Global crude prices continue to grind northward. The Indian crude oil basket is up by more than a third since late last year’s levels. Being a net oil importer, India will watch these trends closely, particularly due to current account implications.

India has run current account deficits (CADs) since the early 1990s, save a brief period in 2002-04. The deficit averaged 1-2.5 per cent of GDP over most of the past decade before rising to 4 per cent in FY12-13 on the back of a jump in oil imports and gold purchases. It has since fallen back to about 1 per cent of GDP and should remain about there in the foreseeable future.

Crude prices and CAD This is good news for an economy which has been frequently under fire for its twin deficits. A narrower CAD has lowered its vulnerability to external shocks.

But this improvement is not a redux of 2002-04 surpluses, which were driven by better fundamentals. This time around, a plunge in global oil prices and subdued investment are mainly responsible for a narrower CAD. Oil prices and a revival in investment spending could widen it again.

We examine what was behind that improving current account trend. The current account deficit narrowed to 1.7 per cent of GDP in FY13-14 from a yawning 4.8 per cent year before.

This sharp correction owed to a smaller merchandise trade deficit, which in turn was due to a plunge in gold purchases. Back then, gold imports were the second biggest import item, second to oil.

The sharp fall in gold demand was engineered through a host of trade/administrative curbs. This led to a sharp 70 per cent fall in the metal’s imports in FY13-14.

Global commodity prices were also softening, helping cap oil imports. Subsequently, the CAD narrowed to 1.3 per cent of GDP in FY14-15 and 1.1 per cent in FY15-16. In these years, the drop in crude oil prices was the main driver; oil imports fell by one-third in value terms.

At the same time, weak investment also softened non-oil, non-gold demand. The latter accounted for a fifth of the fall in overall imports, helping to keep the deficit under control. This year, we expect the CAD to shrink to less than 1 per cent of GDP.

Change over a decade Market commentators have been quick to draw parallels between the ongoing improvement in current account balance and surpluses back in 2002-04. Unfortunately, there are big differences between these two periods.

Back then, much of the better CA balance stemmed from a stable merchandise trade deficit and strong invisibles receipts. The latter was especially important. Within invisibles, service trade (mainly software/ information technology) was a notable contributor, which along with remittances, which together made up 90 per cent of the total receipts.

Hence, the improvement was driven more by firmer exports than weak imports.

At present, the reverse is occurring. The current account has largely benefited from a greater fall in imports rather exports. The sharp drop in crude prices cut the oil import bill by one-third, while subdued investment demand kept a lid on non-gold, non-oil purchases. Amongst invisibles, service receipts and private transfers/remittances are also showing signs of strain. Thus the current improvement in the current account is not as favourable as in 2002-04.

What are the chances that the CAD deteriorates going forward? This depends mainly on the direction of oil prices and a revival in domestic investment. The current dynamics are favourable.

Even as oil prices are off January 16 lows, prevailing levels are not threatening as yet. At the same time, the private sector capex remains subdued. Growth in gross capital formation contracted in the June quarter, while the number of stalled projects has been rising, amidst excess capacity. Against this backdrop, the CAD should narrow to sub-1 per cent of GDP from 1.1 per cent in FY15-16. A stronger current account balance would be at risk if crude prices rose above $60/bbl this year. India imports 70-80 per cent of its oil needs, which leaves 7 per cent of GDP exposed to global price swings.

At the same time, a pick-up in investment could also lift imports, putting renewed pressure on the current account. If these risks materialise, a return to the long-term deficit range of 1.5-2.0 per cent of GDP would likely follow.

We need a CAD While the size of the CAD is important, the same holds true for how it is financed. Here too, there have been positive developments. Last year, foreign direct investments were a bigger source of the funding mix rather than portfolio inflows. The former are preferred as these are non-debt creating and long duration focused, unlike portfolio flows which are fickle and reactive to short-term risk swings. Given the government’s move to raise limits, relax sector-specific regulations for FDI, undertake reforms to improve the ease of doing business and efforts to streamline the investment process, we expect FDI to improve in the coming years.

In the past, a wide CAD often coincided with sizeable fiscal deficits, set against a backdrop of a falling savings rate. This forced the economy to fund any revival in investment demand through foreign capital, leaving the economy vulnerable to global risk sentiments.

Rather than pursuing surpluses — which in other words means India lends to higher income/capital abundant countries — the country should run small deficits and channel funds into its own infrastructure needs. Emerging economies, including India, are supposed to be borrowers, not lenders.

The writer is an economist, and vice-president of DBS Bank, Singapore. The views are personal

Related Topics
comment COMMENT NOW