India’s Current Account Deficit from the Savings-Investment Perspective1
The unprecedented widening of India’s current account deficit in recent years is a symptom of underlying macroeconomic imbalances and structural weaknesses (high inflation, large fiscal deficit, and binding supply constraints). Persistently-high inflation has depressed real returns prompting a surge in gold imports and a marked deterioration in household financial savings and the savings-investment balance. In turn, improvement in the public sector’s savings-investment balance was achieved through capital spending cuts, as subsidies remained high and fuel price adjustments lagged. Finally, on the back of rising policy uncertainty, the deteriorating business outlook and supply bottlenecks, corporate investment declined.
1. Over the last few years, India’s current account balance has deteriorated on the back of a worsening trade balance, reaching a historic high of 4.8 percent of GDP in 2012/13. The balance of payments in India has come under significant pressure since late 2011, with the current account deficit (CAD) reaching 6.5 percent of GDP in 2012Q4.2 In addition, the trade deficit reached a high of 8.6 percent of GDP in 2012Q4 from an average of 4.9 percent of GDP in 2010/11. At the same time, the merchandize trade deficit widened to 12 percent of GDP from an average of 10.1 percent of GDP in 2010/11.
India’s Real and Nominal Effective Exchange Rates
Sources: IMF Information Notice System; and IMF staff estimates.
2. The deterioration of the trade balance has happened even with REER depreciation. The deterioration in the trade balance took place as the real effective exchange rate (REER) depreciated by 5.5 percent cumulatively in 2011/12 and 2012/13, but following a 20.5 percent cumulative appreciation in 2009/10 and 2010/11. Moreover, the nominal effective exchange rate depreciated by 17 percent cumulatively in 2011/12 and 2012/13.
India’s Gold and Coal Imports
Sources: Haver Analytics; and IMF staff estimates.
3. The trade deficit has ballooned due to rising gold, coal and oil imports, driven by supply bottlenecks and persistently-high inflation. Gold imports reached a record high in 2011/12 (US$56.4 billion, or 3 percent of GDP). Despite a slowing economy, growth in net oil imports has been high, and India’s coal imports have been rising due to supply bottlenecks in the mining sector.
Savings-Investment Balance, By Sector
Sources: CEIC; and IMF staff calculations.
4. The widening of the current account deficit reflects deterioration in both households’ and the public sector’s savings-investment balances. Between 2010/11 and 2011/12, the overall savings-investment balance deteriorated by 1.5 percent of GDP. While corporates’ savings-investment balance improved by 2 percent of GDP, households’ balance deteriorated by 3 percent, and the public sector’s balance fell by 0.7 percent of GDP.
Households’ Financial Savings and Investment in Valuables
Sources: CEIC; and IMF staff calculations.
5. The current account deficit has widened primarily on account of the deterioration in households’ savings and investment balance. Households’ saving-investment deteriorated by 3 percent of GDP in 2011/12, reflecting a 2.4 percent of GDP decline in financial savings, and a 0.6 percent of GDP increase in investments into valuables, primarily gold.3 Financial savings have been declining since 2009/10 and are at a decadal low level. Furthermore, households’ non-financial savings (mainly housing) have grown rapidly in the last few years. Households’ physical saving averaged about 12¼ percent of GDP during 1999/2000–2009/10 but rose to the average of 13¾ percent during 2009/10–2011/12.
Interest Rates on Savings Deposits 1/
Sources: CEIC; Consensus Economics; Haver Analytics; and IMF staff calculations.
1/ Interest rates on savings deposit of maturities of 1 year and up. Business analyst inflation expectations correspond to CPI-IW next fiscal year inflation expectations from Consensus Economics Surveys. Household inflation expectations correspond to RBI’s survey of household expectations for inflation in the next 12 months.
6. Persistently-high inflation has depressed real returns on households’ financial savings. Households’ financial savings have fallen from an average of 11 percent of GDP in 1999–2010 to only about 8 percent in 2011/12. A fall in broad money as a share of GDP (from 86.5 percent of GDP in 2009/10 to the level of about 83 percent of GDP in 2011/12 and 2012/13) corroborates a decline in domestic financial savings. One clear determinant of the drop in households’ savings is the rise in inflation and inflation expectations, resulting in a decline in real interest rates on households’ financial savings. As CPI inflation picked up in the spring of 2010 to over 15 percent, the real yield on saving deposits turned negative. With inflation remaining elevated, nominal rates on 1-year savings certificates (which are in the range of 8–9 percent per year) continue to imply low real expected returns. Moreover, households’ inflation expectations indicated over 12 percent inflation in the next twelve months (as of mid-2013).
7. Households’ savings have shifted to non-financial assets, in particular gold. While financial savings have declined, investment into valuables (primarily gold) have risen from the average of 1 percent of GDP in 1999–2010 to 2.7 percent of GDP in 2011/12. Of the several reasons cited for the increased demand for gold, there is strong evidence that gold is increasingly being used as a hedge against inflation.4 Gold imports are highly correlated with households’ inflation expectations (the correlation is 0.83 for the period 2006Q3–2013Q2).
Gold Imports and Inflation Expectations
Sources: Haver Analytics; and IMF staff calculations.
8. In turn, the corporate saving-investment balance has improved due to a sharp decline in investment. With slowing growth, corporate savings have moderated. However, the investment decline has been more pronounced on the back of rising uncertainty, deteriorating outlook and supply bottlenecks (Anand and Tulin, 2014). On balance, the savings-investment balance has improved marginally. It may have helped in shoring up the current account deficit, but is likely to adversely affect growth prospects.
9. Public savings have declined; however, public investment has declined even more. Fiscal stimulus following the Global Financial Crisis (GFC) has reduced public savings. Increased fuel subsidies have prevented domestic demand from adjusting to global oil prices. Moreover, to reduce the burgeoning fiscal deficit, the authorities have resorted to capital spending cuts. This has resulted in lower public savings and an even larger decline in public investment, leading to a rise in infrastructure bottlenecks and further weakening of the investment climate.
10. Further efforts to increase financial savings would help reduce the current account deficit sustainably and boost growth. The widening of the current account deficit in India is a symptom of underlying macroeconomic imbalances and structural weakness. Only by tackling these issues (high inflation, large fiscal deficit, and binding supply constraints) can the current account deficit be reduced sustainably. Bolstering households’ financial savings requires reducing persistently-high inflation credibly to increase the real rate of return on financial savings. Taming high inflation expectations is also essential to lower gold imports—gold imports have been a key factor behind the recent deterioration of the current account deficit. In addition, while fiscal consolidation can lend support to monetary policy in fighting inflation and thereby reduce the current account deficit, reforming fuel subsidies will directly help in lowering imported-oil demand. Actions on alleviating supply bottlenecks remain a top priority, not only to lower natural resource imports, but to also promote capital formation and raise potential growth.
Prepared by Rahul Anand and Volodymyr Tulin.
This chapter covers the evolution of the current account deficit up until the end of FY2012/13. While the current account deficit for FY2012/13 came in at about 4.8 percent of GDP, the current account deficit for FY2013/14 is expected to be much narrower at about 3.3 percent of GDP.
In India’s national accounts statistics, households’ investment in construction, machinery and equipment is equal to households’ physical savings.
Other reasons that have been put forward for the increased demand for gold are: i) the increased ease with which loans can be obtained with gold as collateral; ii) reduced incentives for sellers of mutual funds and insurance policies after regulatory changes, which have reduced the growth in these sectors; iii) low real interest rates; iv) rising household income; and v) lack of alternative financial instruments and limited access to formal finance. These explanations are not inconsistent with gold being used as an inflation hedge.