Fixing the deficit: More repairs needed

Fixing the deficit:  More repairs needed

India’s current account deficit (CAD), the equally ugly twin brother of the fiscal deficit, has widened significantly as savings have fallen more than investments.

The deficit grew from an average of 0.3 per cent of GDP in the five years preceding the global financial crisis (GFC) to 3.3 per cent during the five years that followed. This has made India more susceptible to the vagaries of capital flows as we’ve seen in recent months.

The wider deficit partly reflects the lower output in the US and Europe post-GFC, which slowed exports. Higher oil prices also played a role. But, the real problem has been at home. Macroeconomic policies were kept too loose, which combined with insufficient structural reform, widened supply-demand imbalances. Moreover, rising inflation led to a loss of competitiveness and higher gold imports.

The CAD is not sustainable because its high level and poor quality imply an increase in the external debt-to-GDP ratio if left unattended. Encouragingly, the trade deficit has narrowed in recent months, led by slower domestic demand, a weaker currency and policy steps to curb imports. These factors should help narrow the CAD this and next year.

From balance to imbalance

The current account deficit (CAD) widened to an average of 3.3 per cent of GDP between fiscal 2009 and fiscal 2013 from a mere 0.3 per cent during the previous five years. It hit an all-time annual high of 4.8 per cent of GDP in fiscal 2013, even touching 6.7 per cent during the third quarter of that fiscal year. What happened?

The deterioration has primarily been driven by the trade deficit, which rose to 9.3 per cent of GDP on average during the post-GFC period from an average of around 5 per cent in the previous five years.

The services balance, which is in surplus, actually improved post-GFC while the income and transfer balances held broadly steady as a percentage of GDP. What was behind this? For one, the weaker global economic backdrop since the GFC has obviously played a role. With India exporting around 50 per cent of its total exports of goods and services to the hard-hit US and Europe, the permanent loss in demand in these countries led to a slowdown in exports of goods and services after the GFC.

Exports have also suffered due to the mining bans in states like Goa and Karnataka, which hampered exports of iron ore. Finally, having a higher inflation rate than its trading partners likely have hurt India’s competitiveness and, in turn, weighed on exports.

Where to from here?

While the fiscal year did not get off to a good start – the CAD widened to 4.9 per cent of GDP in April-June 2013 from 3.6 per cent in January-March – the trade deficit has narrowed notably in recent months. This has been driven by government steps to curb imports, especially gold, and the weakening of the currency. Moreover, the softening in domestic demand has dampened imports and helped contain the deficit.

The gradual increase in diesel prices is helping narrow the deficit by dampening fuel-related imports. However, price elasticity of fuel demand is relatively low, so the impact is somewhat limited. The fuel price hikes will probably act more as a “tax” on other consumption. If the government decides on an ad hoc hike in diesel prices in addition to the regular monthly hikes, this could help in terms of curbing both fuel and non-fuel imports.

The CAD is also expected to narrow as the global trade cycle improves, although this should mostly be felt next year. This should gradually lift exports of goods and services.
Assuming that the government contains the fiscal deficit and the RBI tightens monetary policy further, the tighter macroeconomic policies will help curb imports as domestic demand is initially contained and as inflation pressures ease.

The latter will also help reduce demand for gold. Moreover, as structural reforms are implemented to tackle supply-side bottlenecks, encourage investment in productive capacity and spur higher productivity growth, domestic production can better meet domestic demand needs.

On the back of this, we expect the CAD to narrow to around $62 billion in fiscal 2014 (vs $88 billion in fiscal 2013), around 3.4 per cent of GDP. This factors in an increase in imports in the coming months during the festive season when purchases of gold and other imported consumer goods typically rise. We have also assumed that coal imports will rise to help meet demand from power plants.

Can the deficit be financed?

A big concern is whether India will be able to finance its CAD, even if it is narrowing. Much depends on the ability to contain the deficit, the success of efforts to attract more capital inflows, and what global financial conditions are like when the US Fed begins to taper.
Let’s have a look at the current fiscal year. Taking our CAD forecast of $62 billion for the full fiscal year, the residual financing need is about $40 billion when we account for the April-June CAD.

A big chunk of this, around $15-20 billion, can be achieved through the inflows generated by the policy steps taken to increase quasi-sovereign bond issuance, external commercial borrowing of government-linked companies, and non-resident deposits. Moreover, we estimate that India could receive around $15 billion worth of FDI between July 2013 and March 2014.

This leaves around $5-10 billion to be financed through net portfolio inflows, external commercial borrowing (corporates and banks), and trade credits. In the absence of another Fed tapering scare and assuming that the administration keeps policies on the right track, this should be achievable.

Furthermore, if India makes progress towards being included in some of the big bond indexes, this could bring in significant inflows (estimates range from $20 billion to $40 billion).

What could go wrong? If Fed tapering fears flare up again and weigh on capital inflows of countries with CAD problems that could spell trouble for India in terms of financing. Moreover, if this coincides with rising concerns about the country’s ability to meet the fiscal target and implement structural reforms – pre-election politics could be a factor here – that could scare off foreign investors and make it difficult to plug the hole.

Finally, if equity investors become more concerned about the growth story and lose their nerve as growth fails to pick up in coming months, this could lead to equity outflows. While reserve coverage is still adequate (six months of imports, 260 per cent of short-term debt, and 140 per cent of the gross external financing needs), a significant reversal of flows could quickly do a lot of damage. Of course, these are risks rather than baseline assumptions at the moment, but it is important for the government to hedge against these risks.

(The author is Chief Economist for India & ASEAN, HSBC)

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