India’s Balance of Payments (BoP) recorded a surplus of USD 3.8 bn in Q1FY11, somewhat higher than USD 2.1 bn recorded in the previous quarter. Current account balance worsened for the fifth quarter in a row, reaching USD 13.7 bn in Q1FY11 (~3.7% of GDP), which is on the higher side historically. Among broad components of the current account, merchandise balance deteriorated while invisibles improved against the previous quarter. Deterioration in trade deficit is largely the result of relatively robust domestic demand in India, weaker external demand and strong appreciation in INR on REER basis through FY10.
n FII flows weaker; trade credit and ECB flows improve
The higher current account deficit was more than compensated by USD 17.5 bn of net inflows into the capital account. Within the capital account, the portfolio inflows slowed down as risk aversion climbed on account of sovereign debt crisis in Europe. However, trade credit continued its improving trend reaching USD 5.6 bn because of improvement in international financing conditions and healthy recovery in Indian economic activity. ECB picked up pace touching USD 2.7 bn, while FDI remained stable at USD 3.2 bn during the quarter.
n Globally, race for weaker currency could lead to trade frictions
In the wake of sluggish global demand, major economies of the world are vying for weaker exchange rate. The US, which is facing sluggish domestic demand, is looking to reinvigorate the economy by boosting investments and exports through weaker USD. On the other hand, countries such as China and Japan are clinging to their export-oriented growth model. Recent unilateral intervention by Japan in JPY market and Chinese reluctance to allow faster appreciation in RMB is testament to this trend. This is causing trade frictions among major nations. As experience shows, the rise in trade protectionism is quite detrimental to business sentiments globally and hurts investments.
n Current account deficit may remain high in the near term
While the widening current account deficit is more than compensated by higher capital account inflows, concerns remain, especially because large part of it is funded by FII and ECB inflows, which are heavily influenced by the global risk appetite.
The monthly incoming trade data suggest that trade deficit continues to widen in Q2FY11 and, therefore, until invisibles improve markedly, current account deficit could widen even further in Q2FY11. On the currency side as well, while falling domestic inflation would help curb the real appreciation of INR; sustained inflows of foreign capital could put upward pressure on the nominal exchange rate. However, if global demand continues to remain sluggish, softer global commodity and energy prices in second half of FY11 could support the trade account.
In a scenario of widening current account deficit, capital inflows become quite critical in shaping BoP. Any rise in global risk aversion (possibly due to building up currency tensions or renewed concerns about European debt problems) could trigger high volatility in capital flows to EMs including India. However, the damage would be contained given large forex reserves of India (more than USD 280 bn) that can provide sufficient cushion.
