Reversing CAD: Correct the fundamentals

Only till recently, India was hoping that by some quirk of fate, that macro-economic data in the US turns bad and the Federal Reserve halts the taper of Quantitative Easing, as that looked like the only way to correct the reversal in rupee’s fortunes and several other related problems in the economy.

India was lucky, as it did. Also, the new Reserve Bank of India Governor took some measures that halted the fall of rupee and sought to bring more dollars to correct our looming current account deficit (CAD) problem. For, now it seems India is out of the woods on balance of payments front and the red line drawn by Finance Minister P Chidambaram would be adhered to. But at what cost?

 Soon after Governor Raghuram Rajan assumed charge of Mint Street on September 4, he announced special measures for creating deeper and more liquid financial markets.
Among them were RBI’s offer of dollar swap window through which entire dollar demand by oil companies has been taken out of market place to be met directly by the central bank and asking banks to raise Foreign Currency Non-resident Indian (FCNR) – a saving account offered by banks to Indians living abroad -- by giving them some temporary hedging facility. In this account the depositor gets back the money as dollars. Now, foreign banks can exchange this money for rupees for one to three-year period at 3.5 percentage points lower than the market rate. After the three-year period, RBI will give back the money in dollars, whatever the cost of the dollar.

 To remove the current pressure on the rupee and CAD, the government has extended extraordinary gains to those who bring in dollars. Consequently, the rupee has been propped up and much-needed dollars are coming in through FCNR. The RBI governor has only a couple of days ago announced that India has got $5.6 billion through this FCNR window.

But, economists are unanimous that the measure to compress CAD for this fiscal is only postponing the actual correction in CAD further. The actual correction could have come through much needed macro-economic correction and giving a fillip to exports while the rupee is weak.

 They have also suggested that the government should do much more to encourage savings. Public savings in the country have remained depressed for too long. That has contributed in pushing up inflation while economic growth is sluggish.

If public savings are allowed to drop,  an increase in consumption expenditure to boost growth will fuel inflation, quite reminiscent to post-Lehman crisis of 2008. If public savings are depressed at a time when investment in the economy is also sluggish, CAD is only expected to rise. Savings can be encouraged either by rise in income or compression in demand.

So, last fortnight when the RBI raised the policy interest rate, it took a step ahead to curb demand which was pushing inflation while the growth was low and wages did not match people’s expectations.

But the recent steps by the government to infuse capital in banks so that they lend at cheaper rates to certain sectors, will only boost demand and lead to distortion in pricing. Unless demand contracts, it would be tough to correct CAD and that would impact the currency and eventually inflation.

India already has high oil and coal imports, and populist programs that fuel inflation and encourage gold imports will only put downward pressure on the rupee. Gold imports, of late, have come down due to government’s measures.

The inward shipment of yellow metal, which was a record 161 million tonnes in May this year, slowed to 3.38 mt in August but increased in September to 7.24 mt and expected to go up during the festive season ahead. Analysts say that gold import control has worked well in the second quarter only because people did not have a clear idea of rules brought out by the government.

 But now, it is clear that for five times imports, one part has to be exported, so there will be a little more in terms of imports in the third and fourth quarters and festive demand also will pick up, according to a bullion trader in New Delhi.

 If that happens, the trade deficit numbers are again going to go out of control which will eventually translate into a rise in CAD later. So, perhaps, $70 billion is something which is achievable this year or it may be better with some accretion in reserves on the back of a handsome $6 billion of foreign direct investment in the first quarter of fiscal year 2013-14.

The flip side

But, the problem here too may arise if there is capital outflows because the biggest relief in halting a slide in rupee has come from Federal Reserve Chairman Ben Bernanke’s September 18 decision of delaying tapering of stimulus programme in the US. That has pegged India’s stock markets again and given a respite to the flying currency. 

But that is only a temporary measure and will end soon. At best, it has given India a window to take forward reforms and find a lasting solution to the looming CAD problem.
Analysts say that if the government falters on correcting fuel prices, taking steps to enhance exports and correct infrastructure bottlenecks, which are coming in the way of more efficient supply mechanism, the benefit of postponement in taper would be denied.