CAD

Current Account Deficit of India

Effects of Various Factors on Current Account Deficit of India

Dipankar Sharma

MBA Section B

Jeevandeep Singh

MBS Section B

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Objectives of Study

The study is aimed to fullfill the following objectives:-

To study the Current Account Deficit of India To study various the Trade Balance of India To Determine Various Factors effecting the CAD of India To propose paulsible solutions to reduce the effect of various factors

IntroductionGlobal economies are always in transition. Development and growth are moving targets for all economies of the world. Therefore, the related issues often give rise to new research areas.Before one could pin point the research areas , some one question need to be answered ,What are some of the issues that worry a government, particularly the finance ministers, most? One could say that governance in the modern times is a difficult task and there is always an inexhaustible list of problems to resolve. Be that as it may. Yet, one can enumerate the macro problems that the finance ministers have to grapple with all the time. These are: economic or GDP growth, reduction in unemployment, reduction in inflation and reduction of external imbalance.

Though all the four are interconnected, yet depending on the seriousness, one or the other of these issues becomes a cause of concern at different times. There are no universal solutions. Each country may have to respond differently taking into account the prevailing circumstances. For example, the external imbalance manifests in terms of current account deficit (CAD) and may require several steps to keep it at a reasonably low level.

In a country like India which imports majority of its essential commodities like crude oil , precious metals , energy minerals etc , maintaining a Balance of the Current Account is of paramount importance to have a progressive and a stable economy. The current account is an important indicator about an economy's health. It is defined as the sum of the balance of trade (goods and services exports less imports), net income from abroad and net current transfers.'Current Account Deficit' is a measurement of a country's trade in which the value of goods and services it imports exceeds the value of goods and services it exports.

Balance of Payments (BoP) for a country is a statistical statement that summarizes economic transactions between its residents and non-residents during a specific time period. In 2010-11, Reserve Bank of India shifted to the reporting pattern of International Monetary Fund’s Balance of Payment and International Investment Position Manual 6 (BMP 6), which classifies BoP transactions as (i) current account (ii) capital account and (iii) finance account transactions. Current Account includes transactions under the heads “goods” (including general merchandise, non-official gold imports etc.), “services”, “primary income” (including compensation of employees, investment income etc.) and “secondary income”

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(including personal transfers and remittances etc.). Hence it measures the exports and imports of commodities and services, the movement of investment income from one home country to the rest of the world and vice-versa. It measures unilateral transfers between the agents of the domestic country and the rest of the world. India’s fiscal imbalance since 1980 has been widening when during that period, India started to have balance of payments problems. As a result of the Gulf War, India’s oil import bill grew, exports went down, credit dried completely, and investors took their cash out. Large fiscal deficits, consequently, had a snowballing effect on the trade deficit culminating in an external payments crisis. High imports and plummeting exports widened the Current Account Deficit (CAD) and led to serious repercussions. Current Account Deficit (CAD) has been a major concern for the Indian Economy for the past 5 years. In Q2-2013, CAD increased and reached 4.4% of GDP.

Current Account (CA) of is the record of net of all exports, imports, services, dividend/interest and transfer payments between a country and the world that have occurred during a year Current Account can be divided into 3 major components:

Exports Imports Invisibles

CA can also be interpreted as the difference between National Savings and Investment. Given this nature of interpretation, CAD is seen as a necessary feature of a developing economy, such as India, as there is higher need for investments compared to mature economies. At the same time, CAD is known for systematically undermining the macroeconomic stability, as experienced by India during early 1990s.

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-6.00

-5.00

-4.00

-3.00

-2.00

-1.00

0.00 Current account balance (% of GDP)

Current account balance (% of GDP)

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The sizes of current account and fiscal balances are important indicators of the macroeconomic stability and well-being of a country. As economy grows, its demand for foreign goods and services grows simultaneously and the world trade benefits as a whole. Problem that arises is not caused by increasing imports but by a mismatch between exports and imports growth. Without a stable balance between exports and imports, current account imbalance will tend to expand. Cointegration between exports and imports implies that current account deficit (CAD) is only a temporary phenomenon and current account converges toward equilibrium over the long-run. It, in turn, means that the country is not in violation of its International Budget Constraint (IBC), because its macroeconomic policies have been effective in bringing exports and imports into a long-run equilibrium.

History India’s current account position has historically mainly been one of a deficit which is accompanied by a substantial fiscal deficit (FD), as depicted in Figure below. India’s First and Second Five-Year Plans (1951-61) focused on rapid import-substitution industrialization with the main aim of self-sufficiency. The objective also manifested itself in the country foreign trade policy where imports were strictly quantitative import restrictions, which were supplemented by a composite tariff structure with high and differentiated rates across industries

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The extensive protection reduced competition drastically, engendered inefficiency in domestic industries and generated monopoly rent, which resulted in a distinct ‘anti-export bias’. With the export performance remained poor, India’s trade deficit widened and current account deficit increased to 2.4% of Gross Domestic Product (GDP) as the surplus of invisible account also narrowed in 1966-67. This situation was further aggravated by a high fiscal deficit of 9.7% of GDP for the same period, as seen in figure above.

