‘India’s Exports’, for policy initiatives to boost India’s exports.

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