India’s persistent trade deficit — it imports more goods than it exports — is often seen as a sign of weakness of Indian manufacturing. In fact, the deficit reflects not a weakness of Indian manufacturing but India’s relative strength in services and its attractiveness as an investment destination. As long as India retains its relative strength in services and attracts foreign investment, this goods trade deficit will remain. An important implication of these fundamental factors is that for Indian manufacturing to grow faster, it must be driven by domestic demand, not exports. Foreign investment and current account deficit are two sides of the same coin.

• An inflow of funds has to be matched by an outflow or an accumulation of funds. This means that any country that attracts investment (i.e., has a net inflow of funds on the capital account), will necessarily have a current account deficit (i.e., a net outflow on current account), or will accumulate foreign exchange reserves.
• This is not a matter of opinion — it is mathematical reality. Capital account inflows will equal the sum of current account deficit and the increase in reserves. So how should we think about India’s current account in the context of the two related variables — capital inflows and reserve accumulation?
• Let us deal with capital inflows first. India wants to attract foreign investment (i.e., have an inflow on the capital account), which is desirable as it supplements the domestic savings pool and helps us invest more and grow faster.

What about reserves? Let us start with why we hold reserves.

• Reserves are held as a cushion against economic shocks. For example, reserves can be drawn down if an oil shock leads to a spike in the current account deficit.
• Given that holding reserves involves a cost, India should keep adequate reserves for emergencies, but not more. A simple way to think about this is that, as a country we are raising funds from foreigners and using part of those funds to build reserves — and we are offering a higher return to foreigners than we are earning on these reserves.
• The difference between the return earned by foreigners on their investments in India and the return earned by India on its reserves is the cost of holding reserves.
• Let us now go back to our starting point that capital inflows will always equal the sum of current account deficit and reserve accumulation.
• Given that we don’t need to accumulate much more reserves, the current capital inflows will be equal to the current account deficit. Essentially, capital inflows and current account deficits are two sides of the same coin. When we say that we want to attract foreign investment, we are implicitly saying that we are willing to run an equivalent current account deficit (i.e., be a net importer of goods and services in aggregate).
• This current account deficit is, in effect, a feature of an economy that is an attractive investment destination. India has had a very sensible policy of maintaining a current account deficit of ~ 2% of GDP and attracting an equivalent amount of capital flows.

The goods deficit reflects India’s relative strength in services.

• Once we see the current account deficit as the desirable flip side of foreign investment flows, we can try and understand what determines its composition. Keep in mind that a current account deficit means that while the country will be exporting some things and importing other things, imports will be higher than exports (i.e., we will be a net importer of goods and services in aggregate). India’s current account deficit has remained in a healthy range India’s current account deficit has remained in a healthy range.

So what will we export and what will we import?

• We will export those things in which we have the greatest advantage and we will import other things (where our advantage is smaller). India’s greatest advantage lies in services — consequently, we are a net exporter of services.
• However, given that overall we have to be a net importer (of total goods and services), the fact that we are a net exporter of services inevitably means that we are a net importer of goods.
• India’s manufactured goods exports have been enough to keep the current account deficit at the desired level. This has been achieved by exporting goods where India’s advantage is the greatest (over 1/3 of pharmaceuticals consumed in the US are made in India; similarly, India has a solid export base in automobiles and auto components).
• In economic theory, this is the notion of comparative advantage (as distinct from absolute advantage). That Indian exports of some goods are smaller than Vietnam’s or Bangladesh’s only means that India has a greater advantage over these countries in services than it does in these goods. It does not necessarily mean that Indian manufacturing is less productive, in absolute terms, than Vietnam’s or Bangladesh’s.
• It is important to clarify that the above argument — that manufacturing exports are adequate — does not imply that manufacturing cannot grow faster. It merely implies that faster manufacturing growth will depend on greater domestic demand. After all, if there was stronger domestic demand and the current account deficit were to remain stable, the incremental demand would drive greater domestic production.