Our external account looks gloomy

Consider two concepts relating to the balance of payments. Conventionally, the current account deficit (CAD) has been taken to be the quickest indicator of the health of the external sector of the economy. The deficit is then mapped with the capital account to arrive at the final balance of payments situation, which is considered to be positive if there are net additions to the forex reserves.

The capital account ideally should help balance the deficit and in net terms be positive if there are to be additions to the reserves (though ideally the current account has to be in balance or with a minimum deficit). The logic is that one cannot use capital receipts to finance current transactions. This sounds good enough.

The CAD is also explained as the difference between the investment (I) and savings (S) rates, and with the former being higher, there would be a deficit. It is an identity where CAD=I-S. So, if the country is growing fast and investing more with less support from domestic savings, the balance has to come from external sources, which is also the current account deficit.

How then will one judge the current state of our external account, with the first quarter numbers having brought considerable cheer as we are close to a zero deficit? Several agencies have projected a further improvement in the CAD to the extent that there could be a current account surplus by the end of the year. This does seem very comforting, considering that the deficit was past 5 per cent a few years back when oil and gold imports skewed the scenario.

The CAD has come down due to the trade deficit shrinking to $23.8 billion in Q1-FY17 compared with $34.1 billion last year. While this is a good sign, the quality of deficit needs some examination. The main reason for this improvement is the sharp decline in imports by around $12 billion compared with $2 billion in exports. This is due to a combination of stagnant industrial growth necessitating lower quantum of imports as well as lower commodity prices. Exports too have slowed down by a lower sum resulting in a fall in trade deficit. It is hence not a case of our exports growing that has led to this situation.

Falling trade reflects depressed global conditions which also get reflected in the other components of the balance of payments. Net services inflows, which are the second part of the current account, were lower by $4.5 billion in Q1 of FY 17 compared with last year, which can be a concern if it persists as this has provided succour to the account in the past.

Here, the software receipts are stable at $17.5 billion while remittances are down by $2.2 billion. The latter is mainly due to depressed growth conditions in countries where Indian workers stay and earn a living. Lower oil prices in particular have led to less demand for labour in the GCC countries which in turn had affected the ability to send back remittances to families in India. Also work-permits restrictions in UK and US have at the margin affected these flows.

The capital account, which has always had net inflows, presents an interesting picture. Foreign investment, which includes both FDI and FPI, is down by almost $4 billion in net terms. The significant development is that FDI inflows have come down by $4.5 billion. A lot of efforts were put in increasing FDI through liberalisation of norms. Quite clearly, the initial inflow which came in was of a one-time nature. The pace of flow would largely be guided by the state of the investing countries, and once conditions improve could gravitate towards these geographies.

FII flows have been better by around $2 billion in Q1 of 2016-17, which again would be dependent on the global economic developments, in particular, the Fed action. While the Fed has left rates unchanged, it is now expected that by December the rates may be increased. This can have a major impact on the flow of funds across all markets. Three components in particular will be affected.

First, higher interest rates overseas will reduce the rate-differential for investors and with the exchange risk being a constant, may make investments in debt in India less attractive. Second, narrowing of the interest rate spread between global rates and domestic rates (which are headed downwards) would make ECBs a less preferred option for raising debt by corporates. Third, the NRIs may prefer keeping incremental funds in their resident countries on account of better returns rather than park them with Indian banks.

All these factors put together pose a conundrum for this account. The FCNR deposits are to be redeemed in the next two months or so, and the RBI has assured that it has bought dollars in the forward market which would stabilise the exchange rate. But while exports would still keep the CAD on course, the NRI component of the capital account would show a decline. Hence, the comfort that exists today on the balance of payments on the whole may be of a lower order as the year goes by.

Curiously, going back to the ex-post identity of CAD=I-S, the lower deficit has resulted from the investment rate declining in the country. The CSO data showed a decline from 31.6 per cent of GDP in Q1-FY16 to 28.3 per cent in Q1-FY17 – a decline of 3.3 per cent of GDP which is very high. Assuming that savings have been virtually static (bank deposits growth has been comparable with last year), it is the negative development on the investment front that has led to a good current account statistic. This should moderate the cheer.

The writer is chief economist, at CARE Ratings. The views are personal