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Business News/ Opinion / India, fragile no more?
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India, fragile no more?

Surging gold imports were a big reason for India's huge current account imbalance. That danger is over, for now

Photo: Bloomberg Premium
Photo: Bloomberg

It is fairly well known that the two prominent vulnerabilities of the Indian economy over the past few years, have been persistently high inflation and a large current account deficit (CAD). On the CAD front, the issue was twofold—one, how quickly and sharply it had widened; at $88 billion for FY2013 it was almost 4.7% of gross domestic product (GDP) and the second largest in the world in absolute terms. What compounded this was India’s reliance on short-term portfolio flows, both debt and equity to finance this. It’s been over a year since we were grimly reminded of this vulnerability and got admitted into the infamous Fragile Five Club.

A review of how these five economies have fared since that episode of weakness last year shows that India clearly stands out in the magnitude of current account improvement which has reflected in superior relative performance of the currency as well. Indeed, most forecasters peg the FY2015 CAD at about $40 billion or just over 2% of GDP. Importantly, the basic balance (current account balance plus net foreign direct investment) has also considerably improved in the past few quarters. Based on trailing 12 months numbers, India would be able to fully fund her CAD without any portfolio flows. However one does not see the same excitement about this improvement, as say, one would see if we got a sub 5% reading on the consumer-price inflation and the reason offered is that this CAD is not a “normalized" number. As an aside, we have never understood this quest for the elusive normalized levels of economic variables for we have never seen anybody proclaim that “we are currently in normalized conditions". In fact, no economic variable can ever be expected to achieve and stay at perfect equilibrium. But to get back to CAD—the two major variables that need to normalize to get to a sustainable CAD are gold imports and merchandise imports (excluding gold). The argument is that due to increased import duty on gold, its imports are artificially depressed and once these duties are done away with, they will climb back and widen CAD again. On merchandise imports, the hypothesis is that a growth pick-up will cause CAD to widen as we would be importing more than we currently do. Arriving at sustainable levels for both these variables is worth attempting.

According to data from World Gold Council India’s annual gold imports volume peaked at almost 1,150 tonnes in June 2011. As the accompanying display shows, what’s worth noting is that almost 40% of gold demand for the 12 months ended June 2011 was for investment purposes. It is not surprising that international gold prices peaked at almost $1,900 per ounce in May 2011 and asset managers like us know the bitter truth that there is no better advertisement for an asset class than trailing returns. Gold price has since been on a downward trend and currently hovering around $1,300 per ounce.

The other change is that financial savings which were yielding lesser than inflation (or negative real returns) are now yielding slight positive returns making them more attractive as a savings vehicle than gold. We suspect that even if import duties were to be normalized, investment demand is unlikely to return with same gusto. The local gold price premium in India over international prices (adjusted for import duty) has almost gone down to zero showing that demand pressures have eased. Also, with reducing price premiums, the economic incentive for gold smuggling goes down. Five as well as 10-year average for seasonally adjusted consumption (jewellery) demand for gold has been fairly steady at about 140-150 tonnes per quarter and for the last three quarters this number has averaged around 150 tonnes per quarter. Also the long–term average for investment demand for gold has been about 25%, despite a much elevated level in the last few years. Investment demand for gold has been less than 20% of overall demand in periods of positive real rates. All this points to a normalized gold demand number of about 750-800 tonnes per annum. What was it for trailing four quarters? 761 tonnes. Is it plausible that gold imports have already normalized?

On the issue of relationship between CAD and growth, there seems little correlation between the two variables. Since FY2004 till FY2013, India’s CAD on a trend basis has only worsened despite periods of accelerating as well as decelerating growth. When CAD is compared with India’s growth difference with the rest of the world, there seems to be no correlation again. Thus, though theoretically correct, there is not enough evidence that growth acceleration by itself will cause CAD to widen. From a composition standpoint, imports as a share of GDP accelerated from about 21% in FY2008 to over 27% in FY2013 and the chief contributor to this rise, apart from gold and silver, was petroleum imports. Here’s where the recent fall in commodity prices especially crude oil provides a cushion to CAD. Indeed for every dollar that international crude price softens, CAD improves by just over $1 billion. The current price at which India imports crude is lower by almost $10 per barrel than that for FY2014, providing significant buffer even if non-oil imports were to go up. Considering all the above, it seems plausible that normalized CAD may not be too different, if not better, than what the last 12 months suggest.

Just as we begin to rejoice the possibility that the CAD demon might have been slain, there might be something lurking in the dark that is outside this framework of analysis or to borrow a term from former US secretary of defence Donald Rumsfeld there could be unknown unknowns. The known unknowns though are unlikely to derail the improvement thus far.

Amay Hattangadi and Swanand Kelkar are portfolio managers with Morgan Stanley Investment Management.These are their personal views.

Comments are welcome at theirview@livemint.com

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Published: 21 Sep 2014, 06:09 PM IST
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