Why India needs stable capital flows

Source– The post is based on the article “Why India needs stable capital flows” published in The Indian Express on 28th February 2023.

Syllabus: GS3- Indian economy and mobilisation of resources

Relevance: External sector of economy

News- As per the RBI’s quarterly statistics, the current account deficit widened to 4.4% of GDP in the second quarter of 2022-23, down from 2.2% in the preceding quarter.

What is the performance of other indicators of the external sector of the economy?

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. There was a sharp decline in the trade deficit to $1.27 billion in January.

Remittances and services exports have provided a counter-balance to rising merchandise trade deficits. In the first half of 2022-23, services exports recorded a growth of 32.7 % over the same period last year. Remittances have reached $48 billion in April-September 2022

What are the implications of higher CAD for the Indian economy?

Large and persistent CADs are not good if they show poor export competitiveness and are financed by unstable financing.

Large and persistent CADs expose India to the risks associated with its financing. If CADs can be financed by stable capital inflows, such as FDI, they are desirable.

If deficits are financed by volatile capital flows such as portfolio flows, there may be a cause of concern. Portfolio flows are more susceptible to reversals in case of any global financial shock.

FDI inflows have been weak in the current fiscal year. FDI and portfolio inflows each only financed about 18% of CADs in the second quarter of 2022-23. So, there is a financing issue.

The countercyclical nature of India’s CAD is a matter of concern. The country’s CAD rises when output falls rather than when demand rises. It indicates the dominance of external shocks. For instance, if oil prices rise, it raises the cost of production and leads to a fall in economic growth.

What is the way forward for economic policy in this scenario?

Over the medium term, policymakers need to arrest the negative impacts of slowdown in global trade on merchandise exports.

Further rate hikes by the US Fed may lead to capital outflows. It will generate imported inflation.  Policy measures to facilitate exports by focusing on structural reforms to improve trade competitiveness are needed. The government must sign free trade agreements.

India is currently facing the twin-deficit problem of high fiscal and CADs. Aggressive fiscal consolidation may be undesirable amid the fears of global slowdown.

A comfortable external environment can be maintained by ensuring stable financing. Exchange rates should be used as a shock absorber to manage the  adverse global economic situation.