Balance of Payments - Stress to ease : Edelweiss PDF link

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India’s BoP is under immense stress as a combination of the widening CAD and poor global risk appetite has led to a sharp dip in INR. However, an undervalued exchange rate (on REER basis), softening global commodity prices and weak domestic economy would set the stage for narrowing of CAD to 3.2%-3.3% of GDP in FY13, in our view. We expect slower growth in crude imports due to stable prices at USD110/barrel and a fall of ~20% in gold imports on weakening domestic demand.

On the capital account, Europe holds the key though govt. policy actions on domestic front are equally crucial. Amidst mounting risks of bank runs in Europe, one can anticipate urgent policy actions to stabilise the situation. Besides, we hold that Fed will resort to another QE to support the faltering economy. These measures should help reduce duress in India’s capital account. As regards INR, the near-term trajectory is still uncertain but the medium-term outlook looks more optimistic. We expect USD/INR to average between 51 and 52 in FY13.

CAD to narrow to 3.2%-3.3% of GDP in FY13

India’s CAD breached 4% of GDP in Dec 2011, entering a vulnerable zone. However, key factors are falling into place that should help narrow the CAD. First, the undervalued INR should boost exports and import-competing sectors. Second, softening commodities should lift India’s terms of trade, and third, a weak domestic demand must keep non-oil imports under check. We expect a slower growth in crude imports on stable prices at USD110/barrel and a fall of ~20% in gold imports on weakening demand. Overall, CAD is set to narrow to 3.2%-3.3% of GDP in FY13 vs ~4% in FY12.

Capital flows to normalise

Evolution of the European situation has been the dominant factor shaping capital flows over past few quarters. Specifically, retrenchment in USD financing by EU banks to EMs including India seems to be the reason behind the dramatic plunge in EM currencies. With the risk of bank run mounting in Europe, the region is at crossroads and where policy action is obligatory to stabilise the situation (or else there is risk of disorderly disintegration). Given the renewed weakness in US economy and sharply rising USD, we foresee US Fed undertaking another round of QE. These factors coupled with attractive levels of INR (after ~25% fall from the peak) augur well for India’s capital account.     

Easing BoP to catapult INR trajectory

The INR’s near-term trajectory remains uncertain. However, over the medium term, the currency is likely to appreciate due to narrowing of CAD to 3.2%-3.3% in FY13 and an improving capital flows as Europe stabilizes, Besides we foresee Fed undertaking another round of QE. Accordingly, we expect USD/INR to average between 51 and 52 in FY13. The risk to outlook arises from disorderly exit of Greece from EU.

Balance of Payments - Stress to ease

Regards,