THE key responsibility of any government is to ensure macroeconomic stability by removing uncertainties in the macroeconomic environment and any unpredictability arising from policy actions. As has been argued earlier, this has to be complemented by interventions to prevent infection in other important variables.

The weakest link in our macroeconomic environment is our external account. The financing of the massively sized current account deficit poses serious challenges and implications for domestic inflation and the exchange value of the rupee.

Our current deficit of $18 billion (this is becoming more vulnerable with the rising international oil prices) and the rapidly growing financing needs of debt-servicing commitments are a grim reminder of the continuing stress in discharging these obligations. Why has the current account deficit become so large, increasingly sharply in the last two years? Has this deficit acquired a deeper, protracted and structural nature, as signposted by the secular upward trend in the economy’s import intensity?

There are a number of explanations for its growing level. The policy preference from 2014 onwards to maintain the rupee’s value resulted in the appreciation of its real value. This affected the competitiveness of our exports while making imports cheaper relative to domestically produced goods. As a result, exports plummeted while imports continued to grow at an accelerated rate. The IMF programme initiated in 2013 engendered a further liberalisation of the trade regime, feeding the demand for imports through a lowering of import tariff walls.

The amplification of inequalities has been the result of the nature and composition of our economic growth.

The competitiveness of exports was affected by other equally important factors. The cumbersome and predatory taxation system raised the cost of compliance for businesses. These costs were aggravated by a painfully slow, if not dysfunctional, system for processing tax refunds, high rates of import duty on raw material and intermediate goods used in the production of exports, elevated input costs on account of relatively high energy tariffs and transportation costs (owing to a heavy reliance on taxes on diesel for tax revenues). These factors induced a higher rate of domestic inflation compared with those of our competitors, impairing the economy’s competitiveness.

Until now, we have been narrowing this deficit by financing it through external borrowings and, more recently, through higher import tariffs and measures such as a downward adjustment in the value of the rupee and more timely tax-related refunds to stimulate exports.

In this writer’s view the structural vulnerabilities of the external account can be dealt with comprehensively only in the medium term, there being no quick fixes. However, strong multiple actions are needed urgently, aimed at contracting the current account deficit to around 2.5 per cent of GDP, resulting in a gap that can be financed from more normal and durable inflows of capital. Some of these transitional interventions will have to be phased out in the medium to long term to tackle the structural issues affecting our competitiveness.

Whereas correcting this deficit would necessarily entail a restrained, well-planned and systematised depreciation in the value of the rupee in the medium term, a significant adjustment will be required in the short term. But can a significant adjustment in the exchange rate alone swiftly curtail imports and spur exports in the short term?

In view of the low price elasticity of our imports in the short term we will have to learn to live with this reality. As for exports, the price effect only works partially in our case because improvements in productivity and global demand are the key drivers for our exports — even though much of our exports are of the low-value-added variety and less impacted by the slowing down of global trade.

Therefore, other complementary and supplementary policy initiatives would necessarily be required in the short term to address our Achilles heel. These would include measures to discourage imports and promote exports: a) actions to aggressively reduce the fiscal deficit; b) enhancement in interest rates; c) invoking the emergency provisions of GATT by introducing a regime of minimum import prices (admittedly a non-tariff barrier) — not entirely because of balance-of-payment financing reasons but for administrative ones as well to check under-invoicing; and d) by a wider system of cash margins on imports, the percentage cover ranging from 10pc to 100pc, depending on the nature of the good imported.

However, the more robust explanation of the structural characteristics of the current account deficit, reflected in the increased concentration of certain varieties of imports, is on account of a factor not subjected yet to any serious analysis — the widening inequality of distribution of incomes and wealth. The amplification of inequalities has been the result of the nature and composition of our economic growth over the last two decades, witnessed in the pace of expansion of the capital and skill-intensive sectors of the economy — financial system, IT, telecommunication, energy and the oil and gas sectors, etc.

The impact of these developments manifests itself in the imports of luxury cars (and the resulting imports of parts and more petrol needed for them), designer clothes, expensive mobile phones, generators for domestic use, solar panels and food items, foreign exchange for financing foreign education and travel abroad for recreation.

The worsening inequality of incomes has also heavily influenced the composition and quality of our economic growth, as reflected in the items (both goods and services) imported for consumption or to feed domestic production configurations.

This factor has not only been the key determinant of the outcome on the external front but has also exposed the weaknesses and sustainability of the prevailing model and pattern of growth. Addressing the issues stemming from consumption demands of the affluent segments with large disposable incomes will eventually require basic, structural reforms.

The writer is a former governor of the State Bank.

Published in Dawn, September 30th, 2018