Rising current account deficit - a concern

The Indian economy, which witnessed significant slowdown due to global financial and economic crisis, is now marching towards high growth trajectory. The impressive performance displayed by a slew of lead indicators such as bank credit growth, rise in the production of capital goods, corporate tax collections and exports growth ensures sustainability of the current growth momentum. Even as the optimism about India’s growth prospects is mounting, a widening Current Account Deficit (CAD) has imparted some cautiousness in the overall sentiment.

With the widening of merchandise trade deficit, India’s Current Account Deficit surged to 4.1% of GDP during Q2 FY11 against 3.2% the previous quarter. Despite a pick-up in exports, merchandise trade deficit widened to $35.4 billion during Q2 FY11 from $31.6 billion during Q1 FY11 as imports grew at a higher pace compared to exports. On the other hand, invisibles which often had offset the increase in merchandise trade deficit, continued to remain low during Q2 FY11 resulting in the higher current account deficit. Among invisibles, while export of software services and transfers remained buoyant, non-software services exports (viz. travel, transportation, insurance, business and financial services) witnessed deceleration during Q2 FY11. This can largely be attributed to the slow growth of developed economies.

On the capital account front, the improving domestic business sentiment, buoyant equity markets and strong growth prospects of the Indian economy had boosted FII inflows to India. However, while foreign portfolio inflows witnessed significant rise during Q2 FY11, the continued deceleration in FDI inflows remained a concern. FDI inflows, which were decelerating for last four quarters, fell significantly to $2.5 billion during Q2 FY11 against $7.5 billion during Q2 FY10. The declining contribution of FDI in financing the current account deficit is distressing and calls for a careful watch. Further, in the current scenario the question that now arises is what will happen to Balance of Payment if the FII inflows dries up completely and/or there is a massive outflow of FIIs. Indeed, this had happened in FY09 due to global financial turmoil. The FIIs witnessed an outflow of $15 billion during FY09; however, FDI inflows remained buoyant at $17.5 billion during the same period, thus limiting the negative impact of the FII outflows on overall BoP. Considering the current low level of FDI, a sudden drying up/outflow of FIIs due to any untoward development in India as well as internationally could pose a significant risk to Balance of Payment (BoP).

Besides deteriorating CAD, a substantial rise in India’s external debt needs to be treated with cautiousness. India's external debt stock, which stood at $295.8 billion as at end-September 2010 (up 12.8% from its end-March 2010 level), exceeded the foreign exchange reserves of $294.2 billion as at end-September 2010. The rise in external debt can largely be attributed to increase in commercial borrowings and short-term debt which together contributed over 70% to the growth in India’s external debt. The sharp rise in ratio of short-term debt to total external debt in particular need to be monitored closely as short-term debt is generally highly sensitive to changes in financial conditions.

Though imports growth has remained low during Oct-Nov 2010, it is expected to pick up again going forward given the sustained recovery in domestic consumption and investment demand. Moreover, if global oil prices - which have already surged to around $98/bbl - continue to remain at elevated level would lead to higher oil-import bill. This in turn would translate into the widening of the foreign trade deficit.

Further, though, there is no immediate likelihood of a reversal in foreign capital flows, any untoward development on international front could affect foreign capital inflows. In that case, the already high level of CAD would pose significant risk to BoP.

The author is Senior Economist, Dun & Bradstreet. Views are personal