Higher Rates and Weaker Rupee Can Restore India’s Trade Balance


India’s external balances are under pressure from everything going on in the world: high commodity prices, high inflation, tight monetary policy and slowing growth. India’s current account deficit likely widened to around 5% of gross domestic product (GDP) in the quarter ended September due to high oil imports and slowing export volumes. This is double the 2.5% level considered sustainable.

Every exterior deficit also has an interior angle. A simple macroeconomic identity shows that the current account deficit is the difference between the investment and the savings rate. Intuitively, when investment exceeds savings, external resources fill the void.

So, is the investment growing fast? Maybe not. Even if some investment indicators are on the rise, this does not signal the start of a new investment cycle. Measures of new investment intentions remain weak. Rather, it is replacement capital expenditure, bundled with pandemic period wear and tear.

Which brings us to savings. We think India’s savings rate has fallen, and that’s what’s at the heart of the current account deficit widening to unsustainable levels. Savings are divided into three parts: public sector, private household and private corporate savings.

Public sector borrowing is higher today than before the pandemic. Household financial savings increased during the lockdown period, but fell sharply thereafter to fall below pre-pandemic levels. Lower bank deposits drove much of the decline, and the deposit-to-GDP ratio declined further in fiscal year 2022-23, contributing to the sharply widening current account deficit. What can be done to increase the savings rate?

Increases in policy rates can help increase private sector savings in at least three ways. First, if rate hikes lead households to believe that inflation will fall over time, they may postpone some consumption. Second, higher rates may deter households from borrowing. Third, higher deposit rates will increase the opportunity cost of money, thereby incentivizing savings.

But all is not so simple. Rising interest rates have another offsetting impact. To the extent that they slow growth and incomes, they could reduce what households have left to save.

There is a similar dilemma when trying to increase public savings. If fiscal consolidation is led by spending cuts, it will be negative for GDP growth and income. Already, we see that the reduction in government deficits is largely driven by weak spending, in particular weak government investment spending.

This is where another tool could help: the rupee. Allowing the currency to depreciate gradually would likely make exports more competitive, which would help India’s GDP growth. Exports, especially high-tech exports, have been an impressive driver of post-pandemic economic recovery. Feeding the sector in times of volatility is probably a good idea. And the particularity of the forex depreciation is that it supports growth while reducing imports. By simultaneously making exports competitive and imports expensive, it tends to reduce the trade deficit over time.

From this perspective, a combination of higher rates and a weaker rupee is likely to be the optimal response to the ongoing storm, in our view.

The Reserve Bank of India (RBI) started raising rates in May 2022. By the end of September, it had raised the repo rate by 190 basis points. The rupiah has remained fairly stable for much of this period, thanks to RBI’s currency sales. It was only in September that RBI switched to a two-pronged strategy of higher rates and a weaker rupee. As such, we believe India is now in the midst of an optimal policy response.

The challenge will be to continue on this path. Real deposit rates are still negative and the trade-weighted real effective exchange rate (REER) has not weakened at all since May.

When will the current account deficit go from 5% to the sustainable level of 2.5%? Several different scenarios could play out. We use four sensitivities – the impact of rate hikes on GDP growth, the impact of GDP growth on imports, and the real exchange rate elasticity of exports and imports – to determine the possibilities.

If the RBI offers another 50 basis point hike in the repo rate (taking it to 6.4%) and the REER weakens by around 5%, sensitivities suggest that, with everything else remaining unchanged, the deficit of the current account can be reduced from 5% of GDP to around 3.5. %. This means that around 60% of the adjustment could be achieved. The remaining 40% could occur if the global environment changes (for example, if commodity prices fall rapidly).

In a separate scenario, larger rate hikes (about 60 basis points higher than our forecast, bringing the repo rate to 7%) and a larger REER adjustment (by about 10%) could reach 100% of adjustment of the current account deficit.

These scenarios are indicative and certainly come with wide margins of error in a very volatile global context. But they give an idea of ​​the importance of the two-pronged strategy of higher rates and a weaker rupee in terms of restoring India’s balances.

Pranjul Bhandari is chief economist for India at HSBC.

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