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RBI says economy is taper-ready; expects CAD to stay under 3%

Mumbai, Dec 30 (PTI): The country’s external sector can now handle the US Federal Reserve’s proposed tapering of its monetary stimulus, the Reserve Bank of India said Monday.

The central bank, in its 8th Financial Stability Report released Monday, said it expects the current account deficit to remain below three per cent of gross domestic product or GDP for this financial year.

The Fed’s monetary stimulus programme, which had supported inflows of cash into emerging markets, was to have been reduced gradually but such plans have been postponed to January 1.

”External sector risks have been considerably reduced and the effect of the tapering on the economy is expected to be limited and short-lived,” the report said.

The delay in the tapering of the $85 billion-a-month bond buyback programme by the Fed gave the country time to replenish its foreign exchange reserves and narrow the high current account gap.

In the third week of December, the US Fed announced that it would cut back bond buying by $10 billion a month to $75 billion from January on the back of improvement in the world's biggest economy.

“The CAD is expected to be less than three per cent of the GDP during the current financial year,” the RBI said in the half-yearly report. “On balance, the country's external position appears to be manageable and reserves seem adequate.”

The CAD shot up to an all-time high of 4.8 per cent last year on account of a heavy trade deficit and higher gold imports.

The high CAD, along with fears of tapering, was one of the factors that took the rupee to a lifetime low of 68.85 against the dollar on August 28 this year. The rupee has improved since then, but is still 14 per cent lower year-to-date.

The authorities acted on several fronts, curbing gold imports, opening currency swap windows to get fresh dollar flows, and increasing money market rates to reduce speculation.

Taken together, these steps have helped bring the CAD down to 1.2 per cent of GDP in the second quarter, while foreign exchange reserves improved to over $295 billion as of last week.

The biggest factor had been a drastic fall in gold imports. The RBI also got $34 billion by way of the two dollar-swap windows.

On the rupee front, the RBI report also acknowledged the role played by the offshore markets, saying there is an increase in the offshore turnover of emerging market currencies in the last few years.

The report, however, stresses that the long-term solution to the external sector problems for the country lies in increasing productivity and the export competitiveness.

It said the inflation differential between the advanced economies and the emerging ones like India is a potential source of volatility in the exchange rates as capital flows could abruptly change directions.

The report also says it is imperative to contain inflation.