India’s balance of payments in transition C. P. Chandrasekhar Jayati Ghosh Recent weeks have seen a weakening of the rupee, even as the BSE Sensex shows signs of buoyancy. Underlying this trend are developments on the balance of payments front which point to a transition that could lead to an increase in external vulnerability, argue C. P. Chandrasekhar and Jayati Ghosh. WITH the rupee touching a 10-month low early this October and settling at well above the 44-to-the dollar mark, observers have begun to express concern over the strength of the currency.
The Reserve Bank of India Governor has, however, declared that such movements are “not unusual”. On the surface, there could be two reasons for the rupee weakening. One, a growing demand for the dollar, driven by expectations of an appreciation of that currency. And the other could be a delayed response of the central bank, which could stabilise the rupee through sales of some of its dollar holdings. Those holdings rose by more than $24 billion over the last 16 months, as a result of large net purchases by the RBI, especially during February and March 2005 (Chart 1).
Offloading some of these reserves, exceeding $140 billion in total, can help the RBI raise the value of the rupee if it so desires. But these grounds for complacency should not result in neglect of certain new trends in India’s balance of payments, which point to an incipient transition in the direction of increased vulnerability. The first sign of such a possible transition is the emergence of a deficit on the current account of India’s balance of payments in recent times.
As Chart 2 shows, after three consecutive years of a current account surplus, which exceeded $10. 5 billion in 2003-04, the country experienced a return to a current account deficit amounting to $6. 3 billion in 2004-05. That this was not a short-term tendency is reflected in the balance of payments figures for the first three months of this financial year (April-June 2005), recently released by the RBI. Those figures (Chart 3) point to the emergence of a quarterly current account deficit of $6. billion (equal to the 2004-05 annual average), as compared with a positive $3. 4 billion current account balance during April-June 2004. This increase in the current account deficit has principally been on account of a widening of India’s trade deficit, which increased from $15. 4 billion in 2003-04 to $38. 1 billion in 2004-05. Simultaneously, remittance inflows fell by $2. 4 billion dollars, transforming a large current account surplus into a significant deficit despite the 41 per cent rise in revenues from exports of software services.
These trends have only strengthened in recent months. Thus, according to RBI figures the trade deficit more than tripled from $5. 2 billion during April-June 2004 to 15. 8 billion during April-June 2005. Since invisible incomes did not rise very much (from $8. 6 billion to $9. 6 billion), this has resulted in the large quarterly current account deficit noted earlier. It is only because capital account inflows rose sharply from $4. 2 to $7. 4 billion that India’s foreign reserves rose by $1. 2 billion during the first three months of this financial year.
These trends are particularly disconcerting because they are accompanied by signs of vulnerability on the trade front. According to the latest trade statistics released by the Directorate General of Commercial Intelligence and Statistics (which has a more limited coverage than that of the RBI) relating to the first five months of this financial year (April-August), the deficit in India’s merchandise trade stood at $17431. 2 million compared with $9728. 5 during the corresponding period of the previous year.
A crude projection based on: i) this 80 per cent increase in the deficit; and ii) the average difference between trade deficit figures as reported by the DGCIS and the RBI for the last three years indicates that the trade deficit over the full year 2005-06 could be as much as $83 billion as compared with $38. 1 billion in 2004-05. Capital inflows to cover such a huge deficit are more than unlikely. It could be argued that such an increase was inevitable, given the sharp increase in the international prices of oil, which was and is expected to substantially increase India’s oil import bill.
Indeed, over the first five months of this financial year, oil imports rose in value by close to 37 per cent, rising from $12002 million to $16428 million. However, what is noteworthy is that over the same period non-oil imports also rose by a similar 37 per cent from $26803 million to $37763 million. In the event, despite a creditable 23 per cent increase in the dollar value of India’s exports during April-August 2005, the trade deficit has widened substantially. Even if the increase in the oil import bill is seen as temporary because oil prices must moderate and even fall, the same cannot be said of the non-oil import bill.
Clearly import liberalisation has meant that any buoyancy in the economy, even if it is not focussed on the commodity producing sectors, results in import bill increases that match those generated by events such as the current oil shock. If that increase has to be moderated or reversed for any reason, lower economic growth must be the price that has to be paid. The full significance of this trend comes through when we note that one comforting feature of India’s balance of trade between 2000-01 and 2003-04 was the surplus on the non-oil merchandise trade account.
That surplus helped partially moderate the effects of a rising oil trade deficit, which rose sharply between 2001-02 and 2004-05, partly because of a gradual increase in oil prices and partly as a result of dramatic increases in the domestic consumption of oil and oil products. However, in 2004-05 the non-oil trade balance was once again negative, removing the partial cushion offered by the trade in non-oil products against the effects of a rising oil trade deficit at a time when the rise in oil prices was sharper.
