India’s Balance of Payment Crisis fears are vastly exaggerated

Over the last few months the fears of a new balance of payments crisis in India has gripped headlines and is being propounded by a vast majority of analysts and economists. Although the continuously rising trade deficit is of concern due to the growing domestic demand and a reduction in exports growth momentum due to the economic crisis worldwide the years of an actual BOP crisis are vastly exaggerated.

In the last financial year the trade deficit went up to a record level of $ 185 bn and the current account deficit went upto an estimated $ 65 bn amounting to around 4% of GDP. At the same time the total forex reserves stand at around $ 295 bn. The run rate of imports financial year was around $ 480 billion for the year. Out of this the net import of crude and petroleum products amounted to $ 150 bn, after taking into account refined product exports and total gold imports amounted to $ 65 bn. The total funding gap last year thus amounted to $ 65 bn i.e. the Current Account deficit. For the first month of the current fiscal the Trade Deficit has been $ 13.2 bn and gold imports have fallen from $ 4.7 bn to $ 3.1 bn. The fall in the value of gold imports has also been despite the average price of gold being $ 1650 per ounce as against $ 1150 per ounce at the same time last year. As such it is important to see how the scenario will play out this year and whether the BOP fears are real or now.

The run rate of deficit – As per the April deficit figures the Trade deficit has been $ 13.2 bn. This run rate includes gold imports at prices that are 5-7% higher than the current levels and crude oil imports that were booked in the month of February 2012 when prices were higher by 10% from the current levels. Under the circumstances when we evaluate the performance of trade deficit for the full year this year given that commodity prices in general are down by nearly 15-20% versus the same time last year.  A big part of the increase in crude oil imports last year was more due to the increase in crude oil prices rather than an increase in volumes. For example the average price of Brent in 2010-11 was $ 86 per barrel which jumped to $ 114 per barrel last year. In the current financial year given the demand supply dynamics and the fact that crude oil stocks are continuously growing worldwide the average price of crude in all probability will be at least 5-10% below that of last year. Taking into account the increase in volumes the total value of oil imports in dollar terms should be the same as last years. Now the other major component of imports i.e. gold where prices have been coming down in USD terms due to falling consumption and reducing luster of gold as an investment. Specifically in the Indian context gold consumption has fallen drastically due to two factors. The first has been the decline in the value of the INR by nearly 20% which has totally offset the decline in gold prices by 20% from its peak levels last year. The second factor also has been the imposition of a 4% import duty on gold which has increase the average per 10 grams of gold by nearly Rs 1000. This has further added to the price of gold in rupees and has impacted consumption further. As such my estimate is that the total value of gold imports in the current financial year should fall by nearly 40%. As such total gold imports should fall to $ 40 bn from $ 65 bn last year. Due to various environmental and legal issues Iron ore imports are estimated to have fallen by $ 6 bn last year. These two factors by themselves could result in a fall in trade deficit by $ 25-30 bn in the current financial year.

Exports Outlook – The rate of growth of exports from India have been falling over the last several months. In the month of April the growth was around 3%. However it is also important to see that the increase of 3% came on a 32% increase in exports in the same month last year. Similarly the growth in imports has slowed down to around 4%. I expect that the value of imports will trend down further over the next few months as the dollar value of most commodities has corrected significantly. The lagged impact of the fall in the value of the rupee in boosting export competitiveness should be felt at some stage. I believe that a bigger factor which has prevented most Indian companies in taking advantage of the exchange rate differential that has built up has been largely due to the unavailability of both, adequate credit as well as the extremely high cost of credit due to the excessively tight monetary policy. Since the tight monetary policy is largely targeted at domestic inflation and demand RBI needs to find a way to provide adequate and cheap export credit. The impact of high interest rates has also got exaggerated due to increasing debtor cycle due to a general slowdown. Going forward as interest rates ease off and the global economic cycle stabilizes there is an increased probability that the currency differential export competitiveness will play out. The restrictions put on farm product exports as well as the fall in iron ore exports last year added nearly $ 10 bn additionally to lower exports last year. Farm exports are now being increasingly liberalized and IronOre exports should also start coming back over the next few months. If the government incentivizes labor intensive export industries in the short run it can provide a significant fillip to exports. As RBI eases monetary policy going forward it will also provide some support to the exports. As such the overall outlook for exports does not look very bad except for the uncertain global economic scenario.

Is import cover the right way to evaluate external vulnerability – The way in which the external sector vulnerability has been traditionally measured has been by calculating the import cover based on foreign exchange reserves. This analysis is flawed in its basis thesis. Given that India has 60% plus of its GDP coming from services and services/invisibles exports constitute a significant part of exports currently just evaluating the merchandize trade gap does not have much relevance. Invisibles and remittances amounted to around $ 110-120 bn last year. Out of this software and BPO exports are estimated to have been $ 70 bn last year. As per NASSCOM these are likely to grow by 11-14% in the current year and as such should reach a level of around $ 80 bn in the current financial year.  Secondly let’s come to remittances. Remittances into India last year went up to a record $ 63.5 bn. Now, mostly remittances are a stable form of funding and if we take into account the liberalization in the interest rates that banks can offer to NRI’s both for rupee and Foreign currency deposits to a levels which is much higher than the levels at which it was till last year should significantly boost capital inflows due to NRI deposits. Well placed and financially sound NRI’s can have a huge carry trade by borrowing extremely cheap in western economies and pumping that into India. Given that the US Fed has indicated that it will keep policy rates low for at least the next 2-3 years this carry trade should continue strongly in the near term.

Now let’s come to FDI. It is estimated that the cumulative FDI into India in 2011-12 was to the magnitude of $ 36.5 bn. However there has also been significant outbound FDI in recent times. As such the net figure is more important which should be to the tune of $ 28 bn. In a scenario where key reform bills have been on hold and FDI liberalization has not
happened this is still a very strong flow. Given negative sentiments this can reduce somewhat but should still continue to be strong given India’s long term growth prospects.

The other component of foreign exchange flows i.e. FII flows has been erratic in recent times. After a sharp outflow cycle in 2008 it reversed very strongly in 2009 and 2010. Last year was slow where there was hardly any net inflow from FII’s. In the first four months of the current year net flows have been nearly $ 8 bn. My long term outlook in terms of flows continues to be that globally bonds are much more overpriced as compared to equities. The 1.8% yield on 10yr UST’s and 1.5% on German Bunds is clearly unsustainable. Equity yields worldwide look much more attractive and a long term shift towards equities is imminent over the next few years as the currently unstable European situation stabilizes.

On an overall analysis, taking into account the fact that India’s GDP on a nominal basis should grow by around 13-14% in the current year and the trade deficit will decline by 15-20% (unless and until there is a spike in oil prices) the overall current account deficit is likely to come down to 2.6-2.7% in the current financial year which is easily fundable from even the reduced levels of capital inflows. Also as we have seen that the FDI flows have continued to be strong in uncertain times and both invisibles as well as remittances are a stable source of foreign exchange flows. As such the probability of a balance of payment shock at this stage looks extremely low and improbable. Under the circumstances the outlook for the Indian Rupee as well as external sector macroeconomic stability in India should be sanguine going forward.