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How long is current account deficit sustainable? Examinein the light of the Indian context

The current account deficit (CAD) represents the difference between exports andimports after considering cash remittances and payments.Indias CAD as a percentage of GDP has risen from 1.3% in Q4 10-11 to 4.5% inQ4 11 -12. The main reasons for Indias ballooning current account deficit isimports of oil and gold. One of the reasons for high crude oil demand isgovernment subsidies, which if removed or cut will lead to a lower importvolume and better CAD.India heavily relies on FIIs to fund the current-account deficit. FIIs are a functionof global economic situation and Indias investment climate and none of themare showing any positive signs. Even if FIIs start pouring in money Indiashouldnt rely on it as FIIs by their very nature are volatile source of capital. Wehave already seen the consequences of dependence on FII in Asian financialcrisis.In 2011-12, the CAD rose to US$ 78.2 billion and Net inflows under Capital andFinancial account (excluding changes in reserve assets) were higher at US$ 67.8billion.However, RBI drew down its reserve by USD 12.4bn. India has roughly USD280bn of foreign reserve which isnt sufficient to support INR in the openmarket. If India goes on at this rate within 20 years the foreign reserve willcome down to zero. But 20 years is a long time to assume all the used data willchange in a similar way keeping the draw down close to USD 12.4bn per year.One way by which India can cover for the deficit is through debt inflows but theyare going to affect Indias external debt position and consequently its financialstability. As CAD increases it puts a pressure on the INR which leads todeterioration of conditions of importer. Since most of the imports i.e. oil andgold are inelastic in nature the demand doesnt slow down in the short run but inthe long run demand will go down and exports will become cheaper because ofthe depreciated INR. This combined effect should improve the CAD but since theglobal economy isnt doing well the demand for Indian exports arent risingsignificantly. Hence, the self correcting nature of CAD will take time to correctback but it will happen once CAD reaches a critical level.India can sustain the current CAD as long as it can be financed through capitalinflows or drawing down the foreign exchange reserves. However running downreserves is impractical beyond certain limits because that will hurt the RBIscapacity to defend its currency in times of attack on INR and one cant bet on

capital flows with surety. So, in the long run India needs productive capacity likeChina, Japan, or Taiwan if it has to do away with the fear of rising CAD andfalling INR.In the near-term the sustainability of the deficit will depend on whether foreigninvestors will continue to add Indian assets to their investment portfolio. If theyrefuse to do so India might fail to sustain the current level of CAD provided thegovernment doesnt go for policy reforms. To add more to the worry the growthrate in exports of invisibles have also subsided. But given the growingconsumption by the Indian middle class, which in itself is growing, I think capitalinflows will keep on increasing because of the abundance of opportunitiesavailable in Indian market. That is more than enough to woo the foreign

investors. And if government comes up with some policy reforms then that willbe a huge advantage. So, my overall view is that if government doesnt take any

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step then the current CAD will be unsustainable. However, I think given theharsh consequences of adjustments which government is aware of and therecent plight of INR, government will not remain an audience for a long time.They can either reduce the imports or try to bring more capital inflows or bothas both will serve the governments purpose. They have already allowed FDI in

aviation and it is very likely that FDI in multibrand retail will also get a nod incoming few months. Government is also trying to curb the demand for preciousmetal by increasing the duty and they have also hiked the petrol and diesel pricerecently. Subsidy cut should also follow maybe just after the 2014 elections assubsidy cut and price hike isnt a populist step although they are good in thelong run. One more step, which seems to be very difficult to execute because ofthe conflict of interest, is to bring at least part of the black money stashed awayby Indian citizens in overseas tax havens to bridge the deficit. All these willdecrease the CAD making it sustainable for India.