The current account deficit has come in at 4.1% of the gross domestic product (GDP) for the September quarter. Compared with the same quarter of the previous year, the merchandise trade deficit increased, because export growth slowed while import growth remained strong. While that was the main reason for the deficit, net invisibles, too, fell a bit, mainly because of lower investment income from abroad and a slowdown in remittances. Edelweiss Capital’s Kapil Gupta hits the nail on the head when he writes that the widening current account deficit reflects “stronger economic activity domestically and relatively weaker growth abroad”. Stronger economic growth finds reflection in higher imports, while weaker growth abroad is mirrored in weak exports, lack of growth in remittances and low interest rates leading to lower returns on investments abroad.
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The way the deficit was financed in the September quarter, however, has led to some concerns. While the current account deficit in the quarter was $15.8 billion (Rs70,784 crore today), portfolio inflows totalled $19.2 billion, more than adequately covering the deficit. Commercial borrowings, both short- and long-term, have grown. On the other hand, the share of net foreign direct investment (FDI) has fallen sharply, from $7.5 billion in the September 2009 quarter to $2.5 billion in the September 2010 quarter and $7.75 billion in the April-June 2010 quarter. The drop has been in inbound FDI and could reflect the lack of reforms and overcapacity in the West. As a research note by Kotak Bank’s economic team starkly underlines, “net FII flows at $19.2 billion in 2Q FY11 were 94% of the total capital account surplus for the quarter. In 1QFY10 the comparable figure was at around 50.0%”. The dangers of relying on volatile inflows to fund the current account deficit are well known.
Looking ahead, rising crude oil prices would exacerbate the current account deficit, although a recovery in the West would also be good for exports. As the Kotak report points out, the balance of payments is on a knife-edge, though foreign exchange reserves are high and there are no immediate risks. Nevertheless, with the jury still out on whether the West has recovered fully and especially with the situation in Europe remaining fragile, there could still be bouts of risk aversion that could impact portfolio inflows and cause significant volatility in the currency markets.
Graphic by Ahmed Raza Khan/Mint