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Decimal Digest
02 Jul 2012

The link between negative real rates and ballooning current account deficit in India

This weekly had asserted in the past that the faulty RBI policy of keeping real interest rates negative is diverting resources to speculative activity over the past few years in India. Also, we have been highlighting the risks of an external balance crisis in India.

Now that India has reported a current account deficit of 4.5% in the Jan-Mar 2012 quarter, we will show how the transmission of negative real rates to unsustainable external balance happened via a rapid increase in speculative activity.

The chart below shows change in employment in India from 2005 to 2010 classified by industry:

Chart 1: Change in employment in percentage points 2005-2010

Source: DPA estimates based on various NSSO reports

The above chart clearly shows that in latest five years for which data is available, nearly all the employment gain happened in the speculative field of construction and real estate, which we attribute to obverse incentives, created by negative real interest rates.

India’s movement of its resources from productive, tradable sectors to speculative non-tradable sectors, coupled with an overvalued currency, led to rapid deterioration in the terms of trade.

With the recent sharp depreciation of the currency, one of the factors, namely the overvaluation of currency has been partially remedied. However, in order to achieve significant correction in the external balance, India’s domestic economic order needs to be rebalanced away from speculative activity to productive, tradable activity. This is only possible if RBI allows real interest rates, calculated on the basis of consumer inflation, to rise above zero for a sustained period of time.


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