The pressure on external position led to a more conductive export environment, with the introduction of a number of exports promotional schemes, including the devaluation of Indian rupee in June 1966-the rupee devaluated from Rs 4.7 to Rs 7.5 per dollar. The devolution was accompanied by some liberalisation of import licensing and cuts in import tariffs, and introduction of export subsidies for approximately a year. Improved export performance due to expansion of the world’s total trade and export incentives led to an improvement in India’s current account position during the late 1960s and early 1970s. While this moderation was temporarily reversed in the aftermath of oil prices shock of 1973, a tightening of import control, generous external assistant and fiscal conservatism quickly brought import down.

In the late 1970s, a combination of high domestic inflation, a large fiscal deficit (i.e., 7.1 % of GDP in 1977), second world’s oil price hike of 1979 and a pegged exchange rate generated: (a) low exports, (b) more imports, (c)a wider current account deficit (i.e., 1.1% of GDP in 1977), and (d) near-exhaustion of reserves. As reserves fell critically low, India undertook an International Monetary Fund (IMF) program in 1981. However, unlike first half of the 1970s, no significant current account adjustment followed. With a large macroeconomic imbalance developing in the second half of 1980s, particularly a large fiscal deficit (e.g., 9.1 % of GDP in 1987), growing public debt, high external debt, and their expansionary influences on money supply and high rate of inflation, the current account deficit burgeoned-picked up to 3% of GDP in 1990-91. While the trade deficit remained in 2-2.5% of GDP range, the surplus on invisible account narrowed and moved into a small deficit during the same period.

India’s travails on the Balance of Payments front started from the Second Five-Year Plan (1956), and continued till the crisis of 1991. The 1991 Balance of Payments crisis forced India to open her long shut doors to foreign investments. This was done in a gradual manner by removing various restrictions, which caused India to be under a License Raj. During the License Raj, eighty government agencies had to be satisfied for private companies to produce goods and, the government would regulate production. After the reforms the economy saw a turnaround, from the ease of doing or starting a business to attracting capital flows from abroad.

The opening up the economy led to the inflow of capital from the world. The inflow of foreign capital was good for the economy. India was more connected to the outer world. However, India also had to bear with the uncertainty and speculation surrounding the global financial markets.

The free flow of capital can be a blessing and a curse. Heavy dependence on the inflow of capital in the Capital Account to balance the Balance Of Payments account is dangerous. India is a developing economy and heavily dependent on oil and petroleum products, not just for transport, but for many other industries as well. India is not rich in oil reserves and depends on oil imports for her needs.

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The erosion of international confidence in the Indian economy not only made borrowings in international markets difficult but also led to an outflow of deposits of non-resident Indians with Indian banks. Investment income payments also raised as the structure of external financing shifted away from concessional finance toward higher-cost debt. This situation was further aggravated by indiscriminate fiscal profligacy. It resulted in a sudden drying up of India's foreign reserves (US$ 3962 million or 1.28 per cent of GDP in 1989-90). As foreign exchange reserves close to exhaust, India was brought to a brink of default with respect to external payments liability in January 1991. This was averted by resorting to borrowings from the IMF under the stand-by arrangements (in January and July 1991), mortgaging gold to the Bank of England and adoption of IMF programme. On 4 July 1991, the Government of India undertook the major task of fundamentally altering its development paradigm by announcing a massive dose of external liberalization and other major policies aimed at reducing the fiscal deficit and the current account deficit. The trade liberalization measures include: (a) devaluation of the currency, (b) steady decline in the ceiling on custom duties—peak tariff rates brought down to maximum 50 per cent from up to 355 per cent, (c) drastically prune in the complex import licensing system, (d) removal of non-tariff barriers (NTBs) like quantitative and other restrictions from all tradable except consumer goods, (e) decontrol of foreign exchange, and (f) announcement of sector/market-specific export promotion schemes. For reduction in fiscal deficit, central bank credit for the government (which is the major source of financing the central government fiscal deficit) was reduced. Recently, India’s net current account balance has been turned from a surplus of $14.08 billion in 2003-04 to a deficit of $2.47 billion in 2004-05 which further widened to $38.44 billion or 2.9 per cent of GDP in 2009-10. The fiscal deficit has also been reached to its peak of 9.5 per cent of GDP during the same period.

In the year 2011-12 and 2012-13, current account balance for India reached deficit levels of 4.6 % (US$ 78 billion) and 4.8 % of GDP (US$ 87 billion), mainly on account of a more specific “trade deficit” phenomenon arising from merchandise goods and gold trade deficits. Compared to Current Account Deficit (CAD) figures of 4.6 % and 4.8 % of GDP, India’s trade deficits stood at 10.2 % and 10.8 % of GDP for the years 2011-12 and 2012-13. Also, usually “invisible” surpluses comprising “service” exports and “income” transfers like remittances from abroad have played a crucial role in evening out large trade deficits in India. The remaining CAD in turn have been getting financed by net capital inflows belonging to the financial account, although concerns about volatile nature of these inflows due to predominant share of portfolio investment have been expressed time and again. However, in recent times, while “invisibles” have remained stagnant, capital inflows have reduced significantly in the post financial crisis scenario.

