Date: 17/12/2022

Relevance: GS-3: Indian Economy and Government Budgeting, Government Policies & Interventions.

Key phrases: Current account Deficit ,capital account, BOP, Finance minister, exports, inevitable recessions, Reserve Bank of India (RBI), US Federal Reserve, capital inflows, fiscal stimulus

Why in News?

• Recently, the Finance minister has shown great optimism about India’s near-term growth prospects because of major signs of global energy and commodity shocks subsided.
• However, experts argued that even if these shocks have subsided, India still faces one big problem — 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.

Key Highlights:

• The post-pandemic normalisation has caused the current account deficit to swell to exceptional proportions.
• In India post-pandemic normalisation has spurred a renewed demand for imported inputs. But abroad, it has had the opposite effect, leading to a decline in demand.
• Foreign households' demand plateaued because 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.
  1. Foreign demand will slow further as advanced countries slip into what now seem like inevitable recessions.
  2. 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”.

Key hurdles for India:

1. Difficult to attract foreign direct investment(FDI):
   • Attract foreign capital inflows worth at least four per cent of GDP. This is challenging because:
     • World is currently facing unprecedented levels of uncertainty in the economy.
     • After two years of the pandemic, the world is witnessing a war in Europe.
     • The highest inflation in the developed world in the last four decades.
     • The fastest pace of interest rate hikes in the history of the US Federal Reserve.
     • An energy crisis in Europe, and a slowdown in China that continues to struggle with Covid-19.
2. Large FDI outflows:
   • Foreign investors are prefering to invest in safe assets such as US government bonds rather than emerging markets like India.
   • Persistent rate hikes by the Fed have made US financial assets even more attractive. As a result, India has witnessed large outflows of foreign capital in 2022-23.
3. Depleted Foreign Exchange Reserves:
   • Currently, India is unable to attract the required amount of capital inflows, the RBI’s foreign exchange reserves are deployed to pay for imports.
   • This strategy is neither appropriate nor sustainable. The country’s reserves are meant to tide the country over short-term problems, such as commodity price spikes.
   • The large CAD, however, is not a short-term problem: It is a long-term problem requiring a long-term solution.

Key solutions suggested:

• Balance the demand and supply of dollars:
  • India’s CAD reflects a mismatch between the demand and supply of foreign exchange.
  • India is demanding more dollars than it has access to because the nation is importing more than exporting.
• Needs to depreciate the Indian rupees:
  • Depreciation will make exporting more profitable, inducing more and more firms to explore foreign markets.
  • Foreign demand improves, because the rupee depreciation makes India’s products more price-competitive. As a result, exports increase — and the CAD falls.
  • In the April-January period of 2021-22, India’s merchandise exports grew at a staggering rate of 46 per cent compared to the same period in the previous year. But with exports now declining, this crucial source of growth has now become uncertain for India.
• Incentivisation of Private sector investment:
  • Private investment continues to be sluggish and is unlikely to pick up in an uncertain economic environment.
  • Nor is there room for fiscal stimulus, since the high levels of government deficits and debt need to be reduced.
  • Even though the Indian economy is regarded as consumption-driven, private consumption by itself cannot sustain a growth rate of 7 per cent, especially when all other sources of growth are underperforming.
• Strengthening the export sector:
  • The sector is critical for sustaining growth. It has high potential, since India’s share in global exports is very small and there is ample scope to expand this share.
  • Besides rupee depreciation, it will require structural policies — indeed, a fundamental shift in India’s economic strategy towards more export-oriented and less protectionist policies.
• Streamline tariffs:
  • Over the last few years, average import tariffs have gone up in India.
  • In a world where manufacturers are dependent on global supply chains, levying stiff import duties hampers exports.
  • Such tariffs cannot be overcome by providing subsidies to a selected few producers.

Conclusion:

• In sum, the need of the hour is four-fold: Allow the rupee to depreciate, encourage foreign firms to produce in India by letting them access their supply chains, encourage domestic firms to step up to the competition, and create a level playing field for all players.
• By adopting Pro-competition strategy, India could potentially solve its two most important macroeconomic problems — reducing the large CAD and securing rapid, sustained growth.

Source: Indian Express

Mains Question

Q. The post-pandemic normalization has caused the current account deficit to swell to exceptional proportions in India. Examine this statement and give solutions to reduce the current account deficit in India. (15 marks).