As per the latest policy
statement issued by RBI “By far the biggest risk to the economy stems from
the CAD”. The central bank believes that “A large CAD, appreciably above the
sustainable level year after year, will put pressure on servicing of external
liabilities.” RBI finds that the large CAD is a risk by itself and “its
financing exposes the economy to the risk of sudden stop and reversal of
capital flows”.
Although the CAD could be financed last year because of easy
liquidity conditions in the global system, RBI believes that the global
liquidity situation could quickly alter for emerging and developing economies
(EDEs), including India, for two reasons. First, the outlook for advanced
economies (AE) remains uncertain, and even if there may be no event shocks, there
could well be process shocks which could result in capital outflows from EDEs.
Second, with quantitative easing (QE), AE central banks are in uncharted
territory with considerable uncertainty about the trajectory of recovery and
the calibration of QE. Should global liquidity conditions rapidly tighten,
India could potentially face a problem of sudden stop and reversal of capital
flows jeopardising our macro-financial stability”.
In our view, RBI might be wrong on all counts here.
(a)
CAD arising from trade deficit is never a risk
in itself. The excess of imports over exports essentially means that our
economy is doing better than the other economies who import from us.
In fact, in the present instance RBI itself could be largely
responsible for higher CAD. Higher imports theoretically suggest higher demand
for goods and services and hence make a strong case for investment demand so
that supply side could be augmented. RBI himself has admitted in the policy
statement that the economy faces serious bottlenecks on supply side, resulting
in sticky high inflation.
RBI by persisting with its “inflation over growth” policy has
maintained interest rates at high levels – resulting in collapse of investment
cycle and rise in demand for gold.
(b)
The uncertainty in advanced economies is an
argument for the easy liquidity conditions and continuation of QE and not
against it. Whereas return of growth to these economies will lead to higher
export demand.
Instead of bothering about one or two quarters, RBI should, in
our view, focus on exploiting the easy liquidity conditions and let the Indian
corporates and banks borrow more at cheaper rates to augment supply.
(c)
The government has repeatedly increased the FII
debt limit in past couple of years. These inflows, though not huge, could cause
severe damage in case of a shock event, as panic selling inevitably would lead
to sharp rise in spreads and yields.
A sharp cut in rates
(100-150bps) and buying of US$100bn by RBI may help the economy more at this juncture
than worrying about CAD and constricting investment initiatives. Inflation
should come down with rise in supply and not by curtailing demand. After all we
are not a communist country of 1970s.
(Also read Why
this kolaveri over current account deficit)
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