Why have successive Indian governments since the mid-1950s been obsessed with the capital account and ignored the current account almost altogether? This question is prompted by the statement by the Chief Economic Adviser on the record gross capital inflows in the last 12 months.
That’s good news, doubtless, because more foreign money is good for the economy. But wait: when was the last time you heard any CEA talk about the current account, except in passing?
First, however, the definitions. The current account comprises a country’s balance of trade, net of factor income and cash transfers. That means earnings from what it sells to foreigners. And the capital account shows how their capital is coming in and going out. It shows the country’s overall financial position and the confidence foreigners have in the economy.
That out of the way, the answer to the question about CEAs and the current account was a dismaying nearly never. And this when the capital account is really the balancing factor in the balance of payments. It makes up the shortfall in the current account when a country exports less than it imports.
Before 1947 the capital account wasn’t really an issue because the Indian economy was fully integrated with the British and therefore the global economy. Capital flows were strong and seamless. The Brits saw to it to ensure that they got the investments they wanted or needed. So India had full capital convertibility.
However, the current account did cause a lot of concern to our English lords and masters. They kept fiddling with the exchange rate to keep it in good shape, at least from their point of view. Starting from the early 1890s they made life difficult for us. You should read the controversies on and around the subject.
But after 1955 it’s been the other way round. It is the capital account that governments have been worried about, not the current account even though what happens in the capital account is a consequence of what happens to the current account. Why has this happened? Basically what you don’t earn, you borrow.
Why the capital account?
There can be many reasons. The most important reason has to do with the Second Five Year Plan and the foreign exchange requirement demanded for it by PC Mahalanobis. Such was the capital intensity of that Plan that it was assumed that the money would have to come into the capital account via loans and grants rather than via the current account as a result of earnings from exports. This when India’s share of world trade was still above 2 per cent.
But the emphasis on capital intensive growth came at the expense of labour intensive investments into the export sector. We did the most stupid thing imaginable: we gave up our comparative advantage. You can almost hear Eli Heckscher and Bertil Ohlin groaning.
Another reason was administrative, namely, the division of work between the finance ministry and the foreign trade ministry, as it was then called. The former was in charge of the capital account while the latter, being in charge of exports and imports, was in charge, so to speak, of the current account.
Given the pecking order in government, the Finance Ministry and therefore the capital account took precedence in the setting of priorities. That hasn’t changed since the mid-1950s. The Commerce Ministry has to take its chances on debt and exchange rate policies.
There are other reasons as well such as the political pressure on governments not to be seen as a debtor. The colonial image of a farmer drowning in debt was transferred to the country as a whole.
Pakistan has shown that this is false imagery. It’s been to the IMF two dozen times. But Indian politicians, in their anxiety to avoid this, forgot that if you earn enough, you don’t have to borrow. The current account was therefore ignored by them. In India, capital flows were constrained by fear of debt.
The consequences
There have been two major consequences of this approach to the management of the external sector: one, a steadfast refusal to tap adequately into foreign savings even though our own savings are inadequate. Combine that with a refusal to turn around the current account, and we ended up with a capital shortage. The stigma attached to debt has impeded growth.
The second consequence is the sacrificing of capital efficiency because of import substitution. Not only do investments made behind tariff walls face reduced pressure to be efficient, there is a spillover effect on the labour market where wages are higher than they would otherwise be.
It’s possible to enumerate many more such foolish things but the point ought to be clear. By focusing on the capital account and neglecting the current account, we have made a gigantic mistake. It can be rectified if the thinking changes.
Published on May 4, 2026