Context

• Over the past year, the post-pandemic normalisation has caused India’s current account deficit (CAD) to swell to exceptional proportions. 
• At home, normalisation has spurred a renewed demand for imported inputs. But abroad, it has had the opposite effect, leading to a decline in demand for several goods from India. 
• Foreign demand will slow further as advanced countries slip into what now seem like inevitable recessions. 
• In that case, India’s CAD could widen even further, possibly to four per cent of GDP in 2022-23 — double the level that RBI traditionally regards as “safe”. 

How should India respond?

• One possibility would be to attract foreign capital inflows worth at least four per cent of GDP. 
• However, the world is currently facing unprecedented levels of uncertainty: COVID pandemic, land war in Europe, high levels of inflation in the developed world, the fastest pace of interest rate hikes in the history of the US Federal Reserve, an energy crisis in Europe, and a slowdown in China.
• In such an uncertain environment, foreign investors prefer to invest in safe assets such as US government bonds rather than emerging markets like India. As a result, India has witnessed large outflows of foreign capital in 2022-23.

Depleting Forex

• If India cannot attract the required amount of capital inflows, the RBI’s foreign exchange reserves could be deployed to pay for imports. But this strategy is neither appropriate nor sustainable. 
• The country’s reserves are meant to tide the country over short-term problems, such as commodity price spikes. 
• The large CAD, however, is a long-term problem requiring a long-term solution. 
• In particular, India’s merchandise exports have been structurally weak, stagnating for the past decade, until the pandemic induced a short-lived boom.

Depreciation of Rupee

• India’s CAD reflects a mismatch between the demand and supply of foreign exchange; we are demanding more dollars than we have access to because we are importing more than we are exporting. 
• To restore balance, first and foremost, the price needs to adjust, that is, the rupee needs to depreciate. 
• When this happens, exporting becomes more profitable, inducing more and more firms to explore foreign markets. 
• Meanwhile, foreign demand improves, because the rupee depreciation makes India’s products more price-competitive. As a result, exports increase — and the CAD falls.

Export-oriented Policy

• Exchange rate depreciation is helpful for another reason. It can help sustain growth. India’s share in global exports is very small and there is ample scope to expand this share.
• Over and above rupee depreciation, this will require structural policies. Policy needs to become significantly more export-oriented and less protectionist. 
• Over the last few years, average import tariffs have gone up. In a world where manufacturers are dependent on global supply chains, levying stiff import duties hampers exports. And this obstacle cannot be overcome by providing subsidies to a selected few producers.

Way Forward

• In sum, the need of the hour is four-fold: 
  • Allow the rupee to depreciate, 
  • encourage foreign firms to produce in India by letting them access their supply chains, 
  • encourage domestic firms to step up to the competition, and 
  • create a level playing field for all players.
• By adopting this strategy, India could potentially solve its two most important macroeconomic problems — reducing the large CAD and securing rapid, sustained growth.