Why India needs stable capital flows (2024)

The overall trade deficit has declined to $37.73 billion in the third quarter, from $49.1 billion in the second quarter of 2022-23. The latest statistics also reveal a sharp decline in the trade deficit to $1.27 billion in January on the back of a significant rise in net services exports. So, is the current account deficit a cause for concern?

The answer is not that straightforward. India’s CADs have both desirable and undesirable components. A desirable deficit is a natural reflection of rising investment, portfolio choices and the demographics of the country. However, large and persistent CADs can be undesirable if they reflect bigger problems such as poor export competitiveness and are financed by unstable financing.

The countercyclical nature of India’s CAD is a matter of concern. Research by Ashima Goyal, C Rangarajan and Prachi Mishra suggests that the country’s CAD rises when output falls rather than when demand rises, indicating the dominance of external shocks. For instance, if oil prices rise, and as oil is an input in the production process, it raises the cost of production and leads to a fall in economic growth. In this case, CADs rise with falling growth due to both the inelasticity of oil import demand as well as its major share in India’s total imports.

Large and persistent CADs expose India to the risks associated with its financing. Economic theory suggests that if CADs can be financed by stable capital inflows, such as FDI inflows, they are desirable as they are less prone to capital flight. However, if deficits are financed by volatile capital flows such as portfolio flows, there may be a cause of concern. Portfolio flows are capricious and more susceptible to reversals in case of any global financial shock. Hence, the composition of financing is crucial. While FDI inflows were enough to finance the deficit in 2021-22, these inflows have been weak in the current fiscal year. FDI and portfolio inflows each only financed about 18 per cent of CADs in the second quarter of 2022-23. So, there is a financing issue. Stable capital flows are desirable as they allow debtor countries, such as India, to utilise and allocate them into sectors that may yield long-term productive gains and foster higher economic growth.

Remittances and services exports have provided a counter-balance to rising merchandise trade deficits. India’s services exports grew at 23.5 per cent in 2021-22. In the first half of 2022-23, services exports recorded a growth of 32.7 per cent over the same period last year. Alongside, remittances have reached $48 billion in April-September 2022, an increase of 25 per cent. While capital flows are pro-cyclical and react negatively to contractionary monetary policy by the Fed, remittances have exhibited remarkable stability.

Over the medium term, policymakers need to arrest the negative spillovers from the slowdown in global trade on merchandise exports. Further rate hikes by the US Fed may lead to capital outflows leading to additional exchange rate market pressures. This could be challenging in the current situation as a weaker currency, coupled with a sticky import basket will lead to imported inflation. Policy measures thus must facilitate exports by focusing on structural reforms to improve trade competitiveness, alongside which the government must sign free trade agreements.

India is currently facing the twin-deficit problem of high fiscal and CADs. While aggressive fiscal consolidation may be undesirable in the face of rising fears about a global slowdown, a comfortable external environment can be maintained by ensuring stable financing, along with using exchange rates as a shock absorber to weather the adverse global economic situation.

The writer is assistant professor at IIT Ropar, Punjab. Views are personal