India’s BoP: CAD expectedly collapses but the real story is in the capital account
The BoP data for 1Q14 and the full financial year was not expected to throw up any surprises. There was growing consensus that the CAD would continue to narrow and, in line with those expectations, the 1Q14 CAD printed at a 19-quarter low of 0.2% of GDP. This pulled down the full year CAD to 1.7% of GDP – a dramatic reduction compared to the previous year’s 4.7% of GDP as well as India’s peers such as South Africa and Turkey.
This is clearly good news. But the quibble, if any, is that the vast majority of this compression (65%) is “cyclical and regulatory” and has occurred due to stringent gold curbs as well as weak growth impulses at home that have resulted in non-oil, non-gold imports contracting for a second successive year. But neither of these are likely to sustain. Gold imports will eventually have to be liberalized (to ensure the parallel gold economy does not get entrenched), though India will continue to benefit from softening gold prices. Similarly, if the capex cycle and growth actually pick-up – as is hoped – the import bill could begin to rise quickly. All told, we expect the CAD will widen to about 2.3% of GDP ($48 billion) in FY15 – which should not be considered threatening, especially considering the buffer-stocks of reserves the RBI has adroitly accumulated in recent months.
But the real story of the BoP, and not necessarily a good one, is in the capital account. On the surface, the capital account in 1Q14 saw a healthy inflow of $9.2 bn. But this entire quantum was portfolio flows which are fickle and cannot be relied upon. Instead, adjusting for portfolio flows, capital flows were actually zero in the quarter (!) on the back of large outbound FDI and the more sustained, and therefore ominous, outflow of trade credits. These same trends show up in the full-year capital account which registered a healthy inflow of $49 bn. But remember, $34 billion of this was on account of the one-off subsidized swap scheme by the RBI. And another $5 bn was net portfolio inflows through a rocky year. So again abstracting from the volatile portfolio component and the one-off FCNR/Tier I scheme, net inflows were only $10 bn across FDI, ECBs, trade credits, other bank capital for the full year.
Of particular concern is the sustained outflow of trade credits for the last three quarters, resulting in a net outflow of $5 bn in FY14 vis-à-vis an average inflow of $13 bn over the last three years. This is potentially being driven both by the collapse in the gold imports, which are often financed by trade credits (which is less worrying because it creates a natural hedge on the BoP) and, more worryingly, by the reduced supply of trade credits as the cost of capital internationally has increased on the back of increased regulatory pressures. Admittedly, it is also possible that the FCNR flows cannibalized other flows and so other flows may pick up next year, but for now the capital account dynamics don’t make for comfortable reading.
None of this is to suggest that any BoP pressures are imminent. But at a time when growth – and therefore the CAD – can be expected to widen on the back of a strong election result , the aforementioned dynamics are a stark reminder that the new economic team needs to double-down on jump-starting FDI reforms to attract more stable source of funding and reduce the dependence on volatile and fickle portfolio capital. India may be the darling of emerging markets at the moment and is currently faced with a problem of plenty. But the pain of last summer – when India’s reliance on fickle portfolio flows was suddenly exposed -- is too fresh to forget so quickly.
Import compression not export buoyancy underpins CAD narrowing in 1Q14….
As had been expected, the 1Q14 CAD (also the last quarter of the financial year) narrowed dramatically to $1.2 bn (0.2% of GDP) from $18.2 bn (3.5 % of GDP) in the corresponding quarter of the previous year. But the narrowing was entirely because of import compression rather than any export pick-up. Of the $16.8 bn compression in the CAD, almost two thirds was on account of gold ($10.5 bn), which printed at only a third of its level in 1Q13, as the import curbs continue to bind. The rest of the narrowing was largely underpinned by the compression of non-oil, non-gold imports, which contracted almost 8% ($64.6 bn versus $69.9 bn) vis-à-vis the previous year, reflecting both weak growth impulses in India as well as potentially some expenditure switching on account of the more depreciated real exchange rate. Oil imports dipped slightly, likely reflecting the rationalization of diesel volumes given the sustained price increases, even as oil prices remained broadly flat across the two quarters.
