W P S (DEPR) : 16 / 2012
RBI WORKING PAPER SERIES
Sustainable Level of India’s Current Account Deficit
DEPARTMENT OF ECONOMIC AND POLICY RESEARCH
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Copyright: Reserve Bank of India 2012
Sustainable Level of India’s Current Account Deficit Rajan Goyal ∗ The paper estimates sustainable level of current account deficit (CAD) for India by applying a model akin to `Domar’s Model of Debt Sustainability’ to the threshold level of net external liabilities that economy should not breach to ensure stability of the external sector. Probit analysis based on a select panel of market economies was used to arrive at the threshold level. Study concludes that CAD between 2.4 to 2.8 per cent of GDP is sustainable over the medium term under the assumptions that GDP growth ranges between 6.0 and 8.0 per cent, inflation hovering around 5.0 per cent level and interest rate and size of capital flows broadly following their trends in the recent past.
JEL Classification: F32, F34 Key Words: Current Account, Sustainability, Capital Flows, Debt Service Ratio, Reserves Section 1: Introduction
Diverse experience across the globe shows that excessive current account deficit (CAD) tends to make economy vulnerable to external debt or currency crisis which brings in its wake financial instability and substantial output and welfare losses. In India, unrelenting expansion of fiscal deficit in the late 1980s spilled over to CAD that culminated in Balance of Payments (BoP) crisis of 1991, a situation perilously close to debt default. Following the crisis, a range of external sector policies that emphasized market based exchange rate regime, preference for non-debt creating capital flows and improvement in competitiveness of exports of goods and services, improved India’s BoP situation. At this stage, it was perceived that a CAD level of around 1.6 per cent of GDP was sustainable 1 . CAD in the following decade in fact remained around one per cent of GDP and could be comfortably financed from normal capital flows. While the beginning ∗
Author is Director in the Department of Economic and Policy Research, Reserve Bank of India. Views expressed in the paper do not represent the views of the organization the author works with. Author is grateful to Shri Deepak Mohanty, Executive Director for his guidance and suggestions in the preparation of the paper.
1. High Level Committee on Balance of Payments, 1993.
of the decade of 2000s witnessed marginal surpluses, CAD began rising in the second half of the decade and almost hit the level of 3 per cent of GDP in aftermath of global financial crisis. During 2008-09 to 2010-11, CAD averaging at 2.7 per cent of GDP, however, didn’t cause any stress as capital inflows have been more than adequate. Subsequently, during 2011-12, CAD exceeded the level of 4.0 per cent of GDP and there has been net drawdown of reserves to the extent of about USD 13 billion. Thus the question arises, whether the sustainable level of CAD that was historically believed to be below 2 per cent of GDP has moved up and if so what is the sustainable level of CAD in the current scenario. The economy has moved a long way from the situation that prevailed in the early 1990s in terms of variety of macroeconomic aggregates. For example, economy is far more open, Rupee is convertible on the current account, financial markets are far more deep and vibrant, investment flows are freely permitted,...
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