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CURRENT SITUATION

CAD has gone up sharply in the last two years on the back of higher oil and gold imports. Export growth slowdown has also hit the CAD. There is a huge difference in our imports and exports , which leads to our current account being in negetive . Balance of Trade is very Important to stablise the Current Account as well as the economy of a nation. But in a country like India a vast disparity exists in Total Trade of Imports and Total Trades of Exports

Indicator Name

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Exports of goods and services (% of GDP)

19.28 21.07

20.43

23.60

20.05

21.97 24.27

24.43

25.16 23.59

Imports of goods and services (% of GDP)

22.03 24.23

24.45

28.67

25.43

26.34 30.75

31.12

28.12 25.96

Trade (% of GDP)

41.31 45.30

44.88

52.27

45.48

48.31 55.02

55.55

53.28 49.56

2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

10

20

30

40

50

60Trade Balance

Exports of goods and services (% of GDP)

Imports of goods and services (% of GDP)

Trade (% of GDP)

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The graph shows us the Line Chart Diagram of Total Imports of goods and services and Total Export of Goods and Services as percentage of GDP.

Indicator Name 2011 2012 2013 2014

Exports of goods and services (current US$ Billion) 445 447 468 487Imports of goods and services (current US$ Billion) 564 570 523 536External balance on goods and services (current US$ Billion) -118 -122 -55 -49

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-200

-100

0

100

200

300

400

500

600

700

Trade Balance

Exports of goods and services (current US$ Billion)Imports of goods and services (current US$ Billion)External balance on goods and services (current US$Billion)

US&

in B

illio

n

The graph shows a Bar Chart of Exports and Imports and External balances of India

Oil imports make up a large portion of the total imports and rupee depreciate pushes up the oil bill causing problems to the CAD. In addition to oil, gold also has joined in to cause trouble to the CAD. The metal is a favourite with Indians and is seen as a very attractive investment. Gold imports are increasing and this is adding to the CAD.

The exports sector is not growing at a rate to cover the import bill. The Import bill has increased at a rate of 31% during 2011-15, while exports only grew at 23% for the same period. Oil imports have increased at a rate of 46% and gold 38%. This rise in oil and gold

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imports is alarming and can negatively impact the CAD if not checked. A high and uncontrollable CAD may scare foreign investors which in turn would weaken the rupee, which then would cause a further strain on the CAD.

Given these basic trends in India’s CAD and its financing pattern, detailed analysis of present CAD reveals oil, gold, coal and iron ore as some of the key contributors for the present situation. With a stockpile of 25000 tonnes and accounting for around a quarter of the world demand, gold imports in India increased from US$ 33 billion (in 2009-10) to US$ 57 billion (2011-12) and US$ 53 billion (2012-13). Share of gold in imports has also increased considerably from 7.6 % (2005-06) to 12.6 % (2011-12). Main reason for this phenomenon is said to have been the increase in global prices of gold in the post financial crisis scenario, as the world’s savers looked for ‘safe havens’ to park their savings. Since 2005, gold price has doubled in terms of US$ and tripled in terms of Rupee. Surpassing returns on other investment, between 2007 and 2012, gold gave annual average returns of 23.7 % as compared to 7.3 % by Nifty (National Stock Exchange in India) and 8.2 % by Savings Deposits. In addition, it acts as a good hedge against inflation, which reduces real return on investments (inflation in India stood at 9.6 % and 8.9 % for the years 2010-11 and 2011-12 respectively). Hence, the recent spurt in gold demand and import by India is less about its historical affinity for consumption as jewellery and more about investment dynamics. Gold Loan schemes by Banking and Non-Banking Financial Companies (NBFCs) have further encouraged this demand. While in the year 2008, total gold loans stood at Rs 20,000 crore, the same stood at Rs. 1,50,000 crore in the year 2012. In addition to these, other benefits associated with gold like liquidity, safe source for parking black money, saving instrument for rural areas lacking banking facilities etc. also continued to exert pressure on gold demand.

However, though gold imports have been one of the main reasons for the present CAD, non-gold trade deficits also deteriorated sharply from US$ 96 billion (2010-11) to US$ 131 billion (2011-12) and US$ 144 billion (2012-13). Rising oil and coal import bills and reduced iron ore export earnings have been some of the main components for this trend. Oil bill continues to be one of main components on Indian import bill in light of the inelastic and growing energy demand and rising global crude prices due to exogenous factors like Middle East political economy and recent Arab Spring episodes. Studies have estimated that each US$ 10 per barrel change in crude price impacts current account balance in India by around US$ 8 billion.

For Coal, though possessing world’s second largest coal reserves, India’s import of the same has increased steadily from 20 million tonnes (mt) in 2001 to 74 mt in 2009 and 130 mt in 2012, resulting in an import bill of around US$ 18 billion. With around 60 % to 70 % of the country’s electricity being generated from coal, imports are expected to increase further in future due to domestic production constraints.

