The Devil, as usual, is in the details

Written by Saumitra Chaudhury | Updated: Oct 31 2005, 06:08am hrs
Since 2001-02, Indias Balance of Payments (BoP) had a surplus on the current account, and thus it remained till the first quarter of 2004-05. Some influential pieces have been written on this recently and it has weighed heavily on markets and investors. Before moving further, it might help to explain some terms. The current account measures the payments we make to the rest of the world for imports of goods & services, factor payments (for labour and capital professional fees, interest, dividend etc), and the payments India receives from the rest of the world against these items.

The first of these refers to trade in goods, ie, the merchandise trade balance, which is a very large negative number; we import much more than we export. Second is the trade in services software, ITES, travel & tourism, and here we have a sizeable surplus. Third, remittance from Indians who live overseas, which generates an enormous surplus. Fourth, are dividend and interest payments, where we pay out more than we receive.

Some years back, when India started running a current account surplus, in the midst of the IT/BPO flashing of lights, many analysts across the world, saw a structural shift beginning to happen in this country; namely, that net earnings from these emerging businesses would rapidly expand, more than financing the merchandise trade deficit. Thus, the current account balance would gravitate towards a sustained surplus, interspersed with small deficits in the occasional year. That generated a positive outlook on the currency and deepened confidence in the general solvency of the economy (remember this is in addition to the fact that even if the government balance sheet is in the red, the household balance sheet is solid, with very low debt levels). India was good growth story, and we thus had large capital surpluses. If the investment outlook in the country was positive for Indian business, it was by the same token equally attractive for foreigners. In consequence, there was continued accretion to reserves.

It was also clear that after many years of capital deepening through consolidation and more efficient utilisation of assets, there would come a big stepping up of investment that would generate larger merchandise trade deficitsby way of import of capital goods and intermediate, large enough to return the current account into a deficit, albeit a modest one. That situation has, indeed, come to pass.

Alarm over the CAD size is due to fears of excessive public or private demand
It seems so with the 3.2% figure for Q1, but DGCI&S and BoP import data vary
From purely economic causes, the CAD would be in the range of 1-1.5% of GDP
The surprise in most quarters was the size of the current account deficit (CAD). In 2003-04, the current account was in surplus to the extent of $10.6 billion or 1.7% of GDP. In 2004-05, this turned into a deficit of $6.4 billion or 1.0% of GDP. In the second and third quarters of 2004-05, the CAD had touched 3.7% of GDP on annualised basis, the figure for the full year brought down by the large surplus in the first, and the small one in the fourth quarter. Generally, a CAD of up to 2% is regarded as safe, provided other indicators are favourable (which in India it was). Then, in the first quarter of 2005-06, the CAD came in at a whopping $6.2 billion, which not only was almost as large as that for the full year of 2004-05, but also amounted to 3.2% of expected GDP (annualised).

This has caused many to become alarmed, and their logic works like this: CAD in excess of 2% of GDP, and certainly at 3%, is indicative of over-heating, due either to excessive public demand (high fiscal deficits) or sharp increases in private demand when fuelled by rapid credit growth, or a combination of both. Credit growth has indeed been very strong, at nearly 30% in recent times. Over-heating, whether caused by fiscal deficits or private borrowing, results in an increase in aggregate demand beyond what domestic supply can service, leading therefore to a larger CAD. It also causes domestic inflation, worsens export incentives and competitiveness. It needs to be corrected through demand management, of which progressive hiking of interest rates is the most common one. There are many other nasty symptoms associated with this illness, including credits turning bad and so on. Hence, many analysts have drawn the conclusion that the short-term outlook has turned negative. Some, domestic columnists have concluded that this signals a huge prospective increase in investment rates.

Both have been over-hasty. There is a massive discrepancy between the DGCI&S imports and BoP imports, amounting to $12 billion in 2004-05 and over $5 billion in the first quarter of 2005-06. Without this discrepancy, the CAD in the first quarter of 2005-06 is just 0.5% (annualised). It is obvious that understanding the discrepancy is crucial. More than half of it is possibly on account of defence purchases, which are (a) not an outcome of economic activities, (b) reflects accumulated defence modernisation needs, and (c) are unlikely to last for ever. If we factor this aspect out, the CAD in the first quarter would have been closer to 2% of GDP.

Finally, as gold prices have risen, we have been splurging on the yellow metal. Last year, we imported $3 billion more than what we had in the year prior to that. And in the first quarter of 2005-06, we imported half as much as we had in the same quarter of last year, that is, another 0.7% of GDP. Thus, from purely economic causes, the CAD, even in the current fiscal, