India Economics: Current account deficit concerns overstated; JP Morgan

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India: Current account deficit concerns overstated but rupee weakness could re-emerge on inflation concerns

FY11 CAD likely to print around 3% of GDP—lower than the market and RBI’s forecast of 3.5% of GDP—on narrowing trade deficit Despite rising crude prices, 1Q11 CAD unlikely to widen much on lower non-oil imports Despite improving current account fundamentals, the INR underperformed ADXY for much of January on concerns of inadequate policy response to inflation and regulatory uncertainty The surprising resilience of the INR in recent weeks suggests that the trade deficit continues to remain muted but currency weakness could re-emerge if inflationary concerns linger The “twin deficit” (fiscal and current account) issue raised by the RBI seems overstated and was more applicable last fiscal FY12 CAD likely to widen if crude stays elevated and the investment cycle turns on, but will be financed Current account deficit concerns overstated; trade dynamics have changed markedly in 4Q10 Ever since India’s quarterly current account deficit widened to $16 billion in Q2 FY11 from $12 billion the previous quarter, alarm bells have gone off about India’s current account deficit printing significantly above 3% of GDP for FY11, which would be the highest print in 20 years. The RBI has reinforced this fear by devoting an entire page on India’s twin deficits (fiscal and current account) and estimated that India’s current account deficit for FY 11 would print at an “unsustainable” level of 3.5% of GDP. While we share the RBI’s concern on India’s fiscal profligacy in recent years (see, “India’s fiscal outlook, flattering to deceive”, January 5 2011), we believe concerns about India’s CAD are significantly overstated. Undoubtedly the CAD did widen in the first two quarters of this fiscal year, but these were also the quarters in which global woes (sovereign debt crisis in Europe, a faltering of US and Chinese growth) were at their peak, and India’s exports slumped markedly in those quarters. In contrast, government spending continued to surge, keeping demand and non-oil imports high. The monthly trade deficit widened to more than $11 billion in May 2010 (from an average of $9 billion the previous fiscal) and further up to $13 billion in July and August. Things have changed markedly since then. An upturn in economic activity in the United States and China in 4Q10 has meant that exports have surged over the last few months. The behavior of exports over the last three quarters is unsurprising in light of our findings (see, “India: more open than you think,” Oct 14, 2010) that export volumes (especially the new age engineering and pharmaceutical exports) are very sensitive to changes in global demand, and much less so to changes in the real exchange rate. Given that growth in the US and other DMs is forecast to further accelerate from 1Q2011, we believe that the current export momentum could sustain, even if not at the frenetic pace observed in 4Q2010. In addition, with the much-anticipated private investment cycle still to turn on in earnest, non-oil import growth has been relatively sluggish in recent months and grown much less than what was initially anticipated. With no signs of an imminent upsurge in the capex cycle and with government spending expected to moderate from the levels observed earlier in the year, non-oil import growth is expected to stay muted for the rest of this fiscal at least. The oil import bill could certainly increase over the remaining months of this year (see below for a fuller discussion of this risk), but despite crude basket rising from $85 per barrel in November to $90 per barrel in December, oil imports (in value terms) actually contracted in December compared to November as volumes fell more sharply than the rising price of crude. As a consequence, the merchandise trade deficit has been on a secular decline since mid-year falling from $13 billion in August, to $10 billion in October, $9 billion in November and down to less than $3 billion in December. Even if the monthly trade deficit were to rise to $10 billion, on average, for the rest of this fiscal, the trade deficit for FY11—which had threatened to come close to 9% of GDP based on data from the first two quarters—is likely to print at 8% of GDP (barring a surge of defense-related imports in 2HFY11 which are not captured in the monthly customs trade data). This would be a whole percentage point of GDP less than the previous year! Services exports have recovered and could accelerate further A significant development in 3Q10 was a sharp pick-up in India’s net service exports which rose to $10.5 billion after stagnating in the $7-9 billion range for the previous 4 quarters. The improvement was driven primarily by a net improvement in non-software exports (business and management consultancy, architectural, engineering), in response to improving global economic conditions. With global economic conditions expected to improve further in 2011, the recent trend in non-software service exports can be expected to continue. Accelerating growth in the US and core Europe since 4Q10 also suggests that IT exports (software and ITES)—which constitute the vast majority of service exports and are sharply concentrated in the US and core Europe—are poised to grow in the quarters to come. These exports suffered a slight dip in 2010 in response to slowing global demand and therefore can be expected to bounce back as global demand gains buoyancy. Private remittances constitute the other significant component of invisibles and have been stable over the last 12 quarters. Although half of India’s remittances come from the Middle East, much of that originates in the Gulf countries which appear to be relatively shielded from the current political turmoil. In addition, remittances are positively correlated with oil prices and growth in key western economies (U.S, Canada, and West Europe). With growth expected to accelerate in these economies in 2011 and oil prices high, remittances should increase. FY11 CAD likely to print below 3% of GDP In sum, the current account deficit is expected to print at or just below 3% of GDP for FY11, significantly less than the 3.5% of GDP forecast by the RBI and expected by the market. This assumes that the Indian crude basket stay at $100 for the rest of this fiscal year, the monthly trade deficit widens back to $9-10 billion, services exports do not increase from the levels observed in the 2Q (which is a conservative assumption) and that