Column: Learning from history

Jun 11 2014, 22:31 IST
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SummaryHistorical evolution of external balances and exchange rate trends are useful benchmarks

With foreign capital inflows booming once more, familiar issues have resurfaced. A bunch of views on how much reserves will RBI accrete, how much will the rupee appreciate and how that will help lower inflation and bond yields, the impact upon exports, growth, etc, have emerged. There is a sense of déjà vu here. While the common thread across diverse views, viz., reserve-building to insure against financial stability risks, is quite a novelty but entirely explained by last year’s scare, a familiar omission is the role of productivity in exchange rate movements. Should a currency’s strength derive from fundamental gains or should the boom-bust capital flow dynamics continue to be a driver? Let history illuminate the discourse.

The accompanying chart shows the long-term evolution of external balances and the exchange rate, more than two decades since trade and financial deregulation began. To start with, India has done well with financial globalisation. As share of the GDP, the net capital account lifted from an average 2.3% in late-nineties to about 4.1% over 2004 to present. That reflects easing of financing constraints, lowered cost of funds, besides expanding investment opportunities abroad, amongst other things.

Column history

The second is the trend deterioration of the merchandise trade deficit and associated reflection in the current account. From an average -3.5% of the GDP in the late nineties, the goods’ trade deficit more than doubled in 2004-08, notwithstanding the robust export growth during the global trade boom; post-crisis, the trade deficit enlarged to -9.2% of the GDP on average. Exports are increasingly unable to service a fast-expanding economic base that doubled from $500 billion in 2003 to $1 trillion in 2007, and then again to $1.9 trillion at present; even in rapid growth episodes, for example, the merchandise trade deficit widened by a factor of five. This indicates a steady loss of manufacturing competitiveness over time. The current account deficit, a broader measure that includes investment income, reflects the rising drain of net income outflows from FDI-associated liabilities that almost trebled over 2009 to present. The broader picture therefore is overturning of the principle underlying the intertemporal dynamics of the current account, i.e., borrow today to expand the productive base that then generates future surpluses to repay past debts.

The third feature is simply the sum of one and two—trend increase in capital account financing of

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