Once upon an 8%
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Both the RBI and the finance ministry have been very worried about the quality of the widening current account gap, which could be over $80 billion in absolute terms in 2012-13 end. The RBI's analysis shows that, for much of the last decade, when the current account deficit was under 2.5 per cent of the GDP, the gap could be met fully with pure foreign direct investment flows, which is the most stable form of capital flow. This was the case until 2007-08.
However, with the current account gap dramatically doubling over the past two years, FDI flows can meet only 25 per cent of the annual foreign exchange deficit. This is a serious risk because in 2012 we have depended on the more fickle stock market inflows through FIIs (about $25 billion) to partly fill the foreign exchange deficit on the current account. If we face one year of low FII inflows, which has happened in the past, there would be a heavy drawdown from forex reserves held by the RBI. The exchange rate could then become highly volatile.
The current account risk is exacerbated by the fact that much of the deficit has been caused by rising oil and gold imports. Non-oil and non-gold imports are actually declining. That is really bad news from the standpoint of productivity. Oil imports are now over $140 billion annually and gold imports are likely to be over $35 billion, despite government's efforts to discourage it. Gold is seen as unproductive savings from a macroeconomic perspective.
More than ever before, India needs to discourage the wasteful use of petroleum products through subsidies. Higher diesel prices will discourage excessive use and if we manage to cut the oil bill by $10-15 billion a year through rational pricing, the stress on the current account will be reduced considerably.
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