India's BoP Challenge Requires Increased Capital, Not Import Controls

India Faces Balance of Payments Pressures Amid Current Account Deficit

India has a history of dealing with balance of payments pressures, with the 2013 crisis being a notable example. In both instances, the current account deficit was driven by widening trade deficits. However, the current challenge is distinct due to the inability of the capital account to offset the current account deficit.

The current account deficit is being exacerbated by large foreign portfolio investment (FPI) outflows and weaker net foreign direct investment (FDI) inflows. Outward investments and repatriation are offsetting a growing share of gross inflows, putting pressure on the Indian economy at a time when the current account deficit is widening.

India has two primary options to address the current account deficit: achieving balance on the current account or generating enough surplus on the capital account. To achieve balance on the current account, India must fix the goods trade deficit, which means either cutting imports or increasing exports. However, India relies heavily on large imports such as crude oil, chemical fertilizers, and precious metals, making it challenging to restrict imports.

Read also: FirstClub Secures $55 Million in Funding from Peak XV, Sofina, and Other Investors 9 Months After $22 Million Series A Round

Current Account Deficit Comparison

The use of import duties and quality control orders (QCOs) may help check imports, but they also hurt value-added production in downstream industries and, in turn, exports. Moreover, import duties block imports but do nothing to encourage exports, which is necessary to reduce the trade deficit and, subsequently, the current account deficit.

A weaker rupee supports exports, but critics argue that despite the weakening Indian rupee (INR), India's exports continue to struggle. However, this is partly true because it is mainly goods exports that are underperforming. A favorable exchange rate helps, but it cannot substitute for addressing other disadvantages such as lack of free trade agreements (FTAs), high power costs, and other structural bottlenecks unless the rupee is allowed to decline substantially.

Read also: RBI Policy Preview: A Cautionary Wait Ahead

India should focus on achieving an exchange rate that balances its dollar outflows with inflows. However, the Reserve Bank of India (RBI) has often prevented this through frequent interventions in the forex market, despite repeated advice from economists and trade experts in favor of greater exchange-rate flexibility.

Capital Account Challenges

One major factor behind the current account deficit is the rising trade deficit with China, which the Indian government has been struggling to deal with for a long time. Encouraging Chinese FDI in all sectors, except a small negative list of strategic sectors, is a practical way to deal with the rising trade deficit with China.

India worries too much about tax avoidance, which results in increased tax uncertainties. Instead, the country should focus on bringing in more FDI and FPI to make up for a steadily rising trade deficit in an economy burdened with high transaction costs. A predictable and transparent tax regime is essential to attract foreign investment.

To tame FPI outflows, the government cannot do much except reduce or remove long-term capital gains tax while retaining higher securities transaction taxes (STT) to discourage speculative futures and options trading by retail participants.

India should assert its energy independence to keep its energy import bill manageable. The country should make it clear that it will buy oil from any cost-effective supplier, including Iran. Indian policymakers should focus on curing the disease – sluggish goods exports – and not its symptom, the declining INR.