India's economic growth may be back to its pre-2008-09 global crisis trajectory of 9 per cent but there is a risk that it could be derailed by the rapid deterioration in its external balances.
The current account deficit - the gap between the import and export of goods and services - widened to 3.7 per cent of GDP during the first half of 2010-11 and was as high as 4 per cent of GDP during the second quarter.
In fact, these imbalances have been steadily worsening since the second quarter of 2009-10 and are much above what the Reserve Bank of India (RBI) considers a comfort zone of 1.5 to 2 per cent of GDP.
Why is the current account deficit a problem? Why must it be reduced?
The International Monetary Fund's chief economist, Olivier Blanchard, addresses these questions in his latest discussion note*, which was inspired by the G20's request to the Fund to develop "indicative guidelines" for the reduction of global current account imbalances.
A deficit can arise for bad or good reasons. The former includes financial sector regulation failures that fuel credit booms or "misbehaviour of fiscal authorities" in reducing national savings. Good reasons include bright economic prospects leading to investment rates exceeding savings rates.
Blanchard argues that current account deficit must be reduced even if it arises for good reasons since it interacts with distortions to create risks.
A country with investment opportunities attracts foreign savings. Such inflows lead to an appreciation of the exchange rate and can crowd out manufacturing activity and result in Dutch disease-type phenomena.
The current account deficit and real exchange rate appreciation will be difficult to unwind without a painful real depreciation. Foreign lenders may also change their minds, leading to sudden stops and reversals which will trigger a painful adjustment.
In India's case, the high current account deficit stokes memories of the balance of payments crisis of 1990-91 which forced the government to sell some if its gold reserves and seek an IMF loan.
The central bank is also worried about the quality of capital inflows that have been financing the current account deficit since the last fiscal year.
The preference clearly is for non-debt inflows such as equity over debt and for relatively longer-term flows like foreign direct investment over short-term inflows like foreign institutional investments that come and go in a trice and are, thus, highly disruptive in nature.
The RBI is concerned that the composition of net capital inflows during the first-half of 2010-11 has been exactly the opposite of what is preferable. India's current account deficit is now being financed largely by foreign institutional investment and short-term debt rather than foreign direct investment.
The latter more than halved to $5.3 billion during this period when compared to inflows of $12.3 billion a year earlier.
Worse, these developments have been accompanied by a lower pace of reserve accretion and faster increase in external liabilities in relation to external assets, all of which contribute to vulnerability in India's external accounts.
Whether the third-quarter balance of payments data for 2010-11 - due by the end of March - will reflect a further deterioration or an improvement is an open question.
The Prime Minister's Economic Advisory Council in its latest report does note that the magnitude of the current account deficit reflects the growth dynamics of the economy.
That if India's exports continue to improve - as they have of late despite an appreciation of the real exchange rate of the rupee - a moderation in the current account deficit is likely. The deficit in 2010-11 has been pegged at 2.8 per cent of GDP, same as in 2009-10.
The flip side is that India's merchandise trade deficit is unlikely to have improved in the rest of 2010-11 since imports have become costlier with international crude oil trading at $100-plus a barrel.
There is also a big question mark over remittance inflows considering the spread, depth and intensity of the Jasmine.
Revolution unfolding in the Arab world. Remittances held out at similar levels during the first-half of 2010-11, as in the first-half of 2009-10, but moderated in the second quarter of 2010-11.
As the crisis deepens in countries like Libya, the remittances are bound to be affected, worsening the current account.
The upshot is that India's external imbalances might well remain at elevated levels in 2010-11 and thereafter since domestic demand continues to boom.
If the growth story is not to be affected, it is important to eliminate domestic distortions, thereby reducing the deficit so that they don't pose risks, as Blanchard has rightly argued.
Also, concerns about financing the deficit through short-term debt and volatile portfolio inflows must be expeditiously addressed by the government in improving the environment for larger foreign direct inflows that will only reinforce the rapid growth trajectory.
*
Olivier Blanchard and Gian Maria Milesi-Ferretti " (Why) Should Current Account Balances be Reduced?" IMF Staff Discussion Note, March 1, 2011. See also their earlier paper "Global balances:In Mid-Stream?", IMF Staff Position Note, December 2009