UnhideWhenUsed="false" QFormat="true" Name="Book Title" />
/* Style Definitions */
mso-padding-alt:0cm 5.4pt 0cm 5.4pt;
mso-fareast-font-family:"Times New Roman";
India’s current account deficit is rising at a rapid pace. We believe it could widen to 4% of GDP in FY11 and further to 4.3% in FY12, its highest ever level.
- The deficit is being increasingly financed by short-term capital, rather than FDI, which is enlarging short-term debt and raising external vulnerability.
- We flag the deterioration in external balances as the biggest risk to India’s growth story, and one that investors should follow closely.
- That said, gross international reserves currently remain sufficient to cover temporary reversals of capital.
-We think the likely policy response will be to continue to tighten fiscal and monetary policies, and prevent any temporary sharp appreciation of the INR.
The strength in domestic demand which helped India limit the impact from the financial crisis of 2008, has also led to sharply rising trade and current account deficits due to increased imports and sluggish exports. The unprecedented and rising current account deficit has largely been financed by short-term capital inflows, which has increased short-term debt ratios, and the vulnerability to a reversal in flows.
While we remain constructive on India’s medium-term growth outlook, the deterioration in external balances represents the biggest risk, in our view, to the Indian growth story, and one that investors should follow very closely.
The risk to the economy is of a boom-bust cycle reminiscent of emerging markets in the 1980s and 1990s. Strong domestic demand is leading to high and increasing demand for imports, and a reliance on short-term inflows to finance it. A surge of capital chasing growth and yield could exacerbate already high asset and commodity prices, and lead to further real exchange rate appreciation.
This could lead to a further loss of competitiveness, while the easy capital encourages higher imports, further increasing the current account deficit. If capital flows were to reverse for an extended period due to risk aversion, it could lead to a sharp sell-off in the currency, bond, and equity markets driving yields higher, causing a liquidity crunch and a sharp decline in output.
We flag this more as a risk, than a clear and present danger. We believe foreign reserves remain adequate to counter temporary reversals of capital, and the domestic growth and savings are based on sound foundations. Yet, the increased reliance on external capital to fund ever wider current account deficits has increased vulnerability significantly more than before the 2008 crisis.
A worrying current account deficit
India’s current account deficit has risen to unprecedented levels and may rise further. We estimate that the deficit may rise from 2.9% in FY10 to 4% of GDP in FY11, and further to 4.5% in FY12, a level significantly higher than even the balance of payments (BOP) crisis year of 1991.
Strong domestic demand and weak external demand may continue to exacerbate the deficit.
Strong domestic demand and infrastructure needs are leading to a rapid increase in imports. There is a structural component to this as well due to the reduction in import duties in the period 2006- 2008. The increase in imports is across the board and not just limited to oil and gold, as is conventionally thought. Given the strong outlook for growth in FY12, the large infrastructure import needs, such as road and power equipment, and India’s increasing reliance on commodity imports of oil and coal, we think that import demand may remain robust in FY12.
Meanwhile, exports growth remains constrained by the weak external environment. The US
and EU together account for nearly 30% of India’s merchandise exports and a larger proportion of its services exports, and weak demand there is affecting exports growth, primarily to the EU, a situation which is unlikely to get much better in 2011.
Even in services, net exports have fallen sharply. More recently, net non-software trade in
services has become strongly negative, as imports have exceeded exports by a wide margin. The deficit on goods and services has risen to 6.5% of GDP by end-June 2010.
Capital inflows dominated by short-term flows
India’s current account deficit is increasingly being funded by non-FDI, short-term inflows. Portfolio inflows in 2010 have nearly exceeded their all-time highs in 2007. Trade credit and external loans by corporates are also at the peak levels of 2007. Nearly 80% of the capital inflows are non-FDI related. Given the excess spare capacity globally, FDI may remain weak going forward. Indeed, after the Asian financial crisis of 1997, FDI to the region remained weak for several years. Thus, the Basic Balance of Payments (BBOP) may be in deficit in FY12.
As a result, outstanding debt with a maturity of less than a year has risen to US$115 billion (42% of gross reserves). This number includes short term debt (mainly trade credit) as well as the portion of medium to long-term debt that is due within the next year (mainly non-resident Indian deposits). Although these are generally rolled over in normal times, they are a vulnerability during periods of risk reversal. As India has borrowed abroad, the net investment position has also worsened considerably.
That said, the external balance sheet is not at precarious levels yet due to high reserves. On various indicators of reserve adequacy such as short-term debt to reserves, and in months of imports, reserves currently look adequate to cover a temporary reversal in flows. There is also, very likely, a structural element to these flows due to a gradual shift in developed market fund managers’ preference for holding emerging market (EM) assets. However, given the increase in the scale of external financing needs, there is hardly any buffer in case external financing were to become more difficult. For instance, in terms of projected FY12 imports, the forward reserve cover would decline to 6 months.
We would emphasize that any vulnerability from a reversal of capital would be more in the nature of a liquidity issue rather than a balance sheet issue. The latter remains robust, despite the weakening over the past few quarters.
With the economy displaying classic symptoms of a boom-bust—high and rising twin current and fiscal account deficits, high government debt, and appreciating real exchange rates, the policy response will be critical.
We believe the optimal policy response should be to tighten fiscal first and also monetary policy, and keep the nominal exchange rate from appreciating. However, given spending pressures on NREGA, food subsidies, and infrastructure investment, we do not think that fiscal policy will be sufficiently tight going forward in FY12.
We continue to hold the view that the Reserve Bank of India (RBI) will need to tighten policy rates by 50-75 bp by June 2011. We think that the burden in attempting to moderate demand will fall on monetary policy. The risk-reward for the RBI is skewed towards a tighter policy. Raising interest rates would help moderate demand which can then limit inflationary and current account deficit pressures. If inflation were to be brought down, it would also reduce the extent of loss in competitiveness of Indian exports. Finally, higher rates would continue to incentivize capital inflows to fund the growing deficit. There is little downside to raising rates, as in our view, there is little likelihood of a sharp slowdown in consumption or investment demand due to the magnitude of rate increases that we envisage.
Leave Your Comment