Wednesday, December 15, 2010

Current account deficit - how big a deal?

Several observers have expressed concern about India's rising current account deficit. In recent months, the deficit has indeed been on rise.

However, contrary to popular perception this need not cause the same degree of alarm it used to say 10 years ago.

In general a widening current account deficit is a negative. In India’s case however, it is almost acting as the counterweight to the hot money flows and is helping RBI avoid the nasty problem of either letting the currency appreciate (if it does not intervene by buying dollars) or increasing the money supply (it if does intervene). Contrary to a widely held belief, the hot money flows are not only equity markets driven. A good portion of this is also invested in debt in India and that is primarily driven by the differential in interest rates across developed economies and India. Since that is likely to last for a while owing to quantitative easing by the Fed, I would think the hot money flows are unlikely to abate in a significant way in the near future.
Structurally of course it is dangerous to have this fragile equilibrium for long. Hopefully some pick up in global economy would support exports growth from India and reduce the deficit. On the other hand, one can hope that the break up of the capital inflows moves towards more stable FDI. In fact, in one of the recent articles, The Economist highlights the so called 'Delhi Consesus' which in essence is about letting the capital inflows happen as a positive and much needed outcome of superior economic growth in emerging economies vis-a-vis developed ones. Following is an interesting graph from that article.

Even portfolio investments are made out to be much more volatile, bigger and potent villains than they really are. In a country like India sitting on over $280bn of forex reserves, a capital flight out of India of hot money can hardly bring about macroeconomic instability.

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