The merchandise deficit is rising and FII inflows are falling, but higher FDI and stable ECB flows will ensure there's no forex crisis.
The recent sharp rise in the Current Account Deficit has brought attention back to the Balance of Payments accounts. Like many emerging markets, India has seen significant increase in capital inflows over the past few years as consistently above-8 per cent domestic growth attracted global investors. But, it has also seen a rising import bill on account of escalating oil prices and accelerating domestic demand for capital goods and metals. As India relies on oil imports to meet much of its oil needs, it remains vulnerable to volatile and uncertain oil prices. Moreover, relatively lesser liquidity in the global economy and an expected slower domestic growth this fiscal are also likely to generate smaller net capital inflows. But do these risks translate into a serious threat to the balance in external accounts?
Since the beginning of the decade, external transactions have resulted in an addition to the foreign exchange reserves as Capital Account Surplus and this has continually offset the Current Account Deficit. But the Balance of Payments composition and magnitude has changed significantly over the period. Acceleration in economic growth since 2002-2003 not only created increased thrust for imports of both oil and non-oil goods but also attracted large capital inflows. Thus the gap between Current Account Deficit and Capital Account Surplus has continued to widen every subsequent year. In 2007-08, where Capital Account Surplus jumped to record $108.3 billion, the Current Account Deficit soared to a record deficit of $17.4 billion.
The merchandise deficit has been the dominant component influencing the Current Account Deficit, with its contribution increasing sharply. Even though exports grew at a compound annual growth rate of about 20 per cent, imports grew at a much faster 24 per cent over the last seven years. Exports were driven primarily by demand for engineering goods, gems and jewellery, chemicals, and more recently petroleum products. But imports have been driven by demand for crude oil, electronic machinery and electronic goods, gold, machinery and iron and steel in accordance with rising demand for production.
Thus, the surging international price of most of these commodities in the last few years resulted in a much higher payments outflow on account of a higher import bill. Oil imports which constitute one-third of total imports have shot up 5.5 times since 2000-01 to $77 billion and meanwhile non-oil imports have ballooned four times to $171.5 billion. Consistently rising net invisibles balance (sum of net transfer payments, net incomes received from abroad and net services trade) has only partially offset the merchandise deficit. Even as net software services grew at a 26.2 per cent compound annual growth rate in the period, it offset only 40 per cent of the merchandise deficit every year. In 2007-08 specifically, invisibles surplus surged at 36 per cent to $31.7 billion but the merchandise deficit grew a further 42 per cent to $90.9 billion, bringing the Current Account Deficit to 1.5 per cent of the nominal GDP.
In contrast, the Capital Account Surplus has been driven by large inflows on account of portfolio inflows (FII), which have been virtually doubling every year over the past three years whilst the stock market rallied to record highs. Over the decade, these flows have increased 15-fold to $29.3 billion. While robust domestic economic growth and corporate performance attracted FIIs, easing investment regulations across sectors and greater interest rate arbitrage opportunities facilitated inflows of the other two significant constituents — external commercial borrowings (ECBs) and foreign direct investment (FDI). Both components have grown 5-fold to $22.2 billion and $15.5 billion respectively over the decade.
Significant increase in foreign acquisition of Indian companies and widening participation of global private equity players in India raised FDI flows to $9.2 billion in 2005-06 and further to $34.9 billion in 2007-08. The rapidly growing service sector and computer hardware etc. sector have been the largest recipients of these inflows. In 2007-08, housing and real estate and not surprisingly the petroleum and natural gas sector emerged as the other two important sectors attracting FDI.
Meanwhile, as the interest rate differential widened, ECBs became more attractive and easier to obtain as impressive corporate financial performance over the last few years reduced their risk perceptions.
But, de facto capital account convertibility over the last few years has provided resident individuals and companies greater opportunities to diversify their portfolios. This is reflected in the manifold rise in portfolio outflows, to $206.4 billion last fiscal. Importantly, rising global aspirations of Indian firms led to the emergence and growth of Indian multinationals encouraged by the steady rise in limit on their outward acquisition to 300 per cent of their net worth. From an average of about $2 billion for years, FDI outflow jumped to $6.4 billion in 2005-06 and further to $19.4 billion in 2007-08.
But these trends are set to change this fiscal as slowing domestic economic activity, tight global liquidity conditions, and more recently, slowing corporate profit growth point to moderating momentum of FII inflows this year. Yet, the long-term attractiveness of the Indian market will sustain FDI interest in the market and relatively high domestic interest rates are likely to prevent a sharp decline in ECB inflows. Moreover, volatility in equity markets across the world and relative strength in domestic growth vis-à-vis in other emerging countries will deter high capital outflows. The last two trends will cushion the impact of lower FII inflows this fiscal. Thus, the Capital Account Surplus is expected to drop to $ 70 billion or 5.3 per cent of GDP.
This would offset the Current Account Deficit completely. Even as high prices of oil, fertilizers and some commodities persist into fiscal 2008-09, a depreciating exchange rate (Rs 41.5-42/$ by year-end) will accelerate exports and encourage a fall in imports at the same time. While, demand for goods exports from the Asian neighbourhood and the Middle East will bolster growth, diversification of markets for software service exports will propel overall growth. This would partly offset the impact of high oil import bill. The oil import bill is likely to grow at 45 per cent to $111.7 billion in 2008-09, but the already evident fall in non-oil imports will take the total imports bill to $311.1 billion. The merchandise deficit is expected to rise to $123.8 billion as exports clock a 19 per cent growth. Moderation in invisibles surplus growth will result in a Current Account Deficit of $33 billion or 2.5 per cent of GDP.
Thus, while the gap between the Current Account Deficit and the Capital Account Surplus, will narrow in 2008-09, the Balance of Payments situation is still stable. Oil prices are the single-largest factor exhibiting considerable stress on the Current Account Deficit, but they have already begun to moderate, taking off some of the pressure. As of the end of March 2008, the merchandise imports cover of foreign exchange reserves was 15.6 months. By the end of 2008-09, the import cover is expected to reduce by a month and half by our calculations. Thus, while there is some stress, an overall healthy economy will prevent any crisis situation.
The authors are economists at Crisil. ranand@crisil.com, pbhardwaj@crisil.com
