CAD - The Government's Battle Over Deficit And Financing

The Real Picture:

Image Courtesy: www.ekonometrik.com

Since the 2008 financial crisis the global economy has been undergoing a serious turmoil that has deepened the crisis, delaying the recovery process. Initially, it was the developed countries that was hit badly by the crisis and showed poor signs of recovery but in the last one year it is the emerging markets that are struggling with various problems arising out of weak global economic outlook and domestic pressures.

As a result of increasing integration with the global economy India’s external sector has been under pressure, especially in the last two years. The news about India’s high current account deficit has been making rounds since the third quarter of last fiscal that touched a record high 6.7% of GDP. It was a steep increase from the second quarter of last fiscal which stood at 5.4% of GDP. This pressed the alarming button in the Indian market, since then, for which the policymakers have been reacting vigilantly in controlling it from moving further higher.

The Target:

Current Account Deficit is the difference in the imports and exports of a country. It is seen as India by making space for liberalized economic environment by allowing free international trade has also opened room for continuous trade deficit due to higher imports and lower exports. Finance minister P. Chidambaram has quoted saying that a CAD for one or two years is fine but a high CAD year after year is a serious problem as financing it will be difficult. Apart from financing, a higher CAD also puts pressure on rupee that is tumbling beyond 60/$ since March which in turn worsens the CAD. Though the CAD narrowed down to 3.6% of GDP in Q4 last fiscal, it stood at a historic high total $80 billion or 4.8% of GDP in 2012-13.

Adding to the woes, the announcement of US withdrawing its quantitative easing has also made India’s external sector vulnerable to global uncertainties. This called for immediate action and concern over the burgeoning CAD since March 2013, by finance minister setting the target of bringing the CAD to 3 percent of GDP in the current financial year which is within the RBI expectation of 2- 3% that is seen as the normal range. A series of measures has hence been taken to achieve the target. Let us now look at the measures taken, its impact and the trend of CAD.

The Trend:

Higher gold imports is often blamed as the sole reason for the ballooning CAD, however by seeing the data carefully over the course of time one can see that gold is not the only culprit for the widening CAD. India has also been importing huge petroleum and crude oil as it is facing with energy and petroleum crisis in the last three years. India’s coal imports to meet the growing demand for electricity has been doubling adding to the dismal fact that India has one of the largest coal reserves, accounting to 7 percent of the world’s total. Petroleum and Crude oil is a component under the sensitive items category which rose by 65.5% in last financial year from $154967 million to $169319 million from the previous year, registering highest percentage growth among the imports of all sensitive items. Gold Imports, however, rose in the last three years on account of persistent inflation, global uncertainties and absence of attractive alternative domestic investment avenues. Indians see gold high in terms of traditional value than as an investment. The imports of gold accounted to $56319 US million to $53694 US million y-o-y. According to the WGC report, the demand for gold is slowly shifting from India to china in 2013 thus leading India as top consumer on gold import front.

The Measures:

Image Courtesy: The Times of India, Google

Though the numbers have been showing all together a different picture where even other essential commodities have been contributing to the burden of India’s continuing CAD, gold imports is on the spotlight and is of much interest to the policymakers criticism as they see higher gold imports cannot be accepted on the wake of continuing high CAD. So the best they thought they could do is to contain the CAD by reducing the imports of gold which has been contributing a larger share on CAD. To this, the government along with the central bank introduced a series of measures to restrict gold by imposing some curbs.

A brief timeline of the measures and its impact are here: In January the government raised the import duty of gold from 4%to 6% and doubled the duty on raw gold to 5%. The RBI in February relaxed the rules on gold deposit schemes offered by banks and tightened the gold loans offered by the NBFCs. On March, RBI expressed its views on monitoring the banks that sell gold coins to identify systemic issues. The gold imports stood at 16.4 billion in the January – March period. On April the government introduced Inflation Indexed Bonds as an alternative to gold. The RBI restricted import of gold on a consignment basis by banks in May. On June the government raised the import duty to 8% and the jeweler’s association asked its members to stop selling gold bars and coins about 35% of their business followed by voluntary ban on sales in July. The gold imports saw a steep decline to $3.9 billion in the first quarter of 2013-14. The government raised the import duty third time to 10 % in august. The introduction of the 80:20 scheme by the RBI in august was effective in controlling the gold imports sharply according to which it is mandatory for all banks and other nominated agencies to retain at least one fifth of the total gold import which is exclusively made available for the purpose of exports. The government raised the tariff value of gold to $442/ 10gm in October. Since then the RBI also periodically restricted banks from buying gold coins and bars. The total volume demand of gold in 2013 grew at 13 percent and a meager 3 percent in value terms as a result of the curbs imposed by the fiscal and monetary authorities.

Interim Budget Reaction:

Since the curbs were effective as it is seen as reducing the gold imports thereby helping in containing the CAD that fell to $5.2 billion or 1.2% of GDP in the July- September quarter from 4.9 percent in the first quarter, the market was expecting a change from the interim budget presented last month. The gems and jewelry trade leaders were requesting the government to ease the curbs imposed on gold imports on the wake of increasing smuggling and low business sentiment.  As a consequence of high import duty on gold, this encouraged smuggling of around 500kg daily estimating an illegal import of Rs 54,000 crores annually.

Though finance minister was cautious of the CAD numbers and hinted at not reducing the duty on gold and is following the wait and watch approach, sellers were expecting something out of budget but left disappointed. There was a mixed response to the budget but overall budget is seemed to be one that is targeted on reviving growth. Since the demand for gold is not only based on import duties and other restrictive measures, the government could have eased the import duty to 8% from 10% as exports have started to pick up and imports showing a declining trend. The merchandise exports are expected to rise at $326 billion in this financial year, indicating a growth rate of 6.3 percent. The CAD sharply fell to $4.2 billion or 0.9 percent of the GDP in the Q3 of the current financial year. If at all the demand for gold rises as expected by many causing worry by easing the curbs, it would not rise all of a sudden as the demand for gold is influenced by whole lot of other factors such as price, seasonal factors, investor sentiment etc and the number would thus be contained causing not much panic. The budget, seen as the last one of the UPA– II government seems to have no other choice than making some room for growth to kick start as the IIP numbers across various sectors are showing poor results and there has been some noise from the industry for quite some time as RBI is also reluctant to cut interest rate on its fight against inflation.

Financing the CAD:

The hardest part is financing the CAD and thereby seeking solution to one of the most pressing problem. The government already runs a high fiscal deficit leaving pressure for the next government to be hard pressed. The market is expected to set high aspirations after the general election which is seen as crucial in addressing the various problems India is facing. So where does the real solution to controlling the CAD lies?  The solution lies in boosting exports and encouraging foreign investment through FDI and FII towards which the government is doing its best and the results are fruitful and are seen reaping the benefits. Mobilizing gold from the general public to meet the domestic demand could help in controlling the CAD. The problem is seen tolerable only till when we are able to finance the CAD without drawing from our foreign reserves. Until the rupee appreciates and falls below 60/$, inflation is contained and growth gains momentum it is anticipated that the government will continue its tight macroeconomic policy stance in controlling the CAD.