Widening of the external trade deficit to US$17bn in Jun18, only marginally lower than the previous high of US$19.1bn in May13, is a leading indicator of relapse of the Balance of Payment (BoP) deficit in Q1 FY19 after 4 years. The foreign currency assets has declined by US$20bn since its peak of US$400bn in Mar18. The estimated US$14-15bn drain on BoP for Q1FY19 will be highest since Dec08, which marked the impact of the global financial crisis (GFC 2008).
Importantly, the trend recovery in exports of goods since its bottom in mid-2016 at 14% CAGR is far less than 22% for imports. While this trend suggest continued widening of trade deficit, at US$161bn in FY18 it exceeded the annual run-rate of US$149bn seen prior to the decline in global crude oil prices (2013-14). Trade deficit widened to 6.2% of GDP in FY18, after narrowing to 5% in FY17.
It is concerning that the current account deficit (CAD), which also includes Indias net services exports, spiked to 1.9% of GDP in FY18, higher than the FY14 level of 1.7%. Based on provisional data, Indias CAD is expected to rise to 2.5-2.7% on widening trade deficit (7% of GDP), during Q1FY19E.
Widening external deficits is not necessarily bad for a developing economy like India. In a stable growth cycle, propelled by rising demand and capacity creation, widening CAD is a constructive outcome. Sustainable growth, backed by rising domestic savings & investments also attracts external capital and is associated with currency appreciation and moderate hardening in interest rates. This beneficial confluence was observed in most emerging economies (EMs) during 2003-08. India saw INR/USD appreciate from 46 to 39.5 during this period even as trade deficit widened to a peak of 7-8% of GDP.
But, the recent sharp widening in trade deficit is different from the phase prior to GFC 2008. The current swelling in trade deficit is concerning investors, as it is reminiscent of the macro-economic instability seen in 2013-14, which was characterised by rising inflation (CPI at 9.4% in FY14), widening deficits, slowing growth and heightened financial market volatility in the wake of taper tantrum in May13.
Prospective fears of receding global excess liquidity from the expected normalisation of the ultra-loose monetary policy of the US Federal Reserve prompted RBI to build its buffer of FCA since 2013, propping it up from US$250bn to the recent peak of US$400bn (Mar18). However, delayed normalisation by the Fed and decline in global oil prices (during 2014-16), along with the FCA buffer aided in establishing significant macro stability.
Guided by experiences of the past global markets shocks, RBIs approach since 2013 demonstrates strong precautionary stance. Our analysis reveals two important inferences. First, INR/USD movement exhibited rising inflexibility post the taper tantrum of 2013, denoting RBIs preference for accumulation of forex reserves. Second, Indias excess forex reserves (which is an estimated difference between actual FCA from estimated optimal FCA) swelled to a high of US$110bn in early 2016.
But, the corrections in global crude oil prices did not lead to a structural correction in Indias external imbalances. Volume growth of Indias exports at 4.4% since 2010 (as per UNCTAD data) is nearly a third of the average during 2005-08. Net exports of services, transfers by Indian non-residents and income from abroad which are collectively classified as “net invisibles” and act as a natural buffer against trade deficit, has declined to sub 4% levels compared to 8.6% of GDP in mid-2008. Also, despite the rise in FDI flows to an annual average of US$40bn during FY15-18, the aggregate of invisibles, net FDIs and NRI deposits was still lower at 5% of GDP in FY18 compared to 10% in FY08.
Given the current rebound in global crude oil prices to US$73/bbl and hardening of global interest rates (especially in the US) shows that the tide is clearly turning even as Indias external sector indicators are still carrying the vulnerability of the 2013-14 period. Hence, the US$20bn drop in India FCA reserve since Mar18 indicates deficit between actual and estimated optimal reserves (estimated as a function of volatility in imports, trade openness and interest rate differential).
The consequences are not hard to guess. As much as RBIs build-up of excess FCA was responsible for creating positive market conditions, including equities, currency and lower interest rates, now a reversal will make financial markets more volatile.
