When CAD is bad

A record high current account deficit,at 6.7 per cent,is causing concern among policymakers. It is not yet clear whether 5 per cent will become the new normal. But evidently,old-style policies,like imposing a duty on gold imports,which policymakers had brought back a long time after the then Finance Minister Manmohan Singh had reduced it in 1991,have not contained the deficit. The import duty on gold had not prevented the deficit from rising in the pre-1991 balance of payments crisis,nor has it stopped it from climbing now. There is no simple recipe for a lower level of CAD it depends on sound fundamentals. A high savings rate,encouraged by low inflation and faith in the currency,will reduce the current account deficit,that is,the total of what the country spends in excess of what it produces.

In the short term,the policy challenge is to keep capital flows coming in so that there is no sudden or sharp rupee depreciation. India is not yet comfortable with high volatility of the exchange rate. As long as capital keeps flowing in,there is little danger the rupee will depreciate. The policy environment for investment,fiscal consolidation,tax reforms,capital controls,good governance and political stability all feed into the confidence of foreigners. Considering the difficulties India has on many of these fronts,it is fortunate that there is still a belief in the long run in the India story that brings in money to help finance overconsumption,large fiscal deficits,gold jewellery and a large oil bill.

Can this level of CAD be sustained? Countries that have open capital accounts often see the CAD fluctuate. This also goes with a floating exchange rate regime in that policymakers are not concerned about keeping the exchange rate stable. India has moved towards both very slowly. In the long run,it is unlikely that India will have a sustained 5 per cent or 6 per cent deficit,quarter after quarter. What is more likely to happen is that,as the country becomes more integrated both with global production and global capital flows,fluctuations of the CAD will be high. With a closed capital account and a highly pegged exchange rate,we had to be satisfied with a 2 per cent CAD,as anything above that might have been difficult to sustain without letting the rupee move. Today,even at 6.7 per cent,there is no depreciation,as capital is flowing in. As long as policymakers do not decide that they must step in to defend the rupee at some rate assumed to be the correct rate,India will not have a BOP crisis.