Danger signals

If the capital account deficit continues for another few quarters, the drawdown in forex reserves will begin to erode credibility

The numbers for the country’s balance of payments during the third quarter (October-December) of 2008-09 indicate a dramatic change in the situation from the previous quarter. The trade deficit, the difference between merchandise imports and exports, narrowed marginally from about $38 billion to $36 billion. However, with about $4 billion less inflow in invisibles (service exports and remittances), the current account deficit widened from a little under $12 billion to over $14.5 billion. The most significant development, though, is the transition of the capital account from positive to negative territory. For the first time in over 10 years, the economy saw a quarter with net capital outflows of $3.2 billion, compared to a net inflow of around $8 billion in the July-September quarter. By way of reference, the net inflows during the second and third quarters of 2007-08 were $33.5 billion and $31.2 billion, respectively.

 

The deficit was largely the result of the massive redemptions and exit by foreign institutional investors, estimated at about $5.8 billion. Other categories, such as banking capital and trade credits, also contributed substantially to the deficit, which was moderated by a sharp increase in NRI deposits, continued external commercial borrowings and “other capital”, a residual category mainly capturing the leads and lags in export earnings and payments for imports. Inward foreign direct investment (FDI) continued to be healthy at $6.7 billion during the quarter, but was almost entirely offset by outward FDI. The combined effect of the twin deficits was to bring down foreign exchange reserves by about $17.9 billion, in contrast to an accumulation of $4.7 billion in the previous quarter and in even sharper contrast to an increase of $26.7 billion in the third quarter of 2007-08.

There is certainly cause for concern here. Given the state of the global economy, a resumption of capital inflows is uncertain and, when it happens, likely to be relatively small. If the capital account deficit continues for another few quarters, the drawdown in foreign exchange reserves will begin to erode credibility, which will deter investment. An additional threat here is the prospect of a sovereign ratings downgrade by one or more of the global rating agencies. Although this will be driven by their assessment of the fiscal situation after the new government takes office, it will have massive repercussions on the ability and willingness of foreign investors to allocate funds to India.

Amidst all the bad news, there are also some positive signals from the current account numbers. The trade deficit is narrowing despite declining exports, as commodity prices continue to fall. Services exports, largely comprising IT, continue to hold reasonably steady. Remittances, though down from the previous quarter, are up compared with the previous year. This is reassuring, given the state of the Western and West Asian economies like Dubai. However, it should not come as a surprise if they begin to decline quite sharply, exerting further pressure on an already delicate situation. Fortunately, the reserve position is still healthy and the economy can withstand a few more months of twin deficits without setting off serious danger signals. But the Reserve Bank should opt for allowing the rupee to fall, rather than expending dollars to defend the rupee’s value, if that is the choice that it has to make. Eventually, this is another item on the growing list of challenges that will confront the new government when it assumes office.