As regards Iron Ore, while India exported 117 mt of iron ore in 2009-10, the figures saw a steep decline to 18 mt in 2012-13. With India expected to be a net importer of iron ore in 2013-14, this will mark a quick shift in India’s position from being the third largest exporter of iron ore to a net importer over a very short period of time. Main reasons for this trend are said to have been a cap in production in Karnataka, ban in Goa and strict enforcement of environmental regulations in Odisha due to Supreme Court rulings and state interventions.

Given these diverse forces at play, an effective policy intervention to address present CAD has also to be necessarily multi-pronged. Also, with little room available for managing oil imports in the short run, present CAD management has to be through non-oil components

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only. While since January 2012, government has gradually raised import duty on gold from 2 % to 10 %, the same has been protested by gems and Jewellery industry saying that it would adversely impact the Rs. 2,75,000 crore industry employing around 60 million people. Increased duty is also believed to have resulted in increased smuggling of gold.

Need For Study

Given the complexities involved and the time it might take to set the non-oil current account deficit to tune, government is exploring options to finance the same via long term stable finance account flows. Some of the options that have been recently suggested and tried include liberalization of Foreign Direct Investment policy, allowing PSUs to raise money abroad, continued attracting of sovereign wealth and pension funds to India, raising money from NRIs, and loosening of restrictions for borrowing by Indian companies abroad etc.

Today, the external sector transactions amount to around 108 % of GDP, as compared to around 30 % of GDP for the year 1990-91. These figures point towards a more compelling need to diversify Indian exports, both destination wise and commodity wise. While it is always prudent to take lessons from history, every situation or challenge comes with its own peculiarities. Recent CAD trends in India have clearly shown that increased integration with the global economy brings with it both opportunities and challenges, and it is here that the role of government becomes most crucial to play a balancing act between these two tendencies. It is, therefore, instructive to what factors affect the current account deficit.

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Causes of the Current Account Deficit

India’s Import Composition

One can correlate the composition of India’s import basket and the prices of the significant commodities in it to the downward trend in the Current Account graph.

A substantial portion of our import bill is because of energy related and precious metal commodities. In the current circumstances one would expect the mounting prices (due to global commodity pricing and rupee depreciation) to reduce imports. However the demand for energy related commodities is price inelastic (change in price does not affect the quantity demanded) in the cases of necessary fuel inputs. Especially under the monetary policy employed by the Government, coal, oil, and natural gas are heavily subsidized in order to maintain certain prices. Therefore, the increase in prices is not reflected to the actual consumers (which would drive down demand).They are reflected in Government overspending, resulting in a fiscal deficit (Government spending more money than it is making).

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Gold Imports

The global demand for gold primarily comes from three sources: jewellery, industry (including medical applications) and investments (that are unproductive in nature). Based on data from last few years, the World Gold Council released the following breakdown in India`s demand for gold as per each of the sources.

Jewellery42%

Investment50%

Industrial8%

Uses of GOLD in India

So if people give up on Jewellery, Gold will be among the least useful metals.India imports three things mainly – Crude Oil, Cooking Oil and Gold. The first two are essentials. Gold is considered to be Non-essential. So our Government wants to reduce the import of Gold. Coming to CAD(Current Account Deficit), A measurement of a country’s trade in which the value of goods and services it imports exceeds the value of goods and services it exports. In short Current Account is the difference between a country’s Total Exports to Total Imports. If we have CAD, we need to use our Forex reserves to settle and in the process, we deplete the Forex reserves. If it continues, in the long run we might not have money to get imports. Now let me give you some statistics. In 2001, the total world production of Gold was 3764 tonnes and India imported 462 tonnes, which turns out to be 12.27% of the total production. In 2012, the total production was 4130 tonnes. India imported 1079 tonnes which turns to be 26.12%. India's production is least considerable while it has consumed one-fourth of the total gold production. From 2007 to 2012, CAD has increased from 1.3 to 4.2% of GDP. Net Gold imports has increased from 1.1 to 2.7% of GDP. Net Gold to Current Account Balance has hovered around 70%. Gold export as percentage of Gold Import has decreased from 41% in 2008-09 to 29% in 2011-12 and a record high of 6.7 per cent of GDP in 2013. Gold has remained as one of the chief contributors to CAD. In brief, if we stop importing gold, our CAD would become 1.2% of GDP. In 2011 – 12 India imported 55 billion USD worth of gold. It resulted in 50% of the current account deficit for the nation in the same year.High gold imports is one of main reasons behind high Current Account Deficit (CAD), which touched a record high of 6.7 per cent of GDP in December

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quarter of last fiscal. The CAD is likely to be in the range of 5 per cent for the 2012-13 fiscal. As per experts a CAD of 2.5 per cent is sustainable. The high CAD in turn affects rupee value. The rupee hit life-time low of 59.05 against the US dollar. The country spent $56.8 billion of its precious foreign exchange reserves on gold imports in 2012. Hence spending this huge amount on a non-essential metal effects the economy of the country and Gold accounts for one half of India's Current Account Deficit. This is because of the desire of Indians to hold their capital in the form of gold as an "Unhealthy Addiction". So our Government strongly wants to reduce the import of Gold.