What is happening is that, in a period when oil prices have registered particularly sharp increases, the non-oil import bill has kept pace with the oil import bill, resulting in a massive widening of the deficit on the merchandise trade account. It is of course true that even during the previous two financial years, the widening deficit on the trade account was not a cause for concern because of significant inflows of foreign exchange on account of remittances and exports of software and IT-enabled services. According to the RBI, private transfers brought in a net amount of $20. billion during 2004-05 and software services exports contributed another 16. 6 billion dollars. This net inflow went a long way towards financing India’s foreign exchange requirement in that year on account of the merchandise trade deficit and the deficit under other items of what are termed “invisibles”. As a result, the deficit on the current account of the balance of payments was relatively small. Since India has also been a net recipient of substantial capital inflows on account of debt and foreign direct and portfolio investment, this led to a uge accumulation of foreign exchange reserves that implied a comfortable balance of payments situation. It now appears that India’s relatively strong current account position is weakening rapidly. As noted above, a combination of rising oil prices and dramatic increases in non-oil imports is resulting in a substantial widening of the merchandise trade deficit. Simultaneously, there is evidence that recent increases in remittance inflows are tapering off. Net remittances, which rose from $16. 4 billion in 2002-03 to $22. 6 billion in 2003-094, were down to $20. billion in 2004-05. While net revenues from software services, continue their increase from $8. 9 billion in 2002-03 to $11. 8 billion in 2003-04 and $16. 6 billion in 2004-05, the current account can be expected to widen because of the other two developments. Overall import liberalisation, combined with a concentration of incomes in sections of the population with a significant pent-up demand for imported or import-intensive goods, has resulted in an excess of demand for foreign exchange relative to current account earnings.
Consequently, a greater share of the net capital flows that India attracts in the form of debt and foreign direct and portfolio investment would now be needed to finance the current account deficit. But here too there are signs of a transition. During the three years ending 2003-04, India accumulated large foreign exchange reserves because, the surplus on its current account notwithstanding, it received large inflows on the capital account due to net inflows of foreign direct investment, portfolio capital and banking capital.
In 2004-05, however, there appears to have been a shift in the nature of inflows. While net FDI flows fell from $3. 4 billion to $3. 0 billion, net portfolio flows from $11. 4 billion to $8. 9 billion and net banking capital inflows from $6. 7 billion to $4. 1 billion, flows of loans or debt shifted from a net outflow during the previous three years to a net inflow of $11. 7 billion dollars (Chart 4). In the event, aggregate net capital flows rose from $20. 5 billion to $32. 2 billion. This helped finance the current account deficit in that year and contribute to reserve accumulation.
The return to a reliance on debt, which clearly is private rather than government debt, is disconcerting, inasmuch as it reflects an internally driven increase in dependence on capital flows rather than the outcome of autonomous capital inflows. This is combined with the fact that such flows have now become necessary to finance the current account deficit. Thus, during the first three months of financial year 2005-06, the net capital inflow of $7. 4 billion was not significantly grater than the current account deficit of $6. 2 billion.
If the current account deficit widens as projected above, this gap between the deficit and capital inflows is likely to close. The dependence this implies indicates an increase in external vulnerability. The incipient tendency towards external vulnerability that this entails has thus far been ignored because India’s exports have been performing better in recent years than they did in the past. Other than for 2001-02, when India’s exports declined marginally, exports in dollar terms have been rising at over 20 per cent an annum over most years of this decade. This has been the focus of statements by Commerce Ministry spokespersons.
As and when any reference is made to import growth, a rise in the import bill is presented more as evidence of recovery in the industrial sector, rather than as a cause for concern because that rate has implications for the merchandise trade deficit. Implicit in this view is the belief that a trade deficit does not matter, since invisible revenues ensure that a rise in the trade deficit does not automatically translate into a rise in the current account deficit and that, even if it does, capital flows are more than adequate to cover the likely increase in the current account deficit.
Recent experience has shown that the import surge is such that even with reasonable export growth this view is no longer true. What is more, periodic currency crises elsewhere in the world suggest that reliance on purely hot money flows to finance such a current account deficit is by no means a sensible strategy. But there is a more fundamental problem here. The success of any liberalisation strategy depends in the final analysis on the realisation of a rate of export growth that can deliver growth without balance of payments problems that are structural. This makes comparisons of the rate of export growth over time meaningless.
Allowing for a reasonable lag, what is needed is a rate of export growth at any point of time that covers the increase in imports that liberalisation involves as well generates the revenues needed to meet commitments associated with capital inflows. It would be absurd to use more capital inflows to cover past capital flow commitments, since this involves a spiral of dependence on capital inflows. Such dependence implies even greater fragility if such capital flows are of a kind that are footloose and investors can exit the country with as much enthusiasm as they showed when they entered.
What the evidence on India’s trade trends suggest is that even as dependence on volatile capital flows increases, an export growth rate that is presented as creditable appears increasingly adequate to cover the import surge in non-oil imports. Add on a surge in the oil import bill and that inadequacy is all the greater. This implies that the dependence on volatile flows, especially of private debt, to sustain the balance of payments is rising. That is a tendency that must be reversed if India is not to follow the example of “emerging markets” such as Mexico, South Korea, Thailand, Indonesia, Malaysia, Brazil, Turkey and Argentina