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India: An 'external' view... - Views on News from Equitymaster
 
 
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  • May 29, 2006

    India: An 'external' view...

    After being in surplus from FY01 to FY04, India's current account ran into a deficit in FY05, with the latest numbers showing deficit of US$ 13.5 bn. In this article, we shall try to understand the reasons for the same and whether this deficit bodes well for the economy.

    Why the deficit?
    The current account comprises of two components viz., merchandise (i.e., trade) account and invisibles (exports of services like software, and remittances from abroad). While the growth in invisibles has been buoyant, it is the widening trade deficit that is weighing heavy on the current account position. The burgeoning trade deficit (US$ 37.4 bn in FY06) can be attributed to two factors viz. increase in both oil and non-oil imports and exports not able to keep pace with imports. This trade deficit has now spilled over to the current account, which started showing a negative balance from the financial year FY05.

    While exports clocked an impressive 28% YoY growth during FY06, imports grew at a much faster clip of 32%, led by both oil and non-oil imports. The 47% YoY rise in oil imports was attributed more to the rise in international crude prices. To put things in perspective, in FY06, while the Indian basket crude oil price witnessed a sharp increase of 42% YoY, volumes grew by a mere 3% YoY (Source: Reserve Bank of India (RBI)).

    That said, international crude prices are a factor of market dynamics and political factors at the global level and with its increased appetite for oil, the effect of the same on the Indian economy is not likely to taper off in the near future.

    Non-oil imports (up 26% YoY in FY06) generally comprise of import of industrial goods and a rise in the same indicates the buoyant demand and growth of an economy. As a result, an increase in non-oil imports does not have to necessarily be construed as a negative sign. Another fact to note is that in the period between FY01 and FY04, the surplus current account was largely due to the contribution from invisibles (US$ 28.1 bn in 9mFY06). While invisibles will continue to play a key role in contributing to the current account, India will have to step up its pace of exports, if the gap has to narrow down.

    There are still the positives...
    Favourable BOP position: Despite this, India's balance payments (BOP) position is still strong, thanks to Foreign Institutional Investors (FIIs), who have poured in money into Indian equities to capitalise on the India growth story and the strong growth in corporate earnings. This can be gauged by the fact that FII inflows registered a 19% YoY growth to reach US$ 8.2 bn during April 2005 to February 2006 (Source: RBI).

    During the same period, FDI inflows into India stood at US$ 5.8 bn, representing a 31% YoY growth on the back of sustained growth in activity and positive investment climate. Here again, considering that the FIIs have largely contributed to the bull-run in the past year, the recent Fed interest rate hikes and the likely outflow of money in the medium term will continue to remain a cause for concern.

    Comfortable forex position: Generally, a current account deficit is detrimental to an economy and tends to put pressure on the forex exchange reserves. However, during 9mFY06, the current account deficit was more than offset by the surplus in the capital account, resulting in an accretion to the foreign exchange reserves to the order of US$ 1.8 bn. India's foreign exchange reserves stood at US$ 151.6 bn at the end of FY06, with India holding the fifth-largest stock of reserves amongst the emerging market economies and the sixth-largest in the world. This was despite an outgo of US$ 7.1 bn on account of redemption of India Millennium Deposits (IMDs) in December 2005. As a result, India's foreign exchange reserves continue to be at a comfortable level, consistent with the rate of growth and the share of the external sector in the economy.

    To sum up...
    While the deficit at current levels can be sustained, it is important to note that any further rise will eventually result in the economy begin to feel the pinch. That said, despite a current account deficit, India's favourable BOP position and comfortable level of forex reserves means that the economy has come a long way since the kind of BOP crisis that emerged in the early 1990s.

     

     

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