private remittances from the Middle East take a significant hit in the 4Q of this fiscal. These assumptions are biased towards a large CAD. The “twin deficit” problem was last year’s issue! Much has been made about India’s twin deficits in the last few weeks. The RBI has repeatedly invoked India’s large fiscal deficit and linked it to the “unsustainably” large current account deficit. This may have been true last fiscal but seems much less of a concern this year. Recall, India’s central government fiscal deficit – net of asset sales – widened from 6 % of GDP in FY09 all the way up to 7.4% of GDP. Unsurprisingly, the CAD for FY10 also widened sharply to 2.9% of GDP from 2.4% the previous year – but this largely escaped attention. This year, things are actually getting better! Government dis-saving is expected to reduce and the fiscal deficit – net of asset sales – is expected to narrow to 6.9% of GDP from 7.4% last year. This improvement, in conjunction with the fact that private investment continues to remain sluggish will mean that the CAD may widen only marginally, if at all. Impact of Middle East turmoil for FY11 CAD likely to be muted In theory, if the current turmoil in Egypt were to spread across the Middle East resulting in significant and widespread economic dislocation, the impact on India’s current account deficit could be meaningful. The impact on exports, however, is likely to be muted because while about 20% of India’s exports are directed to the Middle East, 75% of this are destined to the Gulf countries, which have been relatively insulated from the current crisis. Similarly, bulk of the Middle East remittances come from the Gulf countries. Therefore, the key channels through which the Middle East situation would impact India’s CAD would be though higher crude price. With 10 months of the current fiscal year already passed, the impact of the situation in the Middle East on FY11’s CAD will be muted for the year as a whole (although the CAD in 1Q11 is expected to widen somewhat). Our forecast of the CAD printing at 3% of GDP is predicated on crude staying at $100 for the next two months and remittances from the entire Middle Eastern region declining by 50% in this quarter. Only more extreme scenarios (outlined below) involving crude climbing to $150 in the near-term and remittances from the entire Middle East completely collapsing, would push the CAD for this year to over 3.5% of GDP. Rupee weakness could resurface as capital inflows moderate on domestic concerns… Despite the improving current account fundamentals, the rupee has exhibited increased volatility over the last two months in response to a relative drying up of FII net inflows. Some of this is undoubtedly systemic. January witnessed FII equity outflows from most emerging markets, in likely response to improved economic prospects in key DMs, and India was no exception. For much of January, however, the rupee under-performed the ADXY, for example, suggesting local specific factors were clearly at play. It is not hard to see what these concerns were. Ever since December inflation printed at 8.4% (significantly above the 6% forecast that authorities had), and the RBI responded by increasing its March inflation by 150 bps forecast and only raising policy rates by 25 bps, concerns have mounted about the stickiness of inflation and an inadequate policy response. The longer these inflationary concerns persist, the more volatile FII portfolio flows are expected to be. Compounding this is the negative domestic sentiment emanating from the continuing series of political corruption scandals. More arrests this week seem to have exacerbated concerns about the duration of these scandals and probes and seem to have further depressed sentiment. Surging FII flows over the last few quarters have been one of the factors responsible for the BoP staying in surplus. If FII flows were to fall off sharply in this quarter in response to local concerns and FDI continues to stay anemic, the BoP surplus could narrow sharply and perhaps even register a deficit in the 4Q (for FY11 as a whole, however, we expect the BoP to stay in surplus). This would be despite rising external commercial borrowings (ECBs) in response to an ever widening onshore-offshore interest rate differential. A sharp correction in the equity market over the last month is also likely going to delay public IPOs and FPOs as part of the government’s disinvestment program and further depress inflows. …even though the rupee has shown surprising resilience in recent weeks Despite all the concerns raised about the rupee, it must be said that the rupee has shown remarkable resilience in the last two weeks. This is a despite an FII equity outflow in January and crude prices rising sharply in recent weeks. Part of the reason for this is that while equity flows turned negative in January, there was a sharp pick-up in FII debt flows in response to the new G-Sec and corporate limits being auctioned. As such, FII net flows were still positive, although significantly lower than previous months. More importantly, what this also suggests is that the January non-oil trade deficit has not widened significantly from December, another sign that worries about the CAD this fiscal are overstated. CAD will likely widen in FY12, but remain fully financed In contrast to a lower-than-expected CAD for FY11, the CAD could widen sharply next year. If the much-anticipated private investment cycle were to finally turn on, non-oil imports are expected to grow significantly. In addition, if oil prices continue to stay elevated in response to rising global demand, the oil import bill could rise sharply to. Undoubtedly, both merchandise and service export growth can be expected to be buoyant in this environment but the CAD would breach 3% of GDP. With the onshore-offshore interest rate differential likely to persist for a while, a significant fraction of the non-oil imports will likely be pre-financed through external commercial borrowings. Also, FDI will likely increase once the private capex cycle kicks in. The wild card therefore remains portfolio flows. If policymakers can demonstrate enough resolve to alleviate local concerns on inflation and improve local sentiment, it is likely that even a higher CAD in FY12 will be funded, barring another global shock. However, it is hard to imagine a situation where, India’s investment cycle picks up momentum keeping GDP growth in the 8-9% range, exports remain buoyant, but portfolio flows slacken off and Indian corporates are unable to finance their investment and imports of capital goods through external borrowing.