India is largest importer of gold after china and In first quarter of 2015 it also surpassed china as biggest consumer of gold

Traditional Indians looks gold as preserver of wealth and means of savings as opposed to banking system

Since Indian Economist looks gold imports as unproductive to indian economy as against OIL which adds value to our economy through increased industrial production

Also government had also been effective in reducing CAD during 2013 NOV-DEC by imposing several import duties and quotas on gold imports

The global demand for gold primarily comes from three sources: jewellery, industry (including medical applications) and investments (that are unproductive in nature). Based on data from last few years, the World Gold Council released the following breakdown in global demand for gold as per each of the sources.

The Essential Commodities Act of 1955 does not list gold as an essential commodity. Based on this Act, one can infer that essential commodities are goods required to sustain the economy of a country either as basic inputs to the economic engine or as inputs necessary for increasing domestic productivity in various sectors. Unproductive investments are characterized by not producing any goods or services with any exchange value. By these definitions, only the industrial demand for gold can be considered productive as an investment. High investments in the bullion market can be classified as unproductive and non-essential as gold commodity trading doesn’t directly produce any goods or services that will contribute to the robustness of an economy. Hence, one can conclude that 88 % of the global demand for gold is unproductive.

According to a World Gold Council paper published in 2010, 23 % of the global demand for gold jewellery comes from India.

Financing high imports of gold is not prudent as it encourages the negative trend of hoarding that is prevalent in Indian communities. Excessive gold accumulation drains the health of an economy by allowing savings to breed in vaults when the same savings could be invested in the financial system. The overwhelming demand for gold for unproductive purposes in India, (which contributes significantly to the current account deficit as indicated in the table below) is very a serious problem. Hence, there is an immediate need to drastically cut down on India’s imports of gold.

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Source: Page 29, An Investor’s Guide to the Gold Market, Gold World Council

YEAR GOLD PRICE( 10 gms )/1000 CAD % of GDP

2000 4.4 -0.7

2001 4.3 -1

2002 4.99 0.3

2003 5.6 1.4

2004 5.85 1.5

2005 7 0.1

2006 8.4 -1

2007 10.8 -0.7

2008 12.5 -2.5

2009 14.5 -1.9

2010 18.5 -3.2

2011 26.4 -3.4

2012 31.799 -5

2013 30.03 -2.6

2014 26.287 -1.7

2015 26.214 -1.4

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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

-10

-5

0

5

10

15

20

25

30

35

Gold Price vs CAD

GOLD PRICE( 10 gms )/1000CAD % of GDP

Year 200X

Rupe

es in

100

0

Graph is a Bar Chart of Gold Prices and CAD as a % of GDP from 2001-15

As historically in India, it has been well established that increasing duties and restrictions excessively without addressing the market demand only leads to a flourishing black market. Policy makers need to recognize that economic incentives constitute only one part of a solution to a complex problem. The key is in understanding the underlying causes to the external symptom of an obsession with gold.

1. Inflation Rate

One of the prime reasons for the surging demand for gold is the high inflation rate in the Indian economy coupled with the lack of financial instruments providing good returns in real terms available to the average citizens (particularly the rural population).

2. Illegal Trade and Corruption

Apart from investing in land, tax evaders and other individuals who acquire wealth illicitly choose to extensively invest in gold and diamonds as these commodities are easy to hide and liquidate.

3. Lack of understanding and access:

Apart from the high inflation rate reducing the appeal of the available financial instruments, the lack of access and understanding of these financial instruments is another cause for the

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high demand for gold. Investing in gold could also be seen as a hassle free option as there won’t be any red tape involved in the financial transaction.

Energy Consumption According to the 12th Plan issued by the Planning Commission, India relies significantly on the external sector by importing about 37% of its energy requirement as domestic production is not and cannot meet the domestic demand in the short term. India’s import bills for energy imports have been soaring due to the compounding effect of higher prices and higher consumption. As energy is a fundamental input for a growth engine, domestic demand for energy tends to be price inelastic (especially when it is artificially regulated). The 12th Plan states that if India were to achieve a 9 % growth rate, the growth rate of commercial energy supplies has to be around 6.5 – 7.0 %. It must be emphasized that India’s reliance on imports to meet domestic energy demands will increase as its domestic energy supplies are limited.

Nature of Foreign Investments funding the Deficit The nature of the foreign investments that have been financing India’s current deficit is a cause for concern. India has a lot of portfolio investment from foreign institutional investors (FII) in its equity and debt markets. The more sustainable foreign direct investment isn’t playing as much of a role as it should in India’s capital account. Having a high magnitude of portfolio investment financing the current account deficit leaves the economy vulnerable to sudden capital outflows. A sudden outflow can cause precarious fluctuations in the domestic equity and bond markets as well as cause a rupee-depreciation.

Crude oilCrude price is trading below the $100 psychological level. As everyone knows Crude oil prices play a very significant role on the economy of any country. India’s growth story hovers around the import of oil as India imports 70% of its crude requirements. Any negative change in the crude oil price has an immediate positive impact on the increment in the GDP and IIP. A one-dollar fall in the price of oil saves the country about 40 billion rupees. That has a three-fold effect spread across the economy.

If the average fall in oil prices is about $4 per barrel in 2014-15, the trade deficit will shrink by about $3 billion. In the April-June quarter, the current account deficit had dropped to $7.5 billion, mainly due to customs duty on gold imports. Add to that the fall in oil prices and the current account deficit should come down further and harden the rupee against the dollar.

