Hows and whys of the trade deficit

India?s trade deficit for 2004-05 is set to hit some kind of record. If we extrapolate from the second and third quarters of 2004-05, the merchandise trade deficit on balance of payments (BoP) basis might well touch $40 billion, or 5.7% of GDP. That is a big increase from last year?s $15 billion and way over expectations for 2004-05, which had mostly veered in the range of $25-27 billion. Incidentally, the DGCI&S trade data will also show a deficit in the range of $27 billion. Now, it could well be that large defence payments were made for importing modern equipment, which would, of course, not be detected in the DGCI&S radar. But it could also be reporting inadequacies that exist and the provisional DGCI&S import data might be under-reporting total merchandise imports for civil use. We know high oil prices meant much higher value of oil imports in 2004-05 (by about $9 billion or 45%), but we also know that non-oil import growth was very strong, by about $18 billion, or some 35%.

Whether the expansion of the merchandise trade deficit to well over 5% of GDP was due primarily to civilian import demand or not is a material question, since the answer qualifies our understanding of the rate of increase of domestic demand (and hence of imports).

If the BoP trade deficit does touch 5.7% of GDP and is, indeed, primarily due to civil imports, then the underlying current account deficit for the last three quarters of 2004-05 will be well in excess of 2%?commonly regarded as the ?safe? limit. While our current foreign exchange reserve position insulates us from any consequential instability, questions will, inevitably, be raised as to whether the commonly shared perceptions on the Indian economy need to be revisited.

It was, for instance, widely believed that with the success of the IT/BPO sector and resurgence in domestic manufactured exports, the country?s current account was biased towards the recurrence of a surplus, with attendant implications for the direction of the exchange rate movement. If, however, in 2004-05, the underlying current account had already shifted to a substantial negative number and a repeat in 2005-06, as also in the near term, is likely, then the implications for adjustment in the exchange rate have to be revised in the obverse direction. If, however, the sharp rise in BoP imports was due to one-off defence-related payments, which is unlikely to be a permanent feature, the implications would be quite different.

However, it needs to be emphasised that even if we were to take the DGCI&S trade deficit as the point of departure, the current account would, at best, be only mildly in positive territory in 2004-05, compared to a surplus of nearly $11 billion last year, and over $6 billion the year before. It is also a fact that, given India?s large unsatisfied needs in infrastructure and elsewhere, civilian imports are likely to continue to rise, at least as fast as they have in 2004-05, in the years to come. Thus, in the best case (or worst case, depending on the point of view) situation, the current account in the near-term appears to be biased towards a deficit, albeit a small one, of less than 1% of GDP.

At the other end of the argument, if we take the BoP merchandise trade deficit as the point of departure and take the second and third quarter of 2004-05 as the representative underlying economic position relevant for the near-term, then we are looking at a regime of current account deficits that are larger by an order of magnitude.

While in the first case (of mild deficits) the challenge would be one of maintaining stable conditions in the currency markets, the latter situation might require a weakening of the currency. Not so much for import compression, but to keep speculation about a prospective weakening in the currency from bringing pressure on inward remittances. For, that has happened before and early corrective action can prevent it from happening again. As a byproduct, it would help exporters and domestic producers of tradable goods, and soften the impact of lower import duties.

Capital flows have been strong in 2004-05, perhaps in the range of $35 billion. Most investors, including portfolio investors, are guided by the long-term prospects for growth in the Indian economy and profitability of companies operating in such an environment. Foreign direct investors are guided likewise. There may be an element for whom a likely appreciation in the external value of the rupee goes beyond being an incidental bonus and is a prime consideration in the investment decision. But that element is small. Some Indian corporates, however, do factor in the expectation of favourable currency movement in computing alternative sources of loan finance (rupee as against external debt). They run the risk of finding that the cost of contracted debt turns out to be more expensive than they had bargained for. But in business, people do call their bets wrong and the only remedy lies in the process of learning.

Returning to the issue of the size and composition of the BoP merchandise trade deficit, the developments appear to mark a turning point, albeit in a small way. If the BoP trade deficit is larger than the DGCI&S one primarily because of defence purchases, then we seem to be set on one course. If that is not the case and the difference is mostly due to civil imports, it means there has been a structural shift, with a nuanced, but significant, alteration in expectations on currency movements and related policy approaches. The exact facts of the case, thus, have a material bearing on the direction of the exchange rate and associated expectations.

The writer is economic advisor to Icra