Exports were actually a drag on the CAD, contracting slightly compared to their level in 1Q13. But India was not alone to suffer an export disappointment in the quarter, given the growth disappointment in the US in particular (with growth expected to be close to 0 versus 2.6% q/q saar in 4Q13) and the fact that the global economy slowed meaningfully through the quarter (1.9% q/q saar in 1Q14 versus 3% in 4Q13)
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……which is a microcosm of the full year
The meager 1Q14 deficit pulled down the full-year FY14 CAD (year ending March 2014) to 1.7% of GDP (JP Morgan: 1.7%) -- a dramatic reduction from the 4.7% of GDP in FY13. Furthermore, the dynamics of the full-year were not too different from the last quarter. To be sure, exports did better, with merchandise exports growing nearly 4% in value terms and services exports growing almost 12% largely reflecting the real depreciation of the currency with global growth remaining flat across the two years.
However, the pick-up in merchandise and services exports accounted for only about a third of the CAD compression of the year. Instead, the bulk of the compression was on account on gold imports, which collapsed by 50% from $54 bn in FY13 to $29 billion in FY14. In addition, non-oil, non-gold imports contracted for a second successive year (to $270 bn from $279 bn the year before) reflecting the non-existence of a capex cycle in particular and weak growth more broadly. Consequently, of the $56 bn compression of the CAD over the last year, 45% was because of gold, 35% because of an export lift likely emanating from the FX depreciation and about 15% was on account of the more generalized slowdown in imports arising from weak growth impulses.
The reason this decomposition is important is because it has clear implications for the sustainability of the CAD compression. To the extent that growth is likely to accelerate (which would put pressure on non-oil, non-gold imports) or the gold import restrictions are likely to be progressively liberalized, the CAD is expected to widen, and possibly meaningfully, in the coming quarters, as we discuss below.
But the real story is in the capital account
Even as markets focus on the compression of the CAD, the real story in the BoP data was the organic weakness of the capital account. On the surface, the capital account registered a sizeable surplus of $9.2 bn in 1Q14, resulting in a comfortable BoP surplus of $7 bn. But guess what? All of this was on account of the surge in portfolio flows through the quarter. Debt inflows accounted for a whopping $6.3 bn as a wide interest rate differential adjusted for a moderating forward premium, created an attractive carry trade opportunity. This was complemented by rising equity flows as ($ 3 bn) on the back of growing expectations of political stability implicit in the opinion poll forecasts.
But take away these relatively fickle portfolio flows, and the capital account actually suffered an outflow of $0.1 bn in 1Q14 !! There was both a cyclical and a potentially structural component. Inbound FDI remained healthy, but outbound FDI surged in the quarter, causing net FDI flows to drop to just $0.9 bn – the lowest in 32 quarters. The hope is this was a one-off and that as growth prospects improve in India, the incentives for outbound FDI would progressively reduce.
But perhaps the bigger worry is the fact that for a third consecutive quarter, trade credits continue to register an outflow that is progressively increasing in size (see chart below). This is potentially being driven both by the collapse in the gold imports, which are often financed by trade credits (which is less worrying because it creates a natural hedge on the BoP) and, more worryingly, by the reduced supply of trade credits as the cost of capital internationally has increased on the back of increased regulatory pressures.
 
Scratching the capital account surface does not make for good reading
The short-term trade credit story shows up most starkly for the full year (FY14) as a whole. Short-term trade credits which had averaged $13 bn a year of inflows for the past three years – a time which includes the Euro area bank deleveraging – actually registered an outflow of $5 bn in FY14. The swing between FY13 and Fy14 is particularly stark with an inflow of $21.7 bn turning into an outflow of $5 bn.
The other concern is the extent to which FDI flows have flat-lined. Net FDI flows printed at $21.6 bn in FY14 – almost identical to the average of the last 5 years. The lack of growth in FDI – the most stable source of funding – over the last 6 years is of particular concern because this shortfall is likely to be more exposed when growth and the CAD actually widens.
