Balance of Payments - current account deficit widens sharply in Q2FY11: Edelweiss

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n  Current account deficit widens to ~4% of GDP

India’s Balance of Payments (BoP) recorded a surplus of USD 3.3 bn during Q2FY11, lower than USD 3.7 bn recorded in the previous quarter, despite higher capital inflows. This reflects sharp widening in the current account deficit to USD 15.8 bn (4.1% of GDP) in Q2FY11 from the revised ~USD 12 bn (3.2% of GDP) in the previous quarter. During the quarters, the trade deficit increased to 9.2% of GDP against 8.3% in the previous quarter, largely reflecting decline in exports as % of GDP. On the invisibles side, what is notable is that the surplus declined from 6.9% of GDP in September 2009 to 5.1% currently. Therefore, invisibles funded only ~55% of trade deficit in Q2FY11 against ~69% in Q2FY10. Stronger economic momentum in the domestic economy compared with western economies contributed to widening in the current account deficit.

n  Capital account mainly supported by non-FDI inflows

Capital account surplus improved meaningfully, to USD 19 bn in Q2FY11 (incl. errors and omissions) from ~USD 16 bn in Q1FY11, more than offsetting widening in the current account deficit. However, the key highlight of capital inflows during the quarter is the dominance of FII inflows and continued moderation in FDI inflows. Notably, the share of non-FDI inflows in the total inflows has been steadily rising from ~65% in Q2FY10 to ~83% in the current quarter. Since non-FDI inflows (such as ECB, FIIs) tend to be more volatile, it remains a matter of concern.

n  Impact of QE2 on crude prices and exchange rate needs monitoring 

Ultra-loose monetary policy, particularly by the Fed, improving US growth prospects and strong economic momentum in EMs, is putting upward pressure on global commodity and crude oil prices such that crude prices are now ruling at ~USD 90 per barrel. This is important, given the fact that crude oil imports constitute a significant ~30% of the total merchandise imports of India. Therefore, such elevated prices will surely add to the widening current account deficit. Secondly, QE2 is putting upward pressure on capital inflows into the country. While capital inflows are required to fund the deficit, excess capital flows lead to rising domestic inflation and appreciating INR. 

n  Widening of current account deficit and nature of funding pose risks   

The current account deficit has been widening in the recent quarters, reflecting stronger economic activity domestically and relatively weaker growth abroad. Going ahead, this performance divergence is expected to continue, though recent improvement in the US growth prospects will prove helpful for exports. Further, rising crude oil prices (currently hovering at ~USD 90/barrel), largely reflecting ultra-accommodative monetary policies in the western economies, present another challenge for the already widening trade deficit. Accordingly, we expect current account deficit to remain elevated in the coming quarters.

Apart from the size of the current account, the nature of capital inflows funding the deficit is equally important. Rising share of non-FDI inflows such as FIIs, ECBs in the total capital inflows do not augur well for the stability of BoP, as these flows are highly influenced by the global risk appetite. This is important because global environment remains uncertain, particularly with regards to European sovereign crisis.