Dogmas and the deficit

Conventional economic wisdom suggests that for an economy like India, it is time to start worrying when the current account deficit (CAD) crosses 3 per cent of the GDP. When it crosses 5 per cent, as it did in the second quarter of 2012-13, worrying alone doesn't help. It is time to take immediate corrective action. The question is, what kind of policy action will do the trick? For one thing, a piecemeal approach to bridging the CAD is unlikely to pay off. We need to base the corrective strategy on a comprehensive assessment of our trade policy, our industrial structure and the various imbalances that have fed a rising imbalance in our external account. We also, perhaps, need to jettison some dogmas and look for solutions that possibly lie out of the box of conventional wisdom.

The first thing to recognise is that though the focus has been on rising gold imports as the cause for the rise in the CAD, it is only part of the problem. In 2011-12, the CAD printed at 4.2 per cent of GDP. Even if we were to take gold imports (net of re-exports) out of this, we would be left with a CAD of 1.8 per cent. In 2012-13, when the CAD is likely to be over 5 per cent of GDP, the non-gold deficit would amount to about 3 per cent of GDP. A breakdown of the import bill reinforces this point. Even with the rise in gold imports over the last three years, they constitute about 12 per cent of the total import bill. Thirty-three or 34 per cent of imports is oil, and the balance of around 55 per cent comes from non-oil imports. Thus, reducing gold imports will help pare the deficit to a degree, but it cannot be the sole solution. We need to pay as much attention to other components of the CAD and the merchandise trade deficit that underpins it.

What kind of compression in gold imports can we realistically get? Even if the current surge in gold imports were to abate, there would be a "core" import demand stemming from its demand both for jewellery and, increasingly, as an asset class. As an economy, we have to learn to live with this. The exact quantum of this core demand is difficult to gauge. One could use the average annual gold imports of $15-20 billion that prevailed before the surge in imports started in 2010-11 as an informed "guesstimate".

The rising domestic demand for gold should not be viewed through the prism of the CAD alone. At a time when there is so much policy attention and public awareness about the parallel economy, it might be useful to keep in mind the fact that cash transactions in gold is a conduit for black money. Thus, the bid to curb gold holdings should also be an integral part of the drive to check the rise in the black economy. A first step to do this would be to ensure that all gold transactions over, say, Rs 25,000 are made through cheques.

The RBI's expert committee on gold has made a number of sensible recommendations to reduce gold imports. Financial products (like gold deposits) that both enable investors to enjoy the returns associated with gold but simultaneously enable banks to only hold a fraction of these deposits in gold holdings to "back" these products, could go some way in reducing the demand for gold imports. A couple of other things could also help. For one thing, there has to be an effort to make the domestic market for gold more active, so that fresh demand can be met through domestic stocks of gold rather than imports. Banks could play a major role in making this market by offering two-way quotes in gold. Thus, instead of being allowed to only sell gold as they currently are, banks should also be allowed to buy gold. The other policy initiative that would help would be for the RBI to operate a repurchase (repo) window for banks using its existing stocks of gold (currently valued at Rs 1,437.5 billion). This would help ease temporary problems of gold liquidity that banks could face in making markets.

Lower gold imports will help, but any successful attempt at sustained compression of the CAD will involve a compression of the non-gold component of the trade deficit. The trade deficit for 2011-12 was $189 billion, or 10.3 per cent of the GDP. Net of gold, the trade deficit reduces to $140 billion or 7.6 per cent of the GDP. The trade deficit excluding both gold and oil was $42 billion, or 2.3 per cent of the GDP.

Some analysts argue that the onus of correcting the imbalance in trade should come from exports. This is somewhat unfair. Indian exporters find themselves strapped with inferior infrastructure ranging from inadequate power and port facilities, a cumbersome regulatory system and a challenging labour regime. The World Economic Forum compiles a competitiveness index that factors these elements in. Their latest survey ranks India at 59 among 144 countries in terms of overall competitiveness and 84 on the sub-index of infrastructure. The corresponding ranks for China are 29 and 48; for Thailand (a key Asian exporter) the rank is 38 for overall competitiveness and 46 for infrastructure. The implication is that given the handicap that exporters face, the burden of structural correction of the trade deficit in the short to medium term has to come from imports.

The stock argument when it comes to the large oil import bill is that it is contingent on the vagaries of the global market for oil. There is little we can do domestically about it. However, while it is true that we can do precious little about fluctuations in oil prices, we can ensure that oil import volumes remain in check. Crude oil import volumes have increased by 8-9 per cent on average for the past five years despite a slowing economy. This is because we have done very little to encourage conservation. We must remember that fuel subsidies are not just a drag on the fisc; they also encourage domestic consumers to use much more fuel than is optimal. A net fuel importer like India simply cannot afford this. We have taken the first step towards conservation through the partial deregulation of diesel prices and a cap on LPG subsidies. We need to do much more to make sure that domestic prices are at least partly aligned with international prices.

The writer is chief executive officer of HDFC Bank. This is the first of a two-part series

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