The fall in international oil prices will reduce subsidies that help sustain the domestic prices of oil products. Petrol prices are already decontrolled. The more commonly used diesel has been subject to staggered deregulation since September 2012.

Swinging from a persistent current account deficit, India could well be on the path of moving into surplus, thanks to falling crude oil prices.

India imports nearly two-thirds of its crude oil requirements spending $130 billion annually to meet its burgeoning oil demand. The country’s current account deficit had narrowed to 0.2 percent of the gross domestic product in the January-march quarter as oil prices slumped, and foreign investments flowing into the country remained steady. The fall in oil price alone

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helped India to narrow its trade deficit in the January-March period to $31.7 billion compared to $39.2 billion a quarter earlier.

Current account, which is an indicator of the country’s economic health, is the aggregate of the balance of trade, net overseas income, and net transfers. While a positive current account indicates that the nation is the lender, a negative current account suggests that the country is a borrower.

Current account deficit is estimated to be around 1.5 percent of the GDP in the current fiscal mainly due to lower oil prices, the Reserve Bank had said in June.

YEAR Crude Oil Prices ( US $) CAD % of GDP

2000 53.77 -0.7

2001 96.29 -1

2002 105.87 0.3

2003 109.45 1.4

2004 107.46 1.5

2005 77.38 0.1

2006 60.86 -1

2007 94.1 -0.7

2008 69.04 -2.5

2009 61 -1.9

2010 50.59 -3.2

2011 36.05 -3.4

2012 28.1 -5

2013 24.36 -2.6

2014 23.12 -1.7

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15-20

0

20

40

60

80

100

120

Crude Oil Price vs CAD

Crude Oil Prices ( US $)CAD % of GDP

Year 2001-15

US $

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With the oil demand going downhill, the price of the US-benchmark West Texas Intermediate has lost more 30 percent in the past two months, touching its lowest level since 2009. Meanwhile, The Organization for Petroleum Exporting Countries – which accounts for around 40 percent of the world’s crude oil production --- has been refused to cut its output. Some analysts expect oil prices to fall further as Iran, estimated to be sitting on 40 million barrels of crude oil, is on the verge of entering the global oil market.

Iran’s nuclear accord and relaxing of oil sanctions by western powers by late 2015 could shore up Iran’s output by 100,000 barrels a day. A record output from the US, Russia, and the Middle East will continue to put downward pressure on crude prices.

Credit rating firm ICRA had estimated that for every $1 decline in crude oil prices, India is expected to save Rs 6,500 crore ($993 million). With a global crude oversupply of 2 million barrels a day and additional supplies expected from Iran, oil prices will continue to be weak, it noted.

The cost of oil could be a key factor in helping India’s GDP growth rate to expand to around 6.3 percent in 2015-16 compared with an estimated 5.6 percent in the year earlier. A $50 drop in crude prices equals a saving of about 2.5 percent of GDP in Current Account Deficit.

If oil price continues to fall, India could start the process of deregulating its oil price altogether. The fall is expected to ease the government’s subsidy bill. While the global crude price has declined by around 60%, fuel prices in India have declined by a mere 14 percent because the government had increased taxes on fuel thrice since November.

A fall in global crude oil price could have a soothing effect on inflation. However, the soothing effect on inflation may not be strong enough because the consumption of oil in industry is not that high except in the manufacture of certain products like carbon black.

Transport costs in India have decreased on the back of cheaper fuel with the Wholesale Price Index rising only 0.11 percent since December.

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Linear Regression

Regression StatisticsR 0.80R Square 0.64Adjusted R Square 0.59S 111.97Total number of observations 16.00

CAD (% of GDP *50) =- 154.8895 - 0.4693 * GOLD PRICES ( US$) + 2.1038 * Crude Oil Prices ( US $)

ANOVAd.f. SS MS F p-level

Regression 2.00 295587.34 147793.67 11.79 0.00Residual 13.00 162987.66 12537.51Total 15.00 458575.00

Coefficients Standard Error LCL UCL t Stat p-levelIntercept -154.89 199.98 -586.91 277.13 -0.77 0.45

GOLD PRICES ( US$) -0.47 0.35 -1.22 0.28 -1.36 0.20Crude Oil Prices ( US $) 2.10 1.86 -1.91 6.12 1.13 0.28

T (5%) 2.16LCL - Lower value of a reliable interval (LCL)UCL - Upper value of a reliable interval (UCL)

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1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

-600.00

-400.00

-200.00

0.00

200.00

400.00

600.00

REGRESSION MODEL

GOLD PRICES ( US$)Crude Oil Prices ( US $)CAD (% of GDP *50)

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YEAR GOLD PRICE( 10 gms in 1000) Crude Oil Prices ( US $) CAD % of GDP

