A series of bold measures (the big bazooka approach) by the government will result in lower CAD, reduced gross fiscal deficit (GFD), a stronger currency and large foreign currency inflows (both equity and NRI deposits). A stronger currency can result in a positive self-fulfilling loop of stronger capital inflows and rupee appreciation. This will help India mitigate the negative impact of potential FII outflows arising from a near-certain tapering of the Feds ongoing bond buy-back programme ($85 billion per month). A reversal in the recent depreciation of the currency and in interest rates eventually will restore the confidence of investors in the prospects of the Indian economy. Thus, the immediate focus of the governments policies and regulations should be on curtailing Indias current account deficit (CAD) to around $50 billion (less than 3% of GDP from 4.8% in FY13), and financing the CAD through more long-term and stable capital flows (FDI and equity). Finally, an effective response to the short-term challenges will give India time to implement longer-term fiscal, governance and investment reforms that can put it back on the path of higher economic growth. Indias long-term potential and fundamental strengths remain intact. Its policymakers can and should use all the means at their disposal to meet its short-term challenges.
India is in a unique position to reduce its CAD without affecting GDP growth meaningfully since imports of gold and related items account for nearly half of Indias CAD. A sharp reduction in CAD usually results in lower GDP growth. However, lower gold consumption (and imports) will have no material impact on Indias GDP. Also, India does not have a problem of large short-term foreign currency borrowings, a common reason for foreign currency crises seen in several emerging markets over the past two decades. Short-term borrowings (excluding trade credit and NRI deposits) were $37 billion on March 31, 2013, and FY13 GDP was $1.8 trillion. Also, Indias current foreign currency reserves of $275 billion can cover seven months of imports. Finally, Indias large and diverse equity market can attract large FII inflows if India can implement measures to stabilise the currency and address the policy and regulatory issues in several large sectors such as energy, mining and telecom.
The government and RBI may want to explore the following options to address Indias immediate problems in the areas of high CAD and large GFD. Without immediate and effective