There seems to be a considerable amount of optimism about India’s near-term growth prospects, now that the major global energy and commodity shocks have subsided. But how will this growth be sustained? And 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.
Let’s start with the second problem. Over the past year, the post-pandemic normalisation has caused the current account deficit to swell to exceptional proportions. 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. 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.
Looking ahead, the situation seems set to worsen. Foreign demand will slow further as advanced countries slip into what now seems like inevitable recessions. In that case, India’s CAD could widen even further, possibly to 4 percent of GDP in 2022-23, double the level that the Reserve Bank of India (RBI) traditionally regards as “safe”. How should India respond?
One possibility would be to attract foreign capital inflows worth at least 4 percent of GDP. But is this realistic? The world is currently facing unprecedented levels of uncertainty. Following two years of a pandemic, we are now witnessing a land 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. In such an uncertain environment, foreign investors prefer to invest in safe assets such as US government bonds rather than emerging markets like India. This trend has become all the more acute now, since the 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.
If India cannot attract the required amount of capital inflows, the RBI’s foreign exchange reserves could be deployed to pay for imports. But 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. In particular, India’s merchandise exports have been structurally weak, stagnating for the past decade, until the pandemic induced a short-lived boom.
This means that something fundamental needs to change. Ultimately, India’s CAD reflects a mismatch between the demand and supply of foreign exchange; we are demanding more dollars than we have access to because we are importing more than we are exporting. To restore balance, first and foremost, the price needs to adjust, i.e. the rupee needs to depreciate. 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 for another reason: it can help sustain growth.
The recovery of the Indian economy from the pandemic was largely fuelled by exports. In the April-January period of 2021-22, India’s merchandise exports grew at a staggering rate of 46 percent 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.
This is deeply worrisome, since prospects for the other drivers of long-term growth seem cloudy. Private sector 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. And even though the Indian economy is regarded as consumption-driven, private consumption by itself cannot sustain a growth rate of 7 percent, especially when all other sources of growth are underperforming.
Strengthening the export sector is therefore critical for sustaining growth. True, the task will be difficult, since the global economy slowing down. But it is still feasible, since India’s share in global exports is very small and there is ample scope to expand this share.
Over and above a rupee depreciation, this will require structural policies—indeed, a fundamental shift in India’s economic strategy. Policy needs to become significantly more export-oriented and less protectionist. Over the last few years, average import tariffs have gone up. In a world where manufacturers are dependent on global supply chains, levying stiff import duties hampers exports. And this obstacle cannot be overcome by providing subsidies to a selected few producers.
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 this strategy, India could potentially solve its two most important macroeconomic problems—reducing the large CAD and securing rapid, sustained growth. Will this change come about? Unfortunately, there are no such indications so far.
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