The alarm over widening trade deficit is misplaced

IINDIA’S September quarter (Q2) growth came in at a disappointing 5.4 per cent. The Reserve Bank of India (RBI) has lowered its growth projection for this year to 6.6 per cent, from its earlier forecast of 7.2 per cent. SBI economists put the likely growth rate for the year at 6.3 per cent.

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These estimates combine with ordinary folks’ lived experience of high prices and persistent unemployment and news flashes of a surge in the trade deficit to record highs, with the official narrative still clamouring that India remains the fastest growing large economy.

The economic news is both worse than it looks in some ways and better than it looks in some other ways.

The unexpected spike in the trade deficit in November is no big deal, for example. It was caused by a surge in the import of gold. As global gold prices came down, importers more than doubled the imports of the precious metal — from $7.13 billion in October to $14.8 billion in November. The RBI has, of late, been shoring up gold reserves in the country’s overall foreign exchange reserves as well.

What really matters is not so much the trade balance as a broader measure, the current account balance, which takes into account not just the balance in merchandise trade, but also the balance in export and import of services (computer-related services matter a lot), and inflows and outflows of income from the factors of production, labour and capital, comprising remittances, profits, royalties, interest.

The current account balance determines whether a country is a net supplier of savings to the rest of the world, running up a current account surplus, or a net drawer of external savings, running up a current account deficit.

When the current account is in deficit, we end up owing foreigners money. How does that draw external savings into the economy? Let us consider savings and investment in real, rather than monetary, form.

Everything an economy produces in a year is either consumed, invested or exported. Yet, when we add up consumption, investment and exports, we do not get GDP, the value of everything produced in a year. That is because there is an element of imports in the things we consume, invest and even export — we import crude and export refined products, such as petrol and diesel, for example. So, GDP is the sum of consumption, investment and exports net of imports, exports and imports being seen comprehensively, including all services, covering factor services, apart from goods.

Savings are that part of the output that is not consumed. In other words, savings are equal to GDP less consumption, meaning that savings are equal to investment plus net exports. If net exports, that is, the current account balance, is zero, that is, exports exactly match imports, savings would equal investment.

In a closed economy, what the economy can invest is necessarily what it saves, neither bigger, nor smaller.

If exports are less than imports, the current account balance (next exports) would be negative. Savings, remember, are the sum of investment and next exports. When the net exports element is negative, domestic savings are smaller than domestic investment by that element of net exports. In other words, domestic investment is greater than domestic savings, thanks to that current account deficit (CAD).

With a CAD, you either run down past reserves of foreign exchange or owe foreigners money. That is, foreigners must be willing to finance your CAD. The amount of foreign savings your economy ingests is measured by your CAD, not by capital inflows, classified as foreign direct investments or foreign portfolio investments. These inflows remain as cash balances till they are absorbed into the real economy via financing a CAD.

This is why alarm over a trade deficit is misplaced. India’s CAD for 2023-24 was 0.7 per cent of GDP and has nudged up to 1.1 per cent of GDP in the April-June quarter this year. A current account deficit up to 3 per cent is not only sustainable but also desirable, so that the economy can augment domestic savings to invest more and grow faster.

So, worry over a widening trade deficit is wholly misplaced. The only alarm on the external front is that we are unable to run up a current account deficit large enough to accelerate domestic investment and growth.

Slowing growth is indeed a concern, as is the government’s contradictory policy response. While the Budget did announce a massive capital outlay, spending has been deficient. At the end of October, while total receipts have been 53.7 per cent of the budget estimate (BE), capital expenditure has been just 42 per cent of BE, even as revenue expenditure has been 54.1 per cent of BE. Nor has there been any coherent policy to boost private investment.

A quarter of the manufacturing capacity has been lying underutilised since 2015-16. This dissuades capacity expansion. The government would rather sustain the narrative of corruption under the UPA than design new public-private-partnership policies for large, broad-based private investment in infrastructure.

Yet another dampener is the regressive tax reform. The latest is the proposal to create a sixth slab for GST, beyond the existing range of zero, 5 per cent, 12 per cent, 18 per cent and 28 per cent. Now, a 35 per cent rate has been proposed, purportedly, for sin goods. More goods and services are liable to turn sinful over time. The net result would be loss of revenue and reinforcement of a culture of tax complexity, avoidance and evasion.

Higher import duties on gold and higher excise duties on cigarettes have both encouraged largescale smuggling. Higher rates on luxury goods would drive their purchases totally abroad. The goal in GST reform is convergence of rates and fewer slabs, not rate creep or retrospective levies.

The government should step up capital spending, keep GST stable and incentivise investment in food processing to escape seasonal price surges in vegetables that hold interest rates hostage.