Therefore, even as the headline capital account printed at a very healthy $48.8 bn for FY14 – resulting in a near $16 bn BoP surplus – this was largely on the back of the RBI’s ingenious subsidized swap scheme that attracted $34 bn in FCNR deposits and Tier 1 capital. However, it’s important to recognize that this was a one-off. Adjusting for those flows, the capital account only registered an inflow of $15 bn. And $5 bn of these was the more volatile and fickle portfolio flows. So adjusting for the swap scheme and portfolio flows, other sources of inflows were only $10 bn in FY14!
None of this is to suggest that the BoP faces any imminent pressure. The RBI has very smartly accrued FX reserves to prevent further Rupee appreciation pressures, and the resulting buffer-stock can be used to cover various eventualities. But it does reveal that policymakers need to double-down on attracting more FDI flows to finance a current account deficit that is likely to widen in the coming quarters as growth accelerates and hopefully the capex cycle gathers steam. The need to attract more FDI should gather more urgency if, in fact, there has been a structural shift in the availability of trade credits. Otherwise, the BoP will continue to be reliant on one-off measures of the kind seen last year, or remain at the mercy of more fickle, risk-on, risk-off portfolio flows.
  
FY15 CAD expected to widen: growth and gold hold the key
A key element in all of this is the prognosis of the current account deficit in the coming quarters. Will it remain at such subdued levels, such that concerns of the capital account become moot? Or has the CAD compression peaked?
We believe the CAD is likely to widen in FY15 under our baseline assumptions of an acceleration in GDP growth (FY15 at 5.2% oya versus 4.7% in FY14) and a progressive, albeit gradual, liberalization of gold import curbs by policymakers – some evidence of which was seen last week – to ensure that parallel market dynamics in gold do not get entrenched.
As indicated above, exports have grown by about 4% in value terms over the last fiscal. Our estimates suggest that for every 1 percentage point pick-up in global growth, India’s export volumes pick up by 4 percentage points. With global growth expected to accelerate to from 2.4% oya in 2013 (calendar year) to 2.8% oya in 2014, India’s export volumes should grow by between 5.5- 6%, assuming no large swings in the real exchange rate.
With global oil prices forecast to remain flat in 2014 over 2013, we expect domestic oil imports to increase by 3-4%, presuming a growth acceleration but adjusted for the sustained increase in diesel prices that should rationalize demand for diesel.
These are relatively non-controversial assumptions. Instead, the key will be the impact of rising gold and non-gold imports on the CAD as the gold measures are rolled back and growth accelerates.
Gold volumes have averaged about 30 tonnes a month since the curbs came into effect, but are expected to increase by another 10-15 tonnes a month after policymakers liberalized gold norms slightly last week by adding star and premier trading houses to the list of entities which can import gold under 20:80 scheme. Therefore, as a baseline we start with about 600 tonnes of gold demand for FY15. On this base, we presume there will be some duty roll-backs in the budget and the binding constraint of the 20:80 scheme could be progressively liberalized, and therefore project volume of about 700-725 tonnes in FY15. However, the 15% increase in volumes over FY14 are expected to be partially offset by a further softening in gold prices in the coming year (JP Morgan’s gold forecast in FY15 at $1275 versus an average gold price of $1330 per ounce in FY14). Therefore the total gold import bill is expected to rise to between $33-35 bn from $29 bn this year.
Finally, if growth picks up we expect non-oil, non-gold imports to increase by 10-12% after contracting for two successive years, as capital goods imports – which have declined by about 7% over each of the last two years – are re-stoked as more projects come online and the capex cycle gains some momentum. Similarly, consumptions goods imports – which have also dipped over the last two years could get a lift.
All told, we peg the FY15 CAD at $ 48 bn or 2.3% of GDP. Accelerating growth is bound to attract capital flows and make it easier to finance any CAD. But the challenge and opportunity for policymakers is to ensure that India attracts the right kind of capital flows increasing the attractiveness of FDI in the coming quarters and reducing the dependence on volatile portfolio flows. India may be the darling of EMs right now. But the pain of last summer – when India’s reliance on fickle portfolio flows was suddenly exposed -- is too fresh to forget so quickly.
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