2000 4.4 53.77 -0.7

2001 4.3 96.29 -1

2002 4.99 105.87 0.3

2003 5.6 109.45 1.4

2004 5.85 107.46 1.5

2005 7 77.38 0.1

2006 8.4 60.86 -1

2007 10.8 94.1 -0.7

2008 12.5 69.04 -2.5

2009 14.5 61 -1.9

2010 18.5 50.59 -3.2

2011 26.4 36.05 -3.4

2012 31.799 28.1 -5

2013 30.03 24.36 -2.6

2014 26.287 23.12 -1.7

2015 26.214 27.6 -1.4

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Comparison of India’s CAD with Other economies

In an attempt to understand the situation of other emerging economies, we have studied the CA performance of these economies. Comparison has been drawn between India and other BRICS countries (Brazil, Russia, China, South Africa,) on the basis of their trade deficit. Among these BRICS nations, it has been found that within the timeline from 1987 to till date, China has always had a Current Account Surplus which is increasing with time unlike India or other BRICS nations. Hence, there seemed to be a vast structural difference in India and China. So, in our study we didn’t go much deeper into the components of China’s current account. For all other nations, which have had a Current Account Deficit was analysed in detail. The conclusion of our analysis for these nations is as follows

Russia

Strong CA to the strong oil backed export sector. The current account has never been in deficit in the past 2 decades but the surplus has been decreasing gradually and it is expected to be in deficit by 2015. Our analysis has shown that Slowdown of Oil exports and increasing pace of Invisibles is the root cause of the decreasing surplus.

South Africa

Starting from 2003, it has experienced the longest and most-pronounced deficits. The breakdown of the current account into its major components indicates that from a trade perspective, the main contributor to the current account deficit has been the decline in the trade balance, whereas, the deficit on the services and income balance has not helped in neutralizing this effect as it has been negative throughout the sample period.

Brazil

CA performance of Brazil has been mixed when viewed from 1980. On an average, the economy had a deficit of nearly one Billion dollars since then. The CA reached surplus briefly prior to the financial crisis but has been in deficit ever since. We have observed that falling exports are the main reason for increasing CAD. So, summarizing the cross country comparison, we can take it that other emerging nations also have been under CA stress, like India, but for many varying reasons. Hence it appears that there is no across the board solution for the current problems of India and the only way forward is to forge its own way.

Recommendations

Our analysis so far has shown that increasing POL, Gold & Silver are the root causes for deteriorating CAD. Decreasing demand for exports has been a common trend through the world since the financial crisis of 2008. This slowdown is evident from slowing growth of export based economies like China and commodity based economies like Brazil, Turkey etc. Hence export expansion is not a reliable option for reducing the CAD. Hence, we believe that import substitution is the only credible way for tackling CAD. Consecutively, our recommendations aim at reducing the imports of the major contributors for CAD, POL and Gold & Silver.

Tackling the Energy Problem

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Energy prices in India continue to be heavily deflated due to subsidies from the Government. It is imperative to recognize that rational pricing of energy is the only way to manage demand and have a healthy supply side response. Raising the prices of energy to reflect the global energy prices will incentivize consumers to economize their energy consumption. It will also allow the expansion of domestic supply by allowing companies relevant to energy production to expand by curbing the losses imposed by subsidized energy production and registering profits that can be used for investment in the energy sector. The Integrated Energy Policy approved by the Government in 2009 is aimed at “equalizing domestic energy prices with the prices of imported energy, while allowing for targeted subsidy to the needy and poor.” However prices continue to be below par due to political pressures. Note that the 12th five year plan rightly states that a long term strategy to bring about a calibrated shift to sustainable sources of energy should be etched out by the Government in light of the various environmental crises the world faces due to unsustainable practices. As energy related commodities constitute the most significant part of our imports, these reforms will be critical in addressing the current account deficit in a sustainable fashion.

It must be noted that from a historical point of view there are two occasions that are relevant to the current scenario. Firstly, the 1979 World Energy Crisis caused by Iran halting oil exports in the aftermath of the Iranian Revolution caused the Indian rupee to devaluate by about 125 % in the 1980’s(7.85 rupees per dollar in the early 1980’s to 18.00 rupees in the late 1980’s.) Secondly, the financial crisis of 1991 experienced in India was also a consequence of a high current account deficit caused by a surge in oil prices due to the gulf war, a fall in exports and capital outflows due to negative investor sentiment. There was a major currency devaluation of about 50.00 % at this juncture as well. However note that the foreign exchange reserves were much lower in 1991.

Projected Primary Commercial Energy Requirement

(Million tonnes of oil equivalent)

2010-11* 2016-17@

Oil 164.32 204.80

Of which imports 125.5 (76.4%) 164.8 (80.5%)

Natural Gas & LNG 57.99 87.22

Of which imports 10.99 (19%) 24.8 (28.4%)

Coal 272.86 406.78

Of which imports 54 (19.8%) 90 (22.1%)

Lignite 9.52 14.00

Hydro 10.31 14.85

Of which imports 0.48 (4.6%) 0.52 (3.5%)

Nuclear 6.86 9.14

Renewables 0.95 1.29

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Total Energy 522.81 738.07

Total Imports 190.97 280.12

% of Total Energy 36.53 37.95

Source: The 12th Plan of the Planning Commission

One can thereby establish that tackling the energy problem should be the first priority in our current agenda to achieve a sustainable and stable economy.

