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External account - Gaining strength?

Feb 27, 2006

In the last year's outlook for the external sector, we had mentioned that India, China and the Russian region would continue to be major contributors to global economic growth. This is exactly what has happened, with developing Asia, apart from the US, providing the major fillip to world output. In contrast, the significance of the Euro area and Japan in driving economic growth in periods of cyclical upswings seems to be reducing. In particular, the Euro area is showing an increasing likelihood of slipping into the contraction mode. Therefore, it does appear that the onus of carrying forward global expansion has fallen on developing Asia in general, and India and China in particular.Let us read a little bit more into this performance and analyse the implications thereof, going forward.

Global performance

Developed markets
After turning in a fairly robust economic performance in 2004, the US slowed down in 2005 (estimated). Nonetheless, it is still estimated to clock a 3.5% growth, being the major driver of the increase in global economic output. Thus, it is very clear that, despite all the hullabaloo about the 'BRIC' countries and emerging markets, the US remains, in every sense, a global superpower upon which global economic growth is dependent. The growth forecast for the US remains relatively stable in 2006, with only a minor 20 basis points reduction in estimates.

The Euro zone saw a relatively subdued performance in 2005 as compared to 2004. However, in 2006, the growth forecast is significantly higher than in 2005, possibly driven by better economic prospects for the major German economy, the largest economy in the Euro zone. Japan also grew, albeit at a slower pace, in 2005, and is forecast to maintain the same rate of growth in 2006, undoubtedly an encouraging sign for the global economy.

'Emerging' stars
Despite the good performance of the key US economy, most of the laurels in 2005 went the way of 'emerging Asia'. This was led by India, China, India and Russia. The growth forecast for 2006 is also strong in these regions, particularly in India and China, driven by increased domestic consumption and investment-led demand respectively. However, the major concerns that could impact growth would be higher crude oil prices and higher inflationary expectations, leading to higher interest rates in the US. The revaluation of the Chinese currency, the Renminbi (RMB), is expected to only impact the global economy over a period of time, given the measured approach taken by the People's Bank of China to move towards a managed float.

On an overall basis, global economic growth is expected to hit 4.3%, both in 2005 and 2006.

GDP growth (%)200320042005E2006E
US2.7 4.2 3.5 3.3
EU0.7 2.0 1.2 1.8
Japan1.4 2.7 2.0 2.0
CIS countries7.9 8.4 6.0 5.7
Developing Asia8.1 8.2 7.8 7.2
China9.5 9.5 9.0 8.2
India7.4 7.3 7.1 6.3
Russia7.3 7.2 5.5 5.3
World4.0 5.1 4.3 4.3
Source: World Economic Outlook, September 2005; IMF

India Performance Vs Hype
India's current account continued to remain in deficit during 1HFY06 (April - September). It should be noted that in FY05, the current account turned negative for the first time after three years of surplus. This continued in FY06, with the deficit ballooning to as much as almost US$ 13 bn, as compared to just US$ 485 m in1HFY05. This huge increase has been buoyed by strong import growth (both oil and non-oil, which is primarily dominated by capital goods). Between FY02 and FY04, despite a trade deficit, the invisibles (net) always overcame the deficit to maintain a surplus in the current account, driven partly by software and ITES exports. In FY05 however, this was not the case and this trend has continued in 1HFY06.

The growth in imports was a massive 48.5% in FY05 and 38.3% in 1HFY05. Compared to this, the increase in imports has been to the tune of 48.4% in 1HFY06, despite the high base. Petroleum, oil and lubricants (POL) imports have increased in 1HFY06 by 42.9%. This was driven by an over-40% rise in the average price of the Indian basket of crude. In fact, for the period April 2005 to January 2006, POL imports have increased by 46.9%.

As regards the capital account, the surplus grew by as much as 162% in 1HFY06 to US$ 19.5 bn as compared to US$ 7.4 bn in 1HFY05. The major drivers of this increase have been non-debt creating foreign investment inflows, particularly foreign institutional investor (FII) inflows. In fact, FII inflows were higher in 1HFY06 by 1,150% over 1HFY05. The increase in interest rates in the US does not seem to have deterred the Foreign Institutional Investors (FIIs) inflows at all, rather they have increased at an astonishing pace and stood at US$ 4.2 bn in 1HFY06 as compared to a mere US$ 339 m in 1HFY05. An increase in inflows of commercial borrowings and short-term credits on account of lower interest rate spreads on external borrowings and higher import financing requirements was also seen. Thus, this expansion resulted in an overall surplus in the balance of payments (BoP).

FDI flows increasing in future?
The foreign direct investment (FDI) inflows (net) into the country stood at US$ 2.3 bn in 1HFY06 as compared to approximately US$ 2 bn in 1HFY05. Thus, this is undoubtedly an encouraging sign, although the absolute amount may not be as much as what needs to be brought in, particularly in a capital-scarce country like India. It is likely that the full year FDI figures will be higher than the FY05 figure of US$ 3.2 bn.

Going forward, with big-ticket investments, such as the US$ 12 bn mega-plans of Korean steel giant, POSCO, and a similar big-ticket FDI from Mittal Steel, these are the kind of inflows that India needs in order to sustain a decent rate of economic growth. FDI inflows not only provide strength to the capital account, but also lend stability due to their longer-term nature.

Going forward, India, China, Russia and the rest of 'emerging Asia' are expected to continue to drive global economic growth. However, it needs mention here that the global economy is still over-dependent on the US, and thus, any slowdown on that front could witness negative after-effects globally. Due to the deficit in that country, an upward interest rate bias has already begun, with the Fed rate touching 4.5%, the fourteenth successive increase after it had hit 1% in June 2004. Further increases to a possible 'threshold level' could result in US assets becoming more attractive, an appreciation of the dollar and foreign inflows slowing down to emerging markets. The revaluing of the Chinese Renminbi (RMB), though having started, is expected to have an impact only over a period of time, since the People's Bank of China has adopted a measured approach, using a restricted price band of +/- 0.3%.

In order to maintain a strong rate of economic growth, the rate of investment in the economy needs to increase as a percentage of GDP. While big-ticket FDI inflows, such as POSCO, are on the anvil, more such investments need to be made. India is not too dependent on exports, which accounted for 11.8% of GDP, with international trade accounting for 28.9% in FY05. We believe that the major impetus for India's economic growth will come from domestic demand, with select stories, such as outsourcing, driving exports. The continuation of reforms, particularly on fronts such as infrastructure, will be crucial to the sustenance of India's strong economic growth.

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