Indian capital account deficit as an opportunity

There has been a great deal of consternation in the media about India's recent capital account deficit caused by net outflows of both Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). Some analysts have even raised an alarm about how India will finance its balance of payments. On the contrary, I see no cause for worry, and in fact look at this development as a great opportunity to correct the imbalances that have developed over many decades.

The Indian economy has in my view been suffering from the Dutch disease or rather multiple Dutch diseases. The Dutch disease is a phenomenon first modelled more than four decades ago in which a boom in one sector of the economy causes other sectors of the economy to atrophy leading in extreme cases to de-industrialisation (Corden, W.M. and Neary, J.P., 1982. Booming sector and de-industrialisation in a small open economy. The Economic Journal, 92(368), pp.825-848).

On the external sector, India has benefited from not one but three booms:

1. Huge remittance flows: India currently receives remittances of more than 3% of GDP from Indians who have migrated (temporarily or permanently) to foreign countries. In the early days, this was dominated by relatively low skilled Indian workers in the Middle East, but more recently, the bigger source of remittances has been highly skilled Indian professionals in the advanced economies of North America and Europe. The way that I think about this is that when India runs an almost balanced current account with a deficit of say 0.5% of GDP, it is actually running a deficit in goods and services of nearly 4% of GDP. The global standard in balance of payments accounting regards worker remittances as current account transactions rather than the capital account transaction that they arguably are. The result of this statistical quirk is that we fail to realize that we are running a big current account deficit that is hollowing out our own economy.

2. Large capital inflows: Foreign capital flows into India in the form of both Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). As I described in a blog post in January, India was forced to rely on foreign risk capital in an era in which Indian savers shunned the stock markets in favour of bank deposits. This situation has changed, and India no longer needs this inflow. In fact, net FPI flows should turn strongly negative to provide Indian investors with the benefit of global diversification as I argued in my blog post of February. The reason I call this a Dutch disease is that a capital account surplus has to be offset by a current account deficit as reserve accumulation does not completely neutralize the capital inflow.

3. A strong Information Technology (IT) services sector: India's IT services sector produced large current account surpluses on services that have masked big deficits in the foreign trade in goods. This boom was very important, but it was somewhat benign, because it did not reduce India's global competitiveness. The IT boom only redirected our global competitiveness from goods to services.

The first two booms contributed to a structurally misaligned exchange rate and a loss of global competitiveness. They have helped create a situation where we import far more than we export. I think the time is now opportune for a paradigm shift in the management of our external sector that reverses the Dutch disease, makes Indian businesses globally competitive, and strengthens our strategic economic resilience. Several factors make this shift particularly attractive and urgent:

a. India is going through the peak phase of its demographic dividend that provides a narrow window of opportunity for rapid growth. In another decade, demographics will turn unfavourable, and growth will be much harder.

a. Stable flows of domestic savings into the equity market now enable risk capital to be raised without help from foreigners.

a. Geo-economic instability makes it dangerous to rely excessively on foreign capital, and also makes it imperative to build and nurture strong domestic suppliers of goods and services.

a. Substantial public investment in infrastructure and other industrial support services during the last decade have created the preconditions for a significant step up in exports of goods and services.

The path that I envision is that remittance inflows are roughly matched by net capital outflows led by reserve accumulation, sovereign investments, private portfolio capital outflows and outward foreign direct investments. This would cause the balance of payments deficit to reflect the actual foreign trade in goods and services. The currency would then find its natural level in order to bring the adjusted current account (excluding remittances) to balance or slight surplus.

Some analysts worry about bridging the savings-investment gap if capital flows dry up or reverse. I am sanguine about this for several reasons. First, the savings-investment gap has historically been quite small and so we need only a very small bridge. Second, the rate of savings out of incremental income tends to be higher than the average savings rate, and so if we boost the economic growth rate, savings can be expected to increase. Third, as East Asia demonstrated in its growth phase, fiscal incentives and other measures can be used to stimulate greater savings. Fourth, as businesses shift from rent seeking pursuits in a protected home market to succeeding in global competition, they would be forced to become more efficient, and would allocate capital more carefully leading to a decline in the incremental capital output ratio, and this would reduce the savings-investment gap. Finally, the transition to this path would be a multi-decade process that gives enough time to all economic agents to adapt to the new environment.

On the political-economy side, a big barrier to a sensible exchange rate policy has historically been that big businesses had large debt in foreign currency, and therefore had a vested interest in a strong rupee. As the Indian corporate bond market matures and rupee denominated debt becomes more attractive (see my blog post in April), this political hindrance would be attenuated and it would become easier to let the exchange rate reflect global competitiveness rather than the preferences of some vested interests.

Posted at 6:42 pm IST on Sat, 2 May 2026         permanent link

Categories: Indian financial sector, international finance

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