The euphoria created by the booming stock market has diverted public attention away from the worrisome spurt in trade deficit i.e. excess of imports over exports. There is a link between the two: massive inflows of foreign capital. Foreigners flush with freshly printed dollars are betting high on our stocks, driving the Sensex through the roof. Those very dollars also lead to an appreciation of the rupee, which erodes competitiveness of our exports while making imports cheaper. This shows that what is good for the stock market is not necessarily good for the economy.

Latest numbers on foreign trade suggest that India is headed for a record trade deficit. In the first five months (April-August) of the current financial year, we imported goods worth $141.89 billion against exports of just $85.27 billion, leaving a gap of $56.62 billion. For the year 2010-11, with goods shipments estimated to touch $200 billion and imports of around $335 billion, trade deficit may shoot up to $135 billion.

Imports are surging thanks to the double-digit industrial growth, rising domestic demand and the need for inputs for value added exports. The problem is that although India is growing, the market to which it exports is not growing.

In contrast, exports have been quite flat at around $16-17 billion in recent months. This escapes notice because the comparison in official figures is with the corresponding month of the last year. But if we look at variations from month to month, the loss of all momentum becomes obvious. Hence, the full year could register a trade deficit of $150 billion. At 10 per cent of gross domestic product (GDP), that would be the largest trade deficit in recent Indian history, and also the largest for any significant economy in the world.

Remittances by Indians overseas and the surpluses on trade in services (IT software, BPO, business services, banking, finance, insurance, tourism and the like) neutralise a large part of the deficit in the goods trade. However, even after taking into account these receipts (called invisibles), the deficit on the current account is likely to be more than 3 per cent of GDP, much worse than India’s comfort level of 2 per cent.

The latest data released by the Reserve Bank of India indicate that the current account deficit (CAD) in 2010-11 could be anywhere between 3.5 and 4.0 per cent of (GDP). In the April-June quarter, the CAD surged three-fold to $13.7 billion from $4.5 billion in the same period last year.

Ordinarily, such a scenario should have sent the rupee reeling down against other currencies. But the opposite is happening. In tandem with the rise in the Sensex, we have seen a strong appreciation of the rupee, which has hardened from Rs. 46.79 to a dollar to Rs. 44.33 in a month to October 8. Such a steep appreciation of the rupee in the face of a mounting deficit on external account is not only surprising but also worrying.

Now, it makes no sense at all for the rupee to be stronger against the dollar than it was a decade ago, since Indian inflation has been greater than US inflation throughout the intervening period. On an inflation-adjusted basis, the rupee has moved up quite substantially against the dollar — at a time when the Chinese have done the exact opposite with the yuan, and improved the competitiveness of their exporters.

What explains the strength of the rupee even when we earn far fewer dollars than we need to pay for our purchases? The reason is that, especially in the past five weeks, there has been a surge in portfolio capital inflows, which has helped finance the widening current account deficit and powered the Sensex to a 32-month high of 20,000.

Lured by higher interest rates and strong fundamentals, foreign institutional investors (FIIs) have poured Rs. 96,255 crore ($21.04 billion) into the Indian stock market in the current calendar year so far (7 Oct.). Significantly, more than two-thirds of this, Rs. 65002 crore ($14.12 billion) came in since July 1. In addition, FIIs have bought government and corporate bonds worth Rs. 47,605 crore ($10.37 billion) in the current calendar year.

The resurgence in capital inflows, after their stutter in the early summer, may be due to several factors, including the anemic growth prospects of America, Europe and Japan, and exceptionally loose monetary policies in these jurisdictions. Basically, there is a great deal of liquidity sloshing around in global financial markets looking for an elusive combination of safety and return. It is this footloose money that is driving the Sensex and the rupee up. Until recently, the Reserve Bank used to buy up dollars and moderate the rupee’s appreciation, but it has almost stopped doing so for more than a year now.

So what is the problem, one may ask. If we run up deficit and if foreigners are willing to finance it by pouring money into our coffers, why worry? There is a two-fold reason to worry.

First, the massive inflows of foreign capital are playing havoc with our real economy by pushing up our currency and eroding competitiveness of our exports— thus adding to the already yawning trade deficit. Such appreciation also hurts industry, agriculture and traded services, and is particularly damaging to the recovery prospects for employment-intensive manufactured exports such as garments, textiles, leather products and gems, which took a beating in the global recession.

Goods exports, which had risen to 18 per cent of GDP in the first half of 2008-09, have now fallen to 13 per cent of GDP. In contrast, imports have grown quite strongly from the trough of 20 per cent of GDP in January-March 2009 to an estimated 25 per cent of GDP in July-September 2010.

This means that as the Indian economy recovered from the impact of global recession, its trade deficit has widened to above 10 per cent of GDP in the current quarter. That is not all. There is a significant decline in net invisible earnings (trade in services and remittances from abroad) from 7.4 per cent of GDP in 2008-09 to hardly 5 per cent in the first quarter of 2010-11. So, a whopping current account deficit of 4-5 per cent of GDP seems quite plausible in the first half of the current year, and perhaps even for the full year.

Secondly, as the recent financial crisis showed, financial flows are highly volatile and entirely unpredictable. It would be folly to rely on such flows for stable financing of balance of payments deficits. For reasons that are entirely out of India’s control, inflows could dry up and turn into outflows, creating multiple problems. A spike in oil prices, heightened tensions in West Asia or a debt crisis in Europe could shake foreigners’ confidence and trigger a flight of global capital to the safety of the dollar.

When that happens, it would not be just the Sensex that comes crashing down in consequence. Growth based on excessive external financing is vulnerable to wrenching slowdowns. And the rupee would collapse.

This may not happen anytime soon. But that is no reason not to focus on imbalances. In any trade-off between righting the real economy and paying heed to the financial sector, the former must get priority.

The corrective action has to be two-fold. The Reserve Bank must resume its intervention in the foreign exchange market to restore and maintain the real effective exchange rate (REER—the inflation adjusted exchange rate) of the rupee, as it did successfully during 2003-07. The tools and modalities are available and well-tested.

Secondly, we must ensure that the money that is flowing in is not going to flow out too easily. It is better to get more enduring inflows, even if they are not as voluminous, than whimsical ones that may leave overnight and needlessly disrupt markets. Depending on the scale and variability of capital inflows, it might also be necessary and desirable to undertake capital account management.

The stock markets may not like the idea. So what?

The author is Executive Editor, Corporate India, and lives in Mumbai