Why are the laws of economics and currencies failing in India?
India’s current account deficit (CAD) in the July-September quarter turned out to be far worse than anticipated, a record 5.4% of GDP. Even during the quarters following the sharp depreciation of the rupee since August 2011, the deficit had remained between 3.9% and 4.5% of GDP. (The quarters post the financial crisis of 2008 are not valid comparators since the prices of commodities, particularly crude, had come down sharply.)
Which parts of the accounts were the major culprits? Stepping back, a bit facetiously, note that some part of the worsening was due to the rupee depreciation. Valuing the balances at the average rupee level of the corresponding second quarter of a year ago (R45.8 to a dollar), rather than the actual average (R55.1 to a dollar), the deficit would have been 4.5% of GDP, although this would have remained disconcertingly high. Facetious and not very convincing, since the rupee’s depreciation is actually an endogenous signal of the deterioration of the CAD.
But this is not the way the current and capital account flows are supposed to work. Theoretically, the weaker rupee should have been an incentive to switch from imports to domestic substitutes and for exports to have increased by becoming more competitive (see chart for co-movements). Why are many of the underlying assumptions of this hypothesis turning out to be flawed? While the currency changes have indeed had an effect, the effects have been varied and inconsistent, and need deeper insights into the mechanisms, which have actually driven the flows. The following paragraphs are a start in this direction.
For starters, the deterioration in the CAD in the second quarter came in almost entirely from lower merchandise exports, while imports have remained just below the first quarter’s level (see table for a summary view of important balance of payments components).
Exports have refused to increase. This is not to worry about the terrible growth rates (an average of minus 5.7% yoy over April-November 2012, and minus 6.7% over April-September 2012), since the growth rates had been 34.7% and 41.8% in the corresponding months in 2011 (we think we know the reasons being a rush to try and beat incentive deadlines of September and, we are told, a tendency to over-invoice). What is worrying is a drop in the value of exports (from $201 billion in the first eight months