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This is an archive article published on February 22, 2005

Tips on balancing India’s budget

India's current account (trade balance plus invisibles) in 2QFY05 (second quarter of financial year 2005) went into a deficit, recording an ...

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India’s current account (trade balance plus invisibles) in 2QFY05 (second quarter of financial year 2005) went into a deficit, recording an all time high of US$6.4 billion after staying positive for several quarters. This current account deficit is due to the dual effect of the widening trade deficit (imports more than exports) and the slowing down of remittances and software services on the invisibles side. If this trend continues, the current account balance which has been in surplus since FY02 may turn red for the year ended FY05.

If such a situation was to unfold, then should the current account deficit be looked upon as a concern for India and invoke policy prescriptions to alter the trend? Or should such a deficit be welcomed and be a deliberate policy measure? This article tries to throw light on these contentious issues.

A country running a current account surplus simply means that its savings is more than its investments, and it lends this extra savings to foreign countries thus earning an interest income on it. This is precisely what India is experiencing today. India has a burgeoning forex reserve of US$129 billion, which it invests in short-term US T-Bills, thus earning a paltry 2 per cent return on it. But why invest in US securities if the return is so low?

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The answer to this lies in the mercantilist policies followed by our policy-makers, which favours exports to imports. In order to keep the Indian exports competitive in the global market, the RBI intervenes in the forex market time and again to stop the rupee from appreciating. This is done by buying dollars and selling rupee whenever rupee shows signs of appreciation, and then investing the excess dollars in the US debt markets. So the motive for investing in US securities is not to earn a high return but to keep the domestic currency from appreciating in a misguided attempt to support an export led growth.

This raises a fundamental question — which is more important for an economy: exports or imports? The answer to this question lies in a proper understanding of the relationship between scarcity and abundance. Economics deals with the study of scarce resources. Since human wants are unlimited, and resources are limited, it posits a challenge for economists to devise policies such that the scarce resources are mobilised in the most efficient manner as possible. A good or service derives its value depending on how scarce it is and how much marginal utility it confers.

It becomes implicit from this definition, that items which are scarce in a particular country will be valued much more dearly than the goods, which are available in abundance. Or, in other words, imports are much more important than exports for a country simply because, one imports those items which are scarce in one’s countries and exports those items which it has in abundance. Or, put simply, the export earnings of a country are used to pay for the valuable imports.

Based on the above argument, it becomes clear that the ideal policy prescription for a developing country like India should be to deliberately run a current account deficit (fuelled mainly by a non-oil imports led higher trade deficit). A current account deficit would simply mean that India is investing more than it is saving, the deficit amount being financed by foreign savings. The foreign savings should come in the form of mainly FDI and FII, which will be reflected in the capital account surplus.

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But such a policy stance should come with some caveats. The first requirement should be to bring down the revenue and fiscal deficits to as low as possible, ie, a conscious attempt should be made to achieve a balanced budget on the domestic front. The FRBM Act will prove instrumental in achieving this goal. The second most important point is that the current account deficits should be run for attracting foreign capital only for long-term infrastructure projects and not to finance short-term consumption binge of the citizens.

A balanced budget on the domestic front, coupled with a small (1.5 per cent to 2 per cent) current account deficit to finance long term projects will achieve two important targets. Firstly, such a strategy would help India to achieve a long-term sustainable growth on the back of strong infrastructure base. Secondly, it would make it completely unnecessary for Indian policy makers to adopt faulty interventionist policies of accumulating excess forex reserves through sterilisation policies in the first place and then plan to use those same reserves for infrastructure projects thus running a risk of higher fiscal deficit and inflation.

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