Tackling Gold

The Government of India has increased import duties on gold substantially (upto 8.00% in June, 2013) in an effort to curb its demand. In April, 2013, gold prices plummeted down due to Cyprus’ plan to sell their bullion reserves in wake of their sovereign debt crisis. This in turn caused a spike in the global demand for gold. The Government then took a series of measures to further restrict the import of gold. The Reserve Bank of India has stated that they are prepared to take much more drastic measures if the demand for gold isn’t contained.

Expanding financial inclusion, increasing a saver’s access to financial products whilst reducing inflation is imperative to reduce the demand for gold. The Reserve Bank of India took a positive step in June, 2013 by introducing Inflation Indexed Bonds (IIB’s) sold through the IDBI (Industrial Development Bank of India) bank to wean investors away from gold and real estate. However the IIB’s are linked to the Wholesale Price Index as opposed to the Consumer Price Index which is more relevant for investors.

Setting up of a Bullion Corporation

The idea of a Gold Bank was mooted by the then Finance Minister, Dr.Manmohan Singh, in his budget speech in 1992. However, the proposal was not implemented. The RBI Working group recently suggested that the gold bank could be given powers to import, export, trade, lend and borrow gold and deal in gold derivatives. Its role would be that of intermediary in gold transactions, providing liquidity to holders of gold and gold loan providers

Tackling POL Imports

Transportation accounts for nearly 7% of annual petroleum consumption which is even higher than the consumption for industrial purposes. So, in order to tackling POL imports, it is inevitable that one deals with the excess demand from consumption due to transportation. This can be achieved by manipulating 2 levers that control the overall consumption. They are

Per capita Kilometers travelled (Subsidising Electric & Hybrid Vehicles)

The biggest contributor for increasing demand from transportation is personal transport, mainly cars. So, in order to decrease the POL imports, alternatives for petroleum products should be encouraged. We believe that India should incentivize usage of electric vehicles in the country by providing subsidies/tax cuts etc.

Fuel consumed per Kilometer (Introduction of CAFE norms in India)

Corporate Average Fuel Economy (CAFÉ) is an internationally followed measure to ensure that the automobile manufacturers strive to improve the fuel efficiency of their vehicles. The Obama administration has been pushing aggressively for improving the CAFÉ standards in

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the U.S. CAFÉ regulation in U.S stands at 36 Miles Per Gallon (MPG). In India, no such norms have been established. Given that many of counter parts automobile manufacturers in the U.S are striving towards improving the fuel efficiency, India should push the domestic manufacturers and all other entities present in India to adopt the CAFÉ Norms.

Containing the Inflation Rate

1. Increasing domestic productivity to address rising demand pressures in protein food commodities and so on.

2. Tackling the fiscal deficit by reforming unsustainable populist Government policies (such as the energy policies, pricing policies, etc.), increasing tax revenue and addressing unproductive Government expenditure. Reducing tax evasion and Government corruption is hinged on bringing about a series of reforms based on reforming the political and social framework that incentivizes and rewards such detrimental actions. Inefficiencies in the public sector can be addressed by privatization in certain sectors and increased accountability. In the case of sectors like healthcare and education, it must be emphasized that complete privatization can be inimical to the interests of a majority of India citizens which in turn will affect sustainable growth.

3. Reducing the liquidity in the market to trigger currency appreciation (and hence deflation) through a series of measures taken by the Reserve Bank of India. They are,

Increasing the Cash Reserve Ratio’s (CRR): CRR is the ratio of the total deposits of a bank in India which is kept with the RBI in cash form. As part of the fractional reserve systemii, the higher the CRR, the lower the money supply in the economy.

Increasing the Statutory Liquidity Ratio (SLR): The SLR is the ratio of the liquid assets that must be held by a bank to the Net Demand and Time Liabilities (NDTL) held by the bank. Simply put the NDTL is the total liability of the bank to its customers (through deposits, bank accounts, saving certificates etc). Increasing the SLR reduces the amount of money the bank can pump into the economy.

Interest Rates Associated with the Liquidity Adjustment Facility (LAF). LAF is a monetary policy which allows banks to borrow money through repurchase agreements. The collateral used for these operations are Government of India securities.

Increasing the Reverse Repo Rate: A Reverse Repo operation is when the RBI borrows money for a short term from commercial banks by lending securities. The interest rate paid by the RBI is the Reverse Repo Rate. Banks always lend to the RBI since it is the safest entity to lend money to. So a higher Reverse Repo Rate leads to banks parking more of their money with the RBI thereby sucking the liquidity out of the economy.

Increasing the Repo Rate: A repo operation is when commercial banks borrow money from the RBI to meet short term requirements by lending securities. The interest rate paid by the commercial banks is the repo rate. A higher repo rate causes banks to borrow lesser money from the RBI reducing the liquidity in the economy.

Attracting Foreign Direct Investment

It is imperative to clear up supply side bottle necks and provide economic incentives that will attract the more sustainable foreign direct investment to the country to finance the current account deficit in the short term, as the structural shift to reducing the current account deficit

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significantly will take time. The Government needs to be on the path of fiscal consolidation to bring about stable macro-economic conditions in the Indian economy to attract investors.

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