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For some time, the Prime Minister and his economic advisors have shown much concern about the widening of the current account deficit (CAD). It reached an all-time high of 6.7 per cent of the GDP in the third quarter of this fiscal year. The CAD is the sum of the trade deficit (exports minus imports) and the net invisibles such as accruals from software exports.

The rise in the current account deficit has been due to a bigger trade deficit of $59.6 billion in the third quarter (ending December 2012). This is because exports rose only by .5 per cent whereas imports went up by 9.4 per cent during this period. Higher imports signify that the appetite for gold remains unabated though it has declined from the previous quarter, and oil imports remain high. The deterioration in the trade deficit has also been due to the fall in 'invisibles' led by stagnation in the income from software exports and lower private remittances.

No doubt, the slack demand in the western markets is the reason behind slower software exports. Though the situation seems alarming, it is being financed by 'hot money' or short term FIIs coming to India. But even with so much 'hot money' coming in, the danger to the rupee persists because, on the whole, foreign exchange earnings are much less than the outflows. A weaker rupee could mean more demand for gold as a hedge against further depreciation.

Thus, while foreign direct investment has slowed down considerably, equity investments by FIIs has gone up substantially. The corporate sector has also been borrowing much more from foreign sources through the ECB route which has been relaxed. Short-term debt as a result has risen to 24 per cent of the total external debt in December 2012 from 23.3 per cent last year. The total external debt was at $376.3 billion at the end of December compared with $345.5 billion at the end of March last year. Higher external debt means higher interest payments -- which could lead to worsening of the current account deficit further in the fourth quarter.

Luckily, the government has not dipped into its foreign exchange reserves so far (at $ 292.3 billion) and has financed the CAD with short-term capital inflows which rose to $8.6 billion from $1.8 billion a year ago. But in case there is a change in the world scene and there is a drought of capital worldwide (as predicted by some investment rating agencies), then India is going to face a very challenging and difficult situation.

As is well known, it is not safe to rely on 'hot money' to finance the CAD because of its volatility and its capacity to withdraw from the host country at short notice. The best alternative would be to spur export growth but it seems to be a difficult task right now with the developed countries' markets facing a recession and the EU once again in turmoil. Besides, there has to be an improvement in our export competitiveness by reducing transaction costs. Indian exports have not picked up despite the significant depreciation of the rupee in the last one year.

To woo hot money with a lower GDP forecast would also prove to be difficult for India because there are other destinations in the world which promise higher returns on capital and the economies are growing relatively faster. Though the last Union Budget was successful in averting a downgrade by the international investment rating agencies, there has not been a big rise in FDI. The government has also weathered controversy and successfully opened up multi-brand retail but so far not much FDI in retail has come in. Thus, dependence on 'hot money' and external commercial borrowings (ECBs) has increased making the situation unsustainable. Any sudden withdrawal of FIIs can bring about a currency crisis.

The way out is to improve investment sentiments and not give an impression of political instability. Most foreign investors seem to be waiting and watching till the next general elections. Domestic demand is another problem and from all reports, it seems to be flagging. Investors are always looking for a flourishing and expanding market and low inflation. In India, due to Herculean efforts by the Reserve Bank of India, WPI has been brought down but food inflation and consumer price inflation for industrial workers seem to remain elevated. Food inflation is at 14.98 per cent and CPI at 12 per cent. As a result, most middle class people are cutting down on their consumption expenditure and the lower middle classes (industrial and agricultural workers) are reducing even essential expenditure on health and education.

In the one year that remains before the elections, important economic reforms should be introduced; especially the Land Acquisition Bill needs to be passed. There is much instability and uncertainty in the crucial industrial and mining belt due to problems of land acquisition. Maoist insurgency has to be controlled to improve the investment climate. To make India more attractive for FDI, there has to be political stability and economic reforms in place and an improvement in India's ranking of countries according to the index of 'ease of doing business' in the world (India is at the 132nd rank out of 185 countries).

People are in a despondent mood also because they are seeing a rise in corruption, continuation of high inflation and rising inequality. The governance deficit is serious and omnipresent and people want a strong government which will bring back efficient delivery, law and order and eradicate corruption. They would like to see people with black money punished and brought to book. There is also need for much better infrastructure, sanitation, improvement in the quality of public education and health care and a better housing and more action on the environmental front.

While the domestic economic situation needs various corrective steps to bring back an increase in private investment, which has been the main cause for flagging industrial growth, the external situation needs to be addressed with right export-boosting policies. Raising export growth seems to be the only alternative in the face of a situation when India's imports will continue to remain high because of energy requirements and the rising price of oil and gold can only lose its sheen if the rupee is stable and inflation lower. Otherwise, dependence on 'hot money' will continue and to make India an attractive destination, expenditure cuts will have to be undertaken by the government to reduce the fiscal deficit further. Will it be good for development to have such a volatile situation when the dependence on short-term external finance becomes deeper and stronger?

(The writer is a Senior Fellow at Observer Research Foundation, Delhi)

Jayshree Sengupta (ORF)

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