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Higher Interest Rates To Tackle India’s Current Account Deficit? Two Sides Of The Debate.

India’s current account deficit is expected to widen to near the perceived red-line of 3 percent of GDP this year. A current account deficit of about 2 percent or lower is seen as comfortable. Anything above that prompts nervousness in the currency markets.

That’s exactly what has happened this year with the Rupee plunging more than 11 percent and prompting calls for a policy response. So far, that response has come in two forms. One, an attempt to draw in more capital to fund the current account and hence improve the balance of payments. Two, a discussion around hiking import duties to narrow the trade deficit, which is a part but not the whole of the current account deficit.

Are these the right policy responses?

To judge that, it’s worth recalling that the current account deficit can be seen in more than one way.

1) When the sum of money leaving the country in the form of goods, services and capital, exceeds the sum of money entering the country by the same means, the country runs a current account deficit.

2) When the sum of public and private investments exceed savings, the country may choose to borrow from external sources, creating a current account deficit.

Current Account Deficit: Investments > Savings

Jahanagir Aziz, chief India economist at JPMorgan prefers to analyse the current account deficit as a gap between savings and investments.

We don’t think that the current account deficit is an import export problem, Aziz told BloombergQuint. If you analyse the current account deficit from the point of view of imports and exports, exchange rates and oil prices, you get “lost in the weeds”, said Azis while explaining his analysis of the current problem.

There is another way of looking at the current account deficit , which is basically that it is the part of domestic investments, which is not financed by domestic savings...In our view, two things have happened. In the first two quarters of this year, we have seen some increase in investment. But our sense is that, both household and corporate savings have fallen. Government savings, which is the overall fiscal deficit, hasn’t really moved very much.
Jahangir Aziz, Chief Emerging Market Economist, JPMorgan

The expenditure side of India’s GDP data has shown a pick-up in gross fixed capital formation starting the second quarter of FY18. While the year-on-year growth in fixed capital formation slipped in the first quarter of FY19 compared to the previous quarter, it remains in double digits.

Accurate data of household savings comes with a lag. The government’s fiscal deficit for the current year is pegged at 3.3 percent of GDP compared to a revised 3.5 percent of GDP in FY18.

Aziz believes that, the current account deficit, if viewed from this lens, needs a solution which spans exchange rates, fiscal policy and monetary policy. If you use only one value of adjustement, which is exchange rate, then that adjustment will be “outsized” and that is what we are seeing now, he said. “The adjustment has to be spread across interest rates and reduction in fiscal deficits.”

We are not saying that’s (higher interest rates) the only solution but it has to be part of the solution. It’s much better to distribute the adjustment across different areas, including fiscal policy and monetary policy, rather than let exchange rates be the only valve of adjustment.
Jahangir Aziz, Chief Emerging Market Economist, JPMorgan

Higher interest rates can incentivise savings but also dampen growth and investments.

Aziz does not believe the use of interest rates will run contrary to India’s new inflation targeting regime, where monetary policy is driven by a flexible inflation target of 4 (+/- 2) percent. A weaker currency will lead to higher inflation and justify a tighter monetary policy stance.

Besides, Aziz believes that central banks globally have realised that focusing exclusively on inflation can be detrimental to the interests of the broader economy.

Most open economy central banks respond to domestic economic variables but also global financial conditions, he said. “I don’t think there is any inconsistency in looking at inflation domestically and responding with interest rates to global financial conditions.”

Practical Problems With The Rate Defence

Senior economist Saugata Bhattacharya, while commenting is his personal capacity, explains that there are practical problems that emerge in the use of interest rates as a part of the solution to a wider current account deficit.

Bhattacharya explains that as illustrated in the national income identity, Y = C + I + G + (X – M), the current account deficit is reflective of not just a ‘savings – investment gap’, but of a larger excess demand condition, from consumption (C+G) or investment (I) which is unable to be met by either domestic output or saving. Raising interest rates is a classic textbook response to a widening trade deficit (X-M), explains Bhattacharya.

However, Bhattacharya goes on to add that it can be argued that interest rates have already responded to the widening gap. While the repo rate has only moved up 0.25 percent since July 2017, the benchmark 10 year Govt security rate has moved up by 1.8 percent, he explains.

In India’s case, bank deposits and now, with large household savings being allocated to mutual funds, Commercial Paper (CP) have the maximum bearing on savings. CP rates, which corporates pay to borrow short term funds, rose by an even steeper 2.1 percent, reflecting the tightened liquidity in markets.
Saugata Bhattacharya, Senior Economist

Rates on certificate of deposits have moved up by 2.2 percent, driven more by liquidity than policy rates. This, in turn, feeds into term deposit rates and drives lending rates.

In short, the real interest rate (i.e., inflation adjusted interest rates) has been significantly over the target band, said Bhattacharya. “Whether it should have been even higher is open to debate.”

Higher Interest Rates To Tackle India’s Current Account Deficit? Two Sides Of The Debate.

Bhattacharya also goes on to question whether higher interest rates really have much of an impact on the savings rate.

In the early part of the 2000s, even as real interest rates fell, savings rose sharply, his data shows.

After the financial crisis onset, as real deposit rates rose, savings actually fell. This, of course, includes household physical savings, and we know that this was the segment which contributed to the fall. Even excluding this segment, financial savings in the past decade have remained largely flat.
Saugata Bhattacharya, Senior Economist

This raises the important question of causation, not just correlation, between savings and interest rates. Do savings determine interest rates, rather than the other way around, Bhattacharya asks.

Higher Interest Rates To Tackle India’s Current Account Deficit? Two Sides Of The Debate.