Context

• There seems to be considerable optimism about India’s near-term growth prospects now that the major global energy and commodity shocks have subsided. Even if these shocks have subsided, India still faces one big problem of its large current account deficit (CAD). How will this be managed? It turns out that the answer to both questions lies in one word exports.

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What is Current Account Deficit (CAD)?

• A current account is a key component of balance of payments, which is the account of transactions or exchanges made between entities in a country and the rest of the world.
• This includes a nation’s net trade in products and services, its net earnings on cross border investments including interest and dividends, and its net transfer payments such as remittances and foreign aid.
• A CAD arises when the value of goods and services imported exceeds the value of exports, while the trade balance refers to the net balance of export and import of goods or merchandise trade.
• CAD = Trade Deficit + Net Income from Abroad + Net transfers

What has been the recent trend?

• Swelling CAD: Over the past year, the post-pandemic normalisation has caused the current account deficit to swell to exceptional proportions.
• Decline in demand abroad: At home, normalisation has spurred a renewed demand for imported inputs. But abroad, it has had the opposite effect, leading to a decline in demand.
• India’s import soared while exports fell: Foreign households are no longer demanding so many goods now that the lockdowns that kept them in their houses and the fiscal stimuli that gave them the money to spend have both ended. So, India’s imports have soared just at a time when its merchandise exports have started to fall.
• Statistics for instance: The difference between the value of goods imported and exported fell to $54.48 million in Q4FY 2021-22 from $59.75 million in Q3 FY2021-22.
• Service sector is saviour: However, based on robust performance by computer and business services, net service receipts rose both sequentially and, on a year, -on-year basis.

Future projections

• Looking ahead, the situation seems set to worsen: Foreign demand will slow further as advanced countries slip into what now seem like inevitable recessions.
• In the backdrop of recession India’s CAD could widen further: In that case, India’s CAD could widen even further, possibly to four per cent of GDP in 2022-23, double the level that the Reserve Bank of India (RBI) traditionally regards as “safe”.

Analysis: How should India respond?

1. Attracting foreign capital inflow: Attract foreign capital inflows worth at least four per cent of GDP.

• Is this realistic in time of global uncertainty: The world is currently facing unprecedented levels of uncertainty. Two years of the pandemic, now a land war in Europe, inflation and energy crisis in Europe, interest rate hikes in the history of the US Federal Reserve, slowdown in china, etc. In such an uncertain environment, foreign investors prefer to invest in safe assets such as US government bonds rather than emerging markets like India. As a result, India has witnessed large outflows of foreign capital in 2022-23

2. Deploying RBI’s Forex to pay for imports: If India cannot attract the required amount of capital inflows, the RBI’s foreign exchange reserves could be deployed to pay for imports.

• Is this strategy sustainable: The country’s reserves are meant to tide the country over short-term problems, such as commodity price spikes. India’s merchandise exports have been structurally weak, stagnating for the past decade, until the pandemic induced a short-lived boom.

How depreciating rupee could be helpful?

• Price needs to be adjusted by depreciating rupee: This means that something fundamental needs to change. Ultimately, India’s CAD reflects a mismatch between the demand and supply of foreign exchange. To restore balance, first and foremost, the price needs to adjust, that is, the rupee needs to depreciate.
• Exporting becomes more profitable: When this happens, exporting becomes more profitable, inducing more and more firms to explore foreign markets. Meanwhile, foreign demand improves, because the rupee depreciation makes India’s products more price-competitive. As a result, exports increase and the CAD falls.
• Exchange rate depreciation is helpful in sustained growth: The recovery of the Indian economy from the pandemic was largely fuelled by exports. But with exports now declining, this crucial source of growth has now become uncertain for India. Strengthening the export sector is, therefore, critical for sustaining growth.

Way forward

1. Allow the rupee to depreciate,
2. Encourage foreign firms to produce in India by letting them access their supply chains,
3. Encourage domestic firms to step up to the competition, and
4. Create a level playing field for all players.

Conclusion

• The large CAD, however, is not a short-term problem: It is a long-term problem requiring a long-term solution. By adopting the discussed strategy, India could potentially solve its two most important macroeconomic problems that are reducing the large CAD and securing rapid, sustained growth.

Mains question

Q. What is Current account deficit (CAD)? In a time of global uncertainty How India can reduce its large CAD and secure sustained growth. Analyze

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