Current account improves

India has run current account deficits since the early-1990s, save for a brief period in 2002-04. The deficit averaged 1-2.5% of GDP over most of the past decade before rising to 4% in FY12/13 on the back of a jump in oil imports and gold purchases. It has since fallen back to about 1% of GDP and should remain about there for the foreseeable future, says Development Bank of Singapore (DBS) in a report released on October 18, 2016.

This is good news for an economy which has been frequently under fire for its twin deficits (fiscal and current account). A narrower current account has lowered its vulnerability to external shocks.
But this improvement is not a revisit of 2002-04 surpluses, which were driven by better fundamentals. This time around, a plunge in global oil prices and subdued investment have been mainly responsible. Oil prices and a revival in investment spending could widen it again.

What’s behind the improving current account trend?

The current account deficit (CAD) narrowed to 1.7% of GDP in FY13/14 from a yawning 4.8% year before. This sharp correction owed to a smaller merchandise trade deficit, which in turn was due to a plunge in gold purchases. Back then, gold imports were the second biggest import item, second to oil.

The sharp fall in gold demand was engineered through a host of trade/administrative curbs. This led to a sharp 70% fall in the metal’s imports in FY13/14. Global commodity prices were also softening, helping cap oil imports.

Subsequently, the CAD narrowed to 1.3% of GDP in FY14/15 and 1.1% in FY15/16. In these years, the drop in crude oil prices was the main driver; oil imports fell by one-third. At the same time, weak investment also softened non-oil non-gold demand. The latter accounted for a fifth of the fall in overall imports, helping to keep the deficit under control.

This year (FY16/17), we expect the CAD to shrink to less than 1% of GDP from FY15/16’s 1.1%.

It’s not deja-vu 2002-04

Market commentators are quick to draw parallels between the ongoing improvement in current account balance and surpluses back in 2002-04.

Unfortunately, there are big differences between these two periods.

Back then, much of the better CA balance stemmed from a stable merchandise trade deficit and strong invisibles receipts. The latter was especially important.

As a percentage of GDP, the invisibles balance increased to +4.3% in FY03/04 from +3.1% in FY01/02. Within invisibles, service trade (mainly software/ information technology) was a notable contributor, which along with remittances, which together made up 90% of the total receipts. Hence, the improvement was driven more by firmer exports than weak imports.

At present, the reverse is occurring. The current account has largely benefited from a fall in imports rather than greater exports.

The sharp drop in crude prices cut the oil import bill by one-third, while subdued investment demand kept a lid on non-gold non-oil purchases. The latter fell 9.0% in Apr-Jul16 compared to -4.0% in FY15/16. Amongst invisibles, service receipts and private transfers / remittances are also showing signs of strain.

Thus the current improvement in the current account is not as favourable as the one in 2002-04.

Is the current account at risk?

What are the chances that the current account deteriorates going forward? This depends mainly on the direction of oil prices and a revival in domestic investment. The current dynamics are favourable. Even as oil prices are off January 2016 lows, prevailing levels of US$45-$50per barrel are not threatening as yet.

At the same time, the private sector capex remains subdued. Growth in gross capital formation fell 3.1% YoY in Apr-Jun16 from 4% last year. The number of stalled projects has been rising, with capacity utilisation easing to 70% from 80% in 2011-12.

Against this backdrop, the CAD should narrow to 0.8-0.9% of GDP from 1.1% in FY15/16. A stronger current account balance would be at risk if crude prices rose above USD 60/bbl this year. India imports 70-80% of its oil needs, which leaves 7% of GDP exposed to global price swings.

At the same time, a pickup in investment could also lift imports, putting renewed pressure on the current account. If these risks materialise, a return to the long-term deficit range of 1.5-2.0% of GDP would likely follow.

Financing fix will also determine vulnerability

While the size of the current account is important, how it is financed is equally important. Here too there have been positive developments.

Marking a shift from FY14/15, last year foreign direct investments were a bigger source of the funding mix rather than portfolio inflows.

The former are preferred as these are non-debt creating and long duration focused unlike portfolio flows which are fickle and reactive to short-term risk swings.

Given the government’s move to raise limits/relax sector-specific regulations for FDI, undertake reforms to improve the ease of doing business and efforts to streamline the investment process, we expect foreign investment flows to improve in the coming years.

Emerging markets, including India, should run deficits

India’s problem is not with current account deficits but its size. In the past, wide CAD often coincided with sizeable fiscal deficits, set against a backdrop of a falling savings rate.

This forced the economy to fund any revival in investment demand through foreign capital leaving the economy vulnerable to global risk sentiments.

Rather than pursuing surpluses – which in other words means India lends to higher income/capital abundant countries – the country should run small deficits and channel funds into its own infrastructure needs and growth.

Emerging economies, including India, are supposed to be borrowers, not lenders. A modest deficit of around 1-2% of GDP, accompanied by smaller fiscal deficits is an ideal combination. fii-news.com