The tricky situation is that India is facing a sharp relapse in inflation, along with rise in commodity prices, rebound in currency holding and fiscal reflation (as governments prepare for upcoming state and general elections). Hence, RBI is seen entangled between managing the relapse of external imbalances, receding global excess liquidity and domestic inflation management.
The outcomes have manifested in several ways. INR/USD has depreciated to a new low of 68.6, 10-year G-sec yield has hardened sharply by 140bps to over 8% and RBI is following up with hiking rates. Latest readings of inflation, with core and headline inflation rising to 6.4% and 5.0%, respectively, suggest that RBI will soon move into tightening mode after the recent 25bps hike in repo rate to 6.25%. The lofty valuations of Indias broader equity markets, which reached frothy heights earlier this year, have seen a significant meltdown, even though the benchmark equity indices show some stability, buoyed by just a handful of index stocks.
The outlook is expected to be volatile. On the positive side, if the recent recovery in global trade manages to override the burden of emerging global trade conflicts, there is a possibility of Indias macro conditions improving and sustaining beyond the current fiscal reflation-led recovery. Also, if the Fed tempers its normalisation, the risk to capital flows can ease to some extent.
However, the probability is skewed towards a stronger US dollar as the Fed continues with its policy normalisation process. A sustainable recovery in global trade is at a risk from widening trade conflicts between the US and China and indeed between most G20 countries, including India.
From Indias standpoint, the aftermath of demonetisation and its impact on the informal & agri sectors on one hand and imperatives of political expediency on the other are impelling fiscal expansion. These are leading to rising consolidated public debt even as fiscal multiplier impulses are boosting short-term cyclical recovery. Revenue expenditure has far exceeded the budgeted allocations in recent years. Further, conversion of private bad debt into public debt through interventions such as recapitalisation of public sector banks (PSB) and massive farm loan waivers are adding to the future tax payer burden, thus leading to the re-emergence of twin deficit problem of widening CAD and Fiscal deficit.
Hence, the combination of widening CAD (amid risk to capital flows from narrowing global excess liquidity) and rising inflation (resulting in further overvaluation on REER basis) increases the possibility of INR/USD depreciation likely sustaining. Again, emerging deficit between actual and optimal FCA (amid rising import bill and flaring global interest rates) will aggravate INR weakening amid higher volatility. Active drawdown in FCA by RBI can be used to suppress volatility, but it may come at the cost of tightening domestic liquidity. RBI is expected to utilise open market purchases (OMO) to infuse liquidity, but with rising inflation its ability of active monetisation will also be limited.
All in all, we are likely to see INR breaching the upper bounds of the 68-70 target we have maintained for the past one year. Also, we expect another 50bps hike in the repo rate by RBI during the rest of FY19. This will result in the G-Sec yield curve undergoing a bear flattening with the 10 year benchmark expected to inch up further to 8.4%.
Currency depreciation is also likely to boost sales growth of companies. However, it is unlikely to have a lasting positive impact on the bottom line of Indian companies. Historical experience indicates that there is typically a positive correlation between Indias growth and strength of the Indian currency.
Notably, INR/USD appreciated 14% during 2004-08 to a high of 39.5 along with rebound in corporate profit growth, compounding at 25% p.a. and real GDP rising to 9.5%. However, while the currency has depreciated by a massive 70% from its peak over the past 10 years, average profit growth for Indian companies has been much lower at 5-6% since GFC 2008.
The fact that INR weakened despite huge supply of USD during the ultra-loose dollar supply conditions unleashed by the Fed, suggests that the Indian currency can be far more vulnerable in a scenario of receding USD supply. The delivery of growth has to be far stronger and sustainable to confront the tide of receding global liquidity.
Retrospectively, RBIs attempt to build the FCA buffer and its conservative interest rates stance appears prudent. Even if RBI is unable to reverse the INR weakening and soften rates, it has definitely tried to equip itself with the requisite capacity to curb financial market stress, which is also an important growth conserving strategy. The key question is: will that be enough in the longer term period?