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And Now, the Indian Balance of Payments Crisis

11 April, 2009, Jayati Ghosh

Is there to be no end to the bad economic news? The latest balance of payments data from the Reserve Bank of India (RBI) confirm what many had been suspecting for the past few months: that the global financial and economic crisis has already taken a very heavy toll on the Indian economy. It has been particularly harsh on the external sector, which was already much more fragile than the government and its cheerleaders have cared to admit.

According to the RBI, both the current [1] and capital accounts of the balance of payments have deteriorated very sharply, to the point where both accounts are now in deficit! 

On a balance of payments basis, India's merchandise exports recorded a decline of 10.4 per cent in the period October to December 2008-09 compared to the previous year, as against the increase of 33 per cent that was experienced in October-December 2007. This estimate is based on trade flows recorded by the central bank. It differs from the customs-based data provided by the Directorate General of Commercial Intelligence and Statistics (DGCI&S) because it includes other exports and imports that do not pass through customs, such as government imports. 

The DGCI&S data show an even more precipitous decline for the period October-November 2008, with merchandise exports declining by 16.3 per cent compared to the same period in the previous year. This reflected a fall in exports of all commodity groups except engineering goods. The biggest falls were recorded in the exports of rice, raw cotton, sugar and molasses, iron ore, iron and steel, gems and jewellery. 

While exports collapsed, imports continued to grow, although at a much slower rate. The rate of increase of import values in BoP terms was 9 per cent in October-December 2008, compared to the very high growth rate of 42 per cent in the same period of the previous year. But this was mainly because of the decline in oil prices, which dramatically reduced the value of oil imports. The DGCI&S data show that some categories of non-oil imports also declined, such as capital goods, non-ferrous metals, artificial resins and plastic materials, textile yarn and medicinal and pharmaceutical products. 

As a result of these developments, the trade deficit expanded by a whopping 40 per cent in these three months compared to the same period in 2007, to reach $36.3 billion. 

Meanwhile, both invisibles payments and receipts declined marginally, such that the overall invisibles balance even improved slightly. The one bright spot was in software services receipts, which continued to increase by 11.8 per cent. However, this is really due to the large weight of previous contracts that continued into this period, as industry insiders note that even in this area, exports are likely to come down soon as previous contracts expire and are not renewed to the same extent. This is particularly true for software contracts in the financial industry, which account for around 40 per cent of software services exports, but are increasingly threatened as financial institutions in the US and UK get effectively nationalised. 
So the net invisibles surplus financed 60 per cent of trade deficit, significantly less than before. This in turn meant that the current account deficit increased threefold to US$ 14.6 billion in these three months. This is the highest quarterly deficit in the current account since 1990. In terms of shares of GDP, these are truly stark numbers: a trade deficit of 12.6 per cent of GDP and a current account deficit of 5.1 per cent of GDP for the third quarter of 2008-09, that is October-December 2008. 

Note that many developing countries, such as South Korea and Argentina, have experienced severe balance of payments crises with significantly better numbers in terms of trade and current account deficits. The difference at present is that with the global economic downturn, there are several other countries – both developed and developing – that are also showing rapidly worsening current account deficits as global exports nosedive. 

But the first signs of incipient crisis are already there, in that for the first time in a very long time the capital account has also turned negative. Gross capital inflows to India in these three months amounted to $70 billion ($57 billion less than in the same period of the previous year) as against gross outflows from India at $73.6 billion. The larger outflows were mainly due to net outflows under portfolio investment, banking capital and short-term trade credit. Of course, these have been negative for some months previously, especially portfolio investment which reversed around June 2008 as investors booked their profits in India and moved back to the US and other locations to cover their losses in markets there. What has made things worse, and allowed the entire capital account to turn negative, is that for the first time there was a fall in foreign direct investment and external commercial borrowings inflows. Even inflows under short-term trade credit declined. 

So the capital account deficit amounted to 1.3 per cent of GDP, leading to an overall BoP deficit of 6.2 per cent, the worst such number in more than forty years. This shows how fragile the previous boom was, based as it was on a domestic credit-fuelled expansion encouraged by large inflows of essentially speculative hot money. As is inevitable, such money departs for many reasons, some of which may be determined by factors outside the Indian economy. It can also be influenced by the so-called “fundamentals” which in the Indian case are looking none too healthy. 

But once such capital starts to depart, it immediately affects these fundamentals in turn, causing balance of payments deficits and currency depreciations. If these are sufficiently sharp and rapid, a crisis ensues, as many emerging markets have found to their cost. The sharp devaluations can then cause havoc within the domestic economy, allowing trade and current account to improve only through sharp contractions in domestic output combined with increasing exports. 

But all this typically happens in economies when the global economy is chugging along at approximately the same rate as before. This is clearly no longer the case. International organisations are now vying with each other to provide ever more depressing forecasts about world trade and output changes in the coming year. For example, the latest projection from the OECD suggests that world trade will contract by 15 per cent in 2009. 

If this happens, Indian export figures will look even worse. And not only will protectionism in the developed world inevitably increase (despite whatever pious statements the leaders of these countries may make) but even without it, export markets for India and similar countries will necessarily shrink. So clearly, worse is to follow. 

These are therefore more than just extraordinary times that call for extraordinary responses. This is a period in which failure to take decisive economic action can have effects that last for several years, creating a major depression internally in India even if the rest of the global economy recovers. 

That is why what may be even more worrying than all of this bad news is the current central government's incredible inertia and sense of denial in the face of the apparent collapse of all the assumptions and conditions on which it had based its economic strategy. Our policy makers refuse to accept reality and keep insisting that the Indian economy is still doing well. Even worse, they want to intensify the policies that have brought us to this pass, such as more financial liberalisation. 

They also fail to understand that it is pointless to simply look towards the US and other developed countries and expect them to solve the problem. Instead, much more creative and imaginative policy responses are required, in terms of changing directions of investment and consumption in the home market to emphasise wage-led growth, diversifying exports and generally making moves designed to turn adversity to an advantage. 

This is more than simply a lame-duck government, it is a government that has been crippled by the loss of its economic paradigm, and appears to be helpless and without any clue about how to proceed.

[1] 
The current account balance is the sum of the trade balance and the balance on invisibles, which include services exports and other payments like remittances of income and profits. The current and capital accounts together make up the overall balance of payments, and the difference between them (other than errors and omissions) results in a change in foreign exchange reserves.



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