Let the rupee drop to fix current account?

Tue, 2 Apr Pre-Open

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The current account deficit (CAD) for the quarter ending December 2012 stood at 6.7% of Gross Domestic Product (GDP). This record high deficit was predominantly due to higher gold and oil imports. While the government has given assurance that in the fourth quarter the deficit is likely to narrow we feel these are desperate times as far as managing CAD is concerned. And desperate times call for desperate measures.

Until now, the government has not walked the talk as far as curbing CAD is concerned. While some steps have been taken like raising import duty on gold and removing sectoral caps in some sectors to ease FII inflows none have been productive.

So, what is best course of action to curb the deficit now?

Rupee depreciation is one option which can be explored. Rupee devaluation can boost exports and curb imports thereby lowering the deficit. But it has its own drawbacks. It can lead to inflation. And considering the current inflationary scenario the Reserve Bank of India (RBI) cannot to afford to allow inflation to increase from here on.

Another option to curb the deficit is to curb oil imports. However, this is not possible considering that India is not self sufficient in its energy requirements. Nonetheless, cooling oil prices can provide some respite to the increasing CAD.

Until now, the government was not too keen on taking these measures as it was able to attract capital flows which were used to fund the deficit. However, the capital inflow requirement must be seen in the context of country's total external debt position. It may be noted that India's foreign exchange reserves are just 78.6% of the country's total external debt. And with some of this debt also being short term in nature it has to be repaid in the near future. Thus, the inflow requirement which is required to fund the deficit is significantly higher than thought as some of the money will be used to repay debt. As such, it can get difficult for the government to fund the deficit in the future.

Hence, the only option left with the government is to devalue the rupee. And this devaluation has to happen as the Indian currency is overvalued. This is not what we are saying but what the former deputy governor of RBI itself has to say on the Indian rupee. High inflation in India is an indication that the rupee has lost ground. He opined recently that adjusting for inflation differential the value of the rupee should be far lower than what is prevailing now.

As such, devaluation is a need of the hour to fund CAD deficit. But when is a question? And the answer for it lies only with RBI.