Is India about to breach the 3% CAD red line?

The rising CAD may not be seen as a predictor of an external crisis, but rather an indicator of increased external risk. Photo: Shutterstock
The rising CAD may not be seen as a predictor of an external crisis, but rather an indicator of increased external risk. Photo: Shutterstock

Summary

  • India’s current account deficit is nearing its de facto red mark of 3% of GDP. Is this the time to worry?

The two major forex crises most ordinary Indians would remember are the balance of payments crisis in 1991 and the one after the US Federal Reserve’s “taper tantrum" in 2013. Both events had one common feature: India’s current account deficit (CAD) breached 3% of GDP before they unfolded.

Once again, the CAD is on the verge of crossing that red line. It has already reached $23.9 billion, or 2.8% of GDP, in Q1, and could go beyond 3% soon—a big flip from a deficit of just 1.2% in 2021-22.

This deficit is financed by a surplus on the capital account. Since foreign capital inflows—by way of direct and market investments, external commercial borrowings, and NRI deposits—have averaged about 3.1% of GDP in the last decade, this level has effectively become a “safe" cap on CAD. That cap is about to be breached.

You might also like

Why Q2 results bode well for large private banks  

Indian oil firms eye 50% stake in $3.4 bn project in Kenya

Why Hero Moto's electric scooter has failed to wow investors

The situation has risen mainly out of rising crude oil prices. The commodity formed nearly one-fourth of India’s imports in April-July. The price of the Indian basket has risen over 20% this year, and the rupee has fallen 9.7% against the dollar, which means a hefty increase in import bills. And the worst may not be over.

The announcement of supply cuts by oil producers has led to fears of crude crossing $100/barrel again. High and volatile oil prices plus a weaker rupee make for the perfect recipe for higher CAD. While strong fundamentals will keep India afloat, there are enough reasons to keep policymakers on their toes.

Higher crude prices
View Full Image
Higher crude prices

Unreliability of FPIs

On the capital account, the most volatile component—foreign portfolio investments (FPIs)—showed net outflows until the June-ended quarter in response to rising US interest rates, higher geopolitical risk, and central bank tightening around the world. FPI flows are notoriously volatile, and shift nimbly from one country to another in search of returns. India has suffered partly because FPIs tend to lump all emerging market assets together and sell them off in a risk-averse scenario. But Indian assets—both debt and equity—face another disadvantage. Not only has the rate gap between India and the US narrowed, the weaker rupee has also reduced dollar returns for investors. If the current fiscal ends up with a net pullout of FPI flows, it would reduce dollar inflows available to finance the CAD. India then has to look to other sources of funding (such as the special FCNR deposits launched in 2013) or run down its forex reserves.

Past CAD breaches

CAD has breached the 3% mark only twice since 1990. In 1991, it was due to an oil price rise triggered by Iraq’s invasion of Kuwait, which increased India’s crude bill so much that its forex reserves were not enough to cover even one month of imports. The country was forced to seek funding from the International Monetary Fund, devalue the rupee, and implement economic reforms. During 2011-13, supply disruptions in West Asia pushed oil over $100/barrel, resulting in 4%-plus levels of CAD. By the time of the famous “taper tantrum" speech in May 2013, India’s external position was so fragile that the rupee lost 20% within four months. These events reinforce the role of CAD as a red flag: investors tend to associate a CAD spike with exchange rate weakening and market volatility. Hence, any developments that could push CAD beyond the 3% threshold weaken investor sentiments, leading to dollar outflows and a weaker rupee.

External risk

However, this time, India is unlikely to see a run on the rupee or capital outflows at the levels seen in 1991 or 2013. Being one of the few economies expected to grow at 7% this fiscal, India is an attractive investment destination. Despite recent depletion, its forex reserves are enough to cover about eight months of imports, and the bulk of the national debt is in rupees rather than foreign currency. This makes it less likely to face a panicky scramble for dollars to honour debts.

In other words, the rising CAD need not be seen as a predictor of an external crisis, but rather an indicator of increased external risk. That risk can be mitigated by reducing the deficit or improving foreign inflows. The former is a tough ask in the current global scenario, but the latter is achievable. If India works towards strengthening its economic fundamentals, it may attract enough foreign investment on a sustained basis to not just finance an occasionally higher CAD but to be able to raise the “red mark" itself to a level higher than 3% of GDP.

Deepa Vasudevan is an independent writer in economics and finance.

Elsewhere in Mint

In Opinion, Raghuram G. Rajan & Viral Acharya write how QT shocks made QE so hard to reverse. Madan Sabnavis says this year’s Economics Nobel will ignite debate on reining in the financial system. Pramit Bhattacharya says India’s citizens need to know the whole truth about the 7th economic census. Long Story profiles one of India's most unsafe workplaces.

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
more

topics

MINT SPECIALS

Switch to the Mint app for fast and personalized news - Get App