Is India on the Brink of a Serious Economic Crisis?

Widening Current Account Deficit

The first and most important problem facing the Indian economy is the widening current account deficit or the CAD. The CAD refers to the difference between the exports and the imports, which is always a deficit for countries like India that are dependent on imports of oil for their economy. However, for most of the recent past, the CAD has been manageable leading to a confidence among the policymakers that along with adequate foreign exchange reserves, they can manage the CAD. However, in recent months, the Indian economy has been hit by a double whammy of rising CAD and falling foreign exchange reserves.

As the CAD has to be financed out of the dollars held by the government, any fall in the level of the dollar reserves along with higher deficits sets off alarm bells in the minds of the policymakers. This situation is confronting the finance ministry and the reserve bank of India as they try to manage the rising CAD and falling foreign exchange reserves at the same time.

Falling Rupee

The second and another important problem facing the Indian economy is that of the falling rupee as an exchange rate compared to the dollar. One needs to remember that the CAD is affected by the exchange rate of the rupee and vice versa.

Further, a falling rupee pushes up the cost of the imports and therefore, the prices of all commodities, goods, and services go up as the input costs become higher. Moreover, a falling rupee translates into higher CAD in rupee terms which when taken as a percentage of the GDP or the Gross Domestic Product means that a serious macroeconomic crisis is about to hit the Indian economy. The reason for this is that the CAD must be around 5-6% of the GDP and anything more than that has serious repercussions in terms of financing the deficit.

In other words, a falling rupee, rising CAD, falling dollar reserves are a potent cocktail that can implode the economy any time.

Despite the government introducing reforms like allowing FDI or Foreign Direct Investment as a means to attract more dollars, the response has been lukewarm because the foreign investors are wary of the continuance of the policies if another coalition comes to power after the elections that are due next year. Hence, they prefer to adopt a wait and watch approach.

Rampant Inflation and High Deficits

The third important problem that is causing jitters among the policymakers is the fact that rampant inflation has eroded the savings of the small investors. If your fixed deposit returns an interest rate of 9% and the inflation is at 10%, you are effectively poorer by 1% as the rise in prices offsets the gains from your investments.

Further, inflation whenever it is stubbornly high leads to the RBI not lowering the interest rates and this chokes the amount of money that is available to the industry for investment.

The point here is that all these three problems feed on each other and contribute to a general sense of weakening confidence and even a macroeconomic crisis that can threaten the economy.

Indeed, some western journalists are already questioning whether India is on course for the kind of crisis that arose in 1991. The balance of payments or the CAD when combined with a falling rupee and rampant inflation are leading the Indian economy to the abyss which when combined with the global economic slowdown means that disaster can strike without warning.

Concluding Remarks

Finally, it is not the case that the policymakers are not doing enough to revive the economy. Rather the problem here is that the world and emerging markets like India in particular have gotten used to easy money throughout the last decade and once that has dried up, the chickens are coming home to roost.