The Hindu Business Line : BoP situation set to change

The meltdown and its impact on global economic growth may result in changes in India’s balance of payments position. The Government and the Reserve Bank of India should focus on foreign direct investment and the trade deficit, rather than portfolio flows, while managing the BoP account, says A. SRINIVAS.

India’s banking sector, by virtue of being largely government-controlled and conservatively managed, seems to have escaped the worst of the financial crisis. But as a result of the meltdown and its impact on world economic growth, we are seeing major changes in India’s balance of payments position.

Capital flows will be affected, while the current account too might take a turn for the worse. India is fortunate to have the foreign exchange reserves to tide over such a situation.

Reduced capital flows this year will be largely on account of the flight of foreign institutional investors. Things could have been worse had banks invested irresponsibly in US securities. The fact that banks pulled out $14 billion over the last 15 months from overseas markets also saved the day.

According to the International Monetary Fund, the world economy is expected to grow by 3.7 per cent in purchasing power parity terms, with the US growing at 0.5 per cent, and Europe and Japan 1.4 per cent in 2008.

These estimates were put out well before big investment banks, insurance firms and mutual funds in the US bit the dust.

Whether China, whose external trade accounts for over 70 per cent of its gross domestic product, is able to grow at 9.3 per cent in 2008 in this scenario, as projected by the IMF, is a moot point.

With the external sector making up 40 per cent of India’s gross domestic product, setbacks on this count will have to be made up with efforts to boost domestic consumption and investment. The country is fortunate to be able to exercise this option without resorting to drastic measures.

Current account

That said, the current account could take a bit of a knock. Exports were up 22.2 per cent in the first quarter (Q1) of this fiscal from the corresponding period in 2007-08, while imports increased by 33.3 per cent on account of the spurt in petroleum prices.

With the OECD countries accounting for 40 per cent of India’s export basket, deceleration in export growth is a distinct possibility.

India’s exports have grown at an average annual rate of 23 per cent (in dollar terms) since 2002-03; this marks a sharp departure from the annual growth rate of 7.3 per cent between 1995 and 2000, when the East Asian crisis shook the world.

The ongoing turmoil in asset markets is of a bigger order than the 1997 East Asian debacle.

Merchandise export growth could drop below 20 per cent in the third and fourth quarters, given the impact of a US-led recession, nullifying the impact of a weak rupee. The effect will be felt more in 2009-10.

The only respite could come from import growth, with oil prices falling steeply from about $120 a barrel in July to $89 at present. Petroleum accounts for a third of India’s total imports of close to $250 billion.

A minor drop from Q1 import growth rates of 33 per cent is possible, provided oil prices do not rise again. However, a sudden international political conflict, which cannot be ruled out in a recession that is comparable to 1907 and 1929, could lead to a rise in oil prices all over again. Even at current crude prices, import growth may exceed the 2007-08 level of 30 per cent when oil prices (Indian basket) were ruling at $79.5 a barrel. This is because the rupee is weaker today than in 2007-08, and is likely to remain so in the absence of a surge in capital flows.

A drop in import growth (oil and non-oil) in quantity terms because of a possible slowdown will be nullified by the exchange rate.

The trade deficit can be expected to expand by $30 billion, against a rise of $27 billion last year, to end up at $120 billion.

In 2007-08, the trade deficit of $90 billion was in large measure covered by net inflows of invisibles (essentially comprising software exports and private transfers), amounting to about $72.6 billion, leaving a current account deficit of $17.4 billion.

Software exports, which increased by 21 per cent in Q1 of this fiscal over the corresponding period last year, may not sustain even this modest trend through the year, given the fact that over a third of these earnings accrue from the financial sector. However, the full effect might be felt in the third and fourth quarters, and in the next fiscal.

Of the invisibles inflows of $72 billion in 2007-08, $38 billion was from software exports. Even if remittances buck the recession to grow at about 40 per cent, the current annual rate, the growth in invisibles will fall below the current level of 36 per cent.

A current account deficit of $25 billion by the end of the year, against $17.4 billion in 2007-08, cannot be ruled out.

Capital account

Net capital flows could be down to half the levels of 2007-08. There was a net portfolio outflow of $4.2 billion in this fiscal’s Q1, against a net inflow of $7.4 billion in Q1 of 2007-08. The ouflow is likely to continue, given the ongoing financial turmoil.

Liberalised guidelines for external commercial borrowings (ECBs) may not bring the desired inflows, in view of the credit squeeze and hardening interest rates worldwide. Net ECB flows in April-June this fiscal were $1.6 billion, against $7 billion in April-June 2007-08. Banks might have retrieved all they could from world markets, by bringing in $1.9 billion in the first quarter and $14 billion over the last 15 months.

Net capital flows amounted to $108 billion in 2007-08, of which portfolio flows were $29 billion, ECBs were $22.2 billion, foreign direct investment $15.5 billion, banking capital $11.5 billion and short-term trade credits $17.6 billion.

This year’s flows, led by an increase in FDI, will perhaps be closer to 2006-07 levels of $45.7 billion. Apart from the fact that portfolio flows will be negligible, if not negative, and ECBs lower than 2007-08 levels, short-term debt due for redemption in a year is about $45 billion. Against a reserves accretion of $92 billion in 2007-08, this year’s increase is likely to be insignificant, if at all.

Lessons

The Government should review its approach to liberalising the financial sector in view of the US experience. India needs to build on its current savings and investment levels, rather than risk capital erosion at the current stage of its development.

The fact that India’s economy is not as export-dependent as China’s, and therefore as vulnerable to economic shocks, is also a blessing in disguise.

The Government and the Reserve Bank of India should focus on foreign direct investment and the trade deficit, rather than portfolio flows, while managing the BoP account.

India seems to have survived the ongoing crisis, as it did the East Asian shock a decade ago. Let’s not rock the boat.

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