An unprecedented huge trade deficit characterised last year's external finances. This massive deficit of almost US$ 10 billion and inappropriate monetary and fiscal responses aggravated the balance of payments problem.
Interventions in the foreign exchange market to maintain the exchange rate at an overvalued rate depleted external reserves, while little or no action was taken to correct the trade deficit. Corrective action was delayed. Consequently there was a continuing decline in external reserves. Ultimately, on November 21, the Budget speech announced a devaluation of the currency. This was too little and too late.
The devaluation was followed by a further depreciation of the rupee with the implementation of a more flexible exchange rate policy with minimal state intervention. This resulted in the rupee depreciating from about Rs. 114 to the dollar to about Rs. 122 per dollar at the end of February. While there are expectations of further depreciation of the rupee, there is also a possibility that it may stabilise at about Rs 120 for a US dollar, if the trade position improves and there are capital inflows.
Meanwhile, foreign reserves came down to US$ 5.9 billion at the end of December 2011 from about US$ 8 billion during 2010. Gross official reserves by end December 2011 were equivalent to 3.5 months of imports. About US$ 2.7 billion is estimated to have been drained from the reserves since mid last year owing to the Central Bank intervention to maintain the exchange rate.
Consequently, the current foreign exchange reserves would be lower than those at the end of last year. The gross reserve position is likely to be such that the net reserves are estimated to be negative. What this means is that the reserves are borrowed funds rather than earnings of the country. Furthermore, there are loans and interest payments on foreign borrowings that have to be repaid in the coming months. These render the reserves precariously low.
Policy responses
The initial policy response to the emerging balance of payments crisis was too little and too little. Nevertheless, it could be said that it is better late than never.
The corrective measures taken are the depreciation of the rupee, increase in import tariffs, higher interest rates, increase in fuel prices, electricity rates and the price of bread, among others. The exchange rate policy and fiscal and monetary policies are meant to reduce demand for imports and bring down the trade deficit. The depreciation is expected to ensure that the country's exports retain their competitiveness in international markets, while making imports more expensive and thereby restraining demand for them. Their success in achieving these objectives depends on many factors.
These policies have mostly adverse consequences in the short run. The prices of essential items have increased and it is likely to increase the general price level. Demands for increased wages and industrial unrest are also most likely. However, in the economic situation that the country finds itself, these policies were inevitable. The underlying reason for the price increases and economic difficulties is the massive trade imbalance. This had to be corrected by an appropriate exchange rate and the curbing of import demand by restriction in credit and increasing domestic prices.
Higher interest rates and increasing administered prices are expected to reduce import demand. Increased tariffs on selected items are also likely to rein in demand. It is also important for fiscal policies to ensure that public spending is curtailed. Much of the surge in demand is due to high public expenditure. Even though some of these are developmental expenditure, such as on infrastructure, their adverse impact on the balance of payments must be considered. In the current financial impasse these policies are also likely to slow down growth. This is inevitable and in the long term interests of the economy.
Trade deficit
The fundamental cause of the economic difficulties was the massive trade deficit of US$ 9.74 billion incurred last year. This was nearly twice that of the previous year (2010). It is this huge trade deficit that has been responsible for a drain on the country's reserves. The massive increase in imports was the main cause of the large trade deficit. Import expenditure was 50 percent more than that of 2010 and nearly double export earnings. While exports increased by 22.4 percent in 2011, imports increased by 50.4 percent. Import expenditure was nearly double that of export earnings at US$ 20.2 billion resulting in a massive trade deficit of nearly US$10 billion. This massive increase in imports caused the problem even though exports grew at a reasonable rate.
For several reasons the gravity of this problem was not recognised and there were no policy responses to mitigate it. The serious trade imbalance was made light of in the expectation that the current account of the balance of payments would be a surplus owing to tourist and other service receipts, worker's remittances and other capital inflows. However, the trade deficit was so large that these inflows were unable to offset it as in the past.
Both tourist earnings and worker remittances increased last year by significant proportions, but the trade deficit was so large that it could not be transformed into a current account surplus. Worker remittances grew by 25 percent and tourist earnings increased by 44 percent. However, they were inadequate: worker remittances offset only 52.8 percent of the trade deficit, unlike in 2010 when it offset 80 percent of the trade deficit. Earnings from tourism contributed only 8.5 percent to offsetting the trade deficit.
Fundamental flaw
There is a fundamental flaw in being complacent about the large trade imbalance being offset by capital inflows. Such offsetting does not address the fundamental causes for the imbalance in the trade account. Fundamental weaknesses in the country's external trade require appropriate policy responses to correct a continuing and increasing trade deficit. There is a need to resolve the reasons for the trade deficit even though there could be a balance of payments surplus, as has been so in several years. It was so in 2010, when there was a trade deficit of US$ 4.88 billion, but a balance of payments surplus owing to large inflow of worker remittances and other capital inflows. The problem in the trading account in 2010 was ignored owing to the surplus in the balance of payments. It was this lack of corrective measures that led to a worsening of the trade imbalance in 2011 that has been responsible for the serious financial, economic, political and social predicament of today.
Perspectives
The depreciation of the rupee was an inevitable response to the balance of payments difficulties caused by a huge trade deficit. It was delayed to the extent that it became a fire fighting exercise rather than a timely response. When corrective policies are not taken in time, the needed remedies change from mild medication to deep surgery. The delay in responding to the deteriorating trade balance has resulted in more drastic policies to resolve the problem. Consequently the hardships faced by people are severe.
The sudden significant depreciation of the currency, higher tariffs on imports of basic commodities and increases in prices of essential items have brought severe hardships, especially to lower income groups and fixed income earners. Nevertheless these policies are in the longer term interests of the economy. These economic imperatives are not politically popular but essential remedial measures.
|
E-mail