Long-term investors in India take certain big-picture trends for granted. They assume real GDP will grow at 6-7 per cent a year. Inflation will average 4-6 per cent. The rupee will depreciate by 3-4 per cent a year against the US dollar.

But sometimes these long-held assumptions get challenged by shifts in underlying fundamentals, which fly under the radar. India’s balance of payments, which decides the exchange rate, has been undergoing such changes lately.

After sinking by 10 per cent against the dollar in 2022, the rupee depreciated by less than 1 per cent in 2023 and has held steady this year. Lately, Reserve Bank of India (RBI) actions have been aimed at stemming unruly gains in the rupee rather than declines. This is because of four fundamental shifts underway in India’s balance of payments equation.

Surging services exports

The primary factor that keeps India’s demand for dollars higher than supply is the merchandise trade deficit. Between FY15 and FY20, India ran up a merchandise trade deficit of between $112 billion and $180 billion. With the Covid freeze, this shrank to $102 billion in FY21. After re-opening, imports ballooned while merchandise exports remained sluggish. This saw the goods trade deficit rocket to $265 billion in FY23.

Despite the record deficit, India managed to contain its CAD or current account deficit to $67 billion or 2 per cent of GDP. It shrank further to 1.2 per cent in the first nine months of FY24.

Folks who were in the markets in 2013 will remember the panic about India’s balance of payments and a run on the rupee that year. In FY13, India reported a merchandise trade deficit of $195 billion (much lower than FY23) and this resulted in a CAD of $88 billion (much higher than FY23).

The invisible number that has made all the difference between then and now, is services exports. Unlike India’s merchandise trade, its services trade earns a dollar surplus, which has soared from $64 billion in FY13 to $143 billion in FY23. In the first nine months of FY24, the services surplus at $45 billion amounted to two-thirds of the goods deficit of $71 billion.

The continued rise in the services surplus, even as the goods deficit charts a zigzag path, offers the hope that the two will meet sometime in future.

Not just software

The success story of Indian software services is well documented. Lately though, there have been signs that the global market for India’s IT services may be maturing, with growth moderating to single digits. There’s also worry that the elusive US recession will finally arrive this year.

But thankfully for India’s balance of payments, its services exports are no longer reliant only on IT. Scores of MNCs setting up Global Capability Centres (GCCs) to source operations, product and research services from India have sparked off a boom in ‘business services’ exports. RBI data show that exports of business, financial and communication services netted $24 billion in FY23, up from $9 billion in FY22 and $3 billion 10 years ago.

A December essay from the Chief Economic Advisor noted that business services exports may prove resilient to global crises, as they provide both cost savings during downturns and value-added services during boom times.

Business services have added a new leg to India’s services trade surplus, which can cushion against slowing IT exports.

Resilient remittances

With a vast diaspora, India has always been a topper in inbound remittances. But it was traditionally believed that, with the bulk of remittances flowing in from oil-reliant GCC nations, these inflows were a fair-weather friend.

This thesis was proved wrong during Covid, when the World Bank issued a warning that India’s remittances would fall by 23 per cent and found itself far off the mark. Remittances saw just a 0.2 per cent blip in 2020 and rose 8 per cent in 2021. Between 2021 and 2023, they have further expanded from $83 billion to $125 billion.

Later RBI research attributed this to a material shift in the profile of Indian emigrants. Between 2015 and 2020, even as India saw a material decline in blue-collar emigration to the GCC region, an increasing number of emigrants from the metros headed to white collar work in the US, UK and Singapore. As a result, India’s remittance flows post 2020 have been originating more from white collar workers in the advanced economies than lower-income workers in the GCC region, imparting greater resilience to these flows. The US has been the top source, followed by UAE, UK and Singapore. Given that Indian parents continue to send large cohorts of teenagers abroad to pursue higher education in the advanced economies, this shift in remittances may be here to stay.

FPI in bonds

The dollar shortfall that India runs up with its CAD is usually financed by its capital account surplus. Two heavyweight contributors to the capital account surplus are foreign direct investment (FDI) and foreign portfolio investment (FPI). Until FY22, with ample global liquidity, India attracted a large influx of FDI into its thriving start-ups. But with liquidity reversing, FDI flows have dwindled.

But new FPI flows seem to be rushing in to fill this gap. After stampeding out in the last two years, FPIs poured $41 billion into Indian stocks and bonds in FY24.

FPIs have traditionally been a fickle source of capital flows — moving in and out based on global rates, returns on alternate assets and the rupee outlook.

But one fundamental change in the past year, is Indian government bonds netting $14 billion in FPI flows. Until 2020, FPI in Indian bonds was strictly controlled through a quantitative ceiling. In April 2020, RBI had a change of heart and opened the doors for FPIs in domestic gilts without any strings attached through a new Fully Accessible Route. It took three more years for global bond index providers to include Indian gilts in their indices. But with JP Morgan and Bloomberg making the first moves starting this year, Indian gilts are set to attract regular passive flows.

The timing for this is opportune. US interest rates have peaked, Indian rates are still high and government finances on the mend, making a sound case for global funds to allocate to Indian bonds. Many global equity managers are already overweight on India after the recent spell of 7 per cent plus GDP growth.

Of course, it is early days yet to say if the above shifts will set off long-term improvements in India’s balance of payments or the rupee. But the facts are changing and investors should sit up and take note.