India’s trade deficit unexpectedly surged in March, widening to a 4-month high of $11.8 billion from $6.8 billion in February, and was significantly above market expectations. Markets had budgeted a pick-up in gold imports in March, but the actual increase was significantly larger than expected. Compounding this was the fact that the typical seasonal-lift that exports get every March (end of the financial year) was much more muted, such that, on a seasonally-adjusted basis, export realisations contracted another 5.4% month-on-month (m-o-m), sa, taking the year-on-year contraction to a more ominous 21%. Both these phenomena were responsible for the large surprise in the trade deficit.
On the face of it, these are worrying dynamics: gold imports re-surging and exports continuing to contract sequentially suggesting, prima facie, that the 15% appreciation of the real exchange rate over the last 15 months has significantly impeded export competitiveness. Furthermore, given that policymakers don’t have too many tools to drive a nominal depreciation faced with a large BoP surplus in the near-term, a legitimate worry could be that the problem isn’t going away and, in fact, could get worse given the positive inflation differentials that India runs with its trading partners.
But such a cursory reading of the March trade deficit would be overly simplistic, and makes the problem look much worse than it actually is. For starters, gold and silver imports did surge—from an average of $1.8 billion in the three months leading to March to $5.5 billion in March. However, there are several mitigating factors at play. For starters, higher March import volumes likely reflect payback to weak gold import volumes in January and February because import duties were expected to be cut in the Budget (which did not happen) and those expectations likely drove a postponement of imports. More importantly, it likely reflects imports in anticipation of the Akshaya Tritiya festival on April 21—which is considered an auspicious day to buy gold. In sum, there appears to be a large seasonal element to the March surge. Finally, reports suggest that even as imports have picked up, final gold demand has not picked up in tandem, suggesting inventories may have built up. All this suggests that the gold surge in March may extend into April given the timing of the festival, but are likely to mean revert thereafter.
The more fundamental question, however, is the perceived export weakness. As indicated above, export realizations had another bad month, contracting 5.4% sequentially (m-o-m, sa) causing y-o-y growth to contract by 21%. Two questions come to the fore. First, how much of the fall in export realisations is on account of lower commodity prices vis-à-vis a fall in manufacturing export volumes? To the extent that it is the former, it should not be a concern, because India is a net commodity importer and the trade deficit benefits from lower commodity prices. Second, is any softening of manufacturing volumes, in turn, being driven by weaker global growth—given the sharp disappointment of Q1FY15 growth—or by the sustained appreciation of the real effective exchange rate (REER)? Again, to the extent it is weaker global growth—and the fact that some of the weakness in the first quarter is expected to be temporary with global growth projected to re-accelerate later in the year—Indian policymakers should be less concerned. Conversely, if it is largely the impact of the REER—which is expected to continue to appreciate given the continuing inflation differentials—the problem could get worse.
We try to answer both these questions using the March data. For starters, lower commodity and agricultural exports account for nearly 80% of the y-o-y contraction of total export values in March, with petroleum product exports itself—which contracted 60% y-o-y in March—responsible for 66% of the loss in total realisations. All this suggests that lower commodity prices played a key role in March.
That said, manufacturing exports were still responsible for 20% of the contraction, and their growth rate has slowed secularly over the last 4 months (see accompanying chart). There are competing explanations at play. Global growth momentum has slowed markedly over the last two quarters (from 3.4 % quarter-on-quarter, saar, in Q3FY14 to an estimated 1.6% q-o-q, saar, in Q1FY15) and could be driving the slowdown. Similarly, India’s REER continues its relentless appreciation, appreciating another 5% in 2015 and has appreciated 15% since the beginning of 2014. Both factors are likely to have contributed. The suddenness of the manufacturing export fall-off since December—around the time when global growth began to materially soften—would suggest global demand is likely an important factor. That said, there are likely significant non-linearities between export competitiveness and REER appreciation, and it is not clear when the latter begins to suddenly bite. So, REER culpability cannot be completely ruled out, despite the correlation between the global growth slowdown and the softening of manufacturing exports over the last two quarters.
Drilling down into manufacturing exports, we find that the greatest deceleration has happened in the engineering goods sector over the last three months which we have historically found to be far more sensitive to global demand than to REER movements. That would again point to global demand being a key factor. While the role of REER appreciation cannot be ruled out, the fact that non-oil, non-gold imports growth has slowed over the last few months, at a time when domestic demand seems to be picking up, against suggests that REER appreciation may not be hurting—for now.
All told, the factors that drove the deficit widening in March appear to be transient—gold imports should soon mean-revert and manufacturing exports can be expected to recover, under our baseline case that global growth re-accelerates in the coming quarters.
Finally, even though the deficit widened compared to expectations and the last three months, its March level is not threatening by any means. If the monthly deficit remains at these levels over the next year, it would still be consistent with a current account deficit of about 1.2% of GDP in FY16, similar to this year and benign by historical and comparative standards.
Sajjid Z Chinoy
The author is Chief India Economist, JP Morgan