Weak rupee has helped India correct its external deficit

Growth in its gross domestic product bottomed out in the quarter ending in September after increasing from 4.4 per cent in the previous quarter to 4.8 per cent year-on-year. Although growth is still far from the double-digit rates achieved in the years prior to the global financial crisis, there are signs that the economy might keep recovering in the short term.

India’s current account has been in deficit ever since the global financial crisis, and this added to the economic deceleration in the country over the last couple of years. A rising current account deficit implies outflows of capital, which means that demand for the rupee was constantly falling. As uncertainty grew, so did the demand for gold imports. At the same time exports fell due to the weak level of global demand. The deficit widened significantly, leading to a strong depreciation of the Indian currency.

From January 2008 to the end of August this year, the rupee lost 74 per cent of its value, trading at a historical low of 68.145 per US dollar. A third of the fall came since May this year on fears that the US federal reserve would reduce its monthly liquidity injections. Since then, the country’s trade deficit (a large component of the current account) started to decrease. This was due to: a decrease in gold imports, which become more expensive due to the currency depreciation and the introduction of import restrictions and duty hikes; and a recovery in exports as the cheaper currency made India’s exports more competitive.

In the quarter ending in September, the current account narrowed to its lowest level since 2009, at 1.2 per cent of GDP.

India has also been facing a persistent fiscal deficit. Although fiscal expansion was needed to support the economy following the global financial crisis, the government has continued to spend more than it earned, widening the deficit to close to six per cent of GDP. Despite the government’s effort to reach a fiscal deficit target of 4.8 per cent of GDP for this fiscal year (April 2013 to March 2014), public deficit for the first seven months of this fiscal year has already reached 84.4 per cent of its full-year target, well above the 71.6 per cent for the same period last fiscal year, and even higher than the five year average of 67.5 per cent. Spending is growing in line with its budgeted target of around 18 per cent year-on-year year-to-date, but net tax revenue, which was expected to grow 19.3 per cent, is only growing 6.8 per cent year-on-year year-to-date. If the trend continues at the current pace, it could have a discourage investments further weakening the country’s capital account.

India’s GDP growth came mostly from higher exports and lower imports in the quarter ending in September. However, the external sector is a small component of the economy. Private consumption is more important for the Indian economy, focused on domestic services. So far this fiscal year, domestic consumption has softened due to the erosion of the purchasing power which has cause an increase in inflation. But the recent improvement of the current account balance has reversed this current trend, stabilising the rupee.

Currently, the currency is trading at around Rs61 per US dollar. A stronger rupee is needed for inflation to ease and private consumption to strengthen. Some risks linger in the horizon. Externally, the reduction of liquidity injections in the United States could create another round of capital outflows from India, which would reverse all the recent gains in the currency.

In the domestic arena, an uncertain road to the elections in March 2014 can also lead to rupee volatility. Since the government is focusing in consolidating the fiscal balance, the central bank is on its own to bolster the economy. Yet, the central bank has decided to prioritize the stabilisation of the rupee over stimulating growth through interest rate cuts. The combination of restrictive government spending and monetary tightening to stabilise the currency leaves an uncertain outlook for growth.

The positive side is that these developments are likely to tame India’s stubborn inflation, a major drag on growth. However, in order to curb inflation, structural measures are needed, such as infrastructure spending, which are unlikely to be adopted in the near term due to the upcoming elections and a large fiscal deficit.

The writer is an economist at Asiya Investments, an investment firm specialising in Emerging Asia investments.