The question of why despite easing of policy rates by the RBI, cut in CRR combined with the OMO operations did not lead to a reduction in the interest rates in the economy in terms of translation into lending rate cuts can largely be traced to the high Current Account Deficit. Over the last two years there has been a continuous expansion of the CAD.

In the Financial year 2011-12 the CAD was 4.2% of the GDP amounting to $ 78 billion. This expanded to 4.8% of GDP in the year 2012-13 and amounted to $ 88 billion. Also in these two years Capital flows were broadly  steady while showing some uptick in the year 2012-13 with the inflows growing from $ 80.5 billion to $ 85.4 billion over the last two years. As such there was a small growth in forex reserves in the year 2011-12 and a small depletion last year.

Now in order to understand the impact of a growing CAD on domestic liquidity and interest rates  the basic thing that we need to understand is that a higher CAD means that domestic liquidity is getting exported out of the country. In simple terms what it means is that there is a stock of money in the economy which keeps on growing every year as the money supply increases. However if the imports are growing faster than the exports then the rupees are sucked out of the system in order to buy dollars to pay for the higher amount of imports. As such in a situation where the imports are growing faster than exports the domestic liquidity it getting consumed not only for the growth in credit in the economy but also going to finance the higher amount of imports.

In a situation where capital flows are very strong in the form of either portfolio flows or higher FDI then this growth in the CAD can get financed due to the fact that the capital account is funding the Current Account. However in India, due to the fact that FDI flows have been very moderate over the last three years a large part of the capital flow has been either due to higher investments from FII’s or greater borrowings in foreign currency by Indian corporate. Flows due to higher borrowings are the worst thing as this money eventually needs to be repaid.  As such if these borrowings are hedged on a future basis then flows on the spot and future nullify each other. Of-course there will also be unhedged flows, which will add to liquidity.

Let’s take the case of China which has been running a Current Account Surplus for years. Interest rates in that economy are much lower than in India and the central bank out there has to suck out liquidity from the system on a continuous basis in order to balance the market liquidity so that money supply growth is consistent with the growth of the economy and does not add to inflation. They obviously have another advantage of the Fiscal position of the government being quite strong with a very low level of Fiscal Deficit.

Now looking at the way the trade data is playing out in India, especially over the last three months it is very clear that the sharp fall in the value of the rupee is creating a rebalancing of foreign trade.  The export pickup could have been even stronger if the exporters would have got credit at rates similar to that of exporters in competing economies. The proposal to put export credit into priority sector could go a long way into improving this competitiveness. The other way is to improve the availability of various kinds of pre and post shipment export credit which is constrained for most small exporters.

Last year we had a Trade Deficit of $ 192 billion and invisibles flow of $ 105 billion. The outlook for invisibles flow is strong due to improving external demand and could see a 10% growth this year. The run rate of trade deficit also indicates the possibility of the Trade Deficit potentially falling to $ 170 billion even taking into account a pickup in gold imports going forward.  As such the overall CAD should fall to the range of $ 55-60 billion this year.

What this implies is that the overall outflow of Forex for funding what we buy over what we can sell to the rest of the world is likely to be much lower than last year. If we combine this with the possibility that the swap windows that the RBI has opened to attract US Dollars will be able to garner $20-$30 billion then the overall addition to domestic liquidity due to both these factors could be in the range of $ 50 billion plus i.e. more than Rs 300,000 Crores.  If this combines with a fall in inflation and growing RBI comfort on lower inflation going forward we could see interest rates in the economy come down going forward.

As I am finishing writing this article there is also a strong news flow that India’s inclusion in global bond indices is more or less done now. This could potentially attract flows of $20-$25 billion that are stable and largely passive. Let’s see how this goes.

There is only a particular amount of capital flows that the economy can attract every year. As such, if the current account is moderated then we can have a moderate interest rate regime going forward. Obviously, it also requires some fiscal discipline from the government as a growing Fiscal Deficit could suck out this liquidity and keep rates higher.

MARKETS CONTINUE TO RALLY AS EXPECTED and have defied calls by most FII Equity Strategists who were predicting a sharp fall in October. That’s the nature of the beast. Overall trend is now becoming stronger for the long run. Can’t help but share this message that I got yesterday.

Nifty 5400 india story Bad
At.    5500 very Bad GDP CAD
At.    5600 Downgrade likely
At.    5700 Nifty earnings will fall in Sep qtr
At.    5800 Dollar & Crude Syria Drama
At.    5900 pull back rally
At.    6000 Banks Downgrade
At.    6100 CAD to improve
At.    6200 Rupee strong

At.    6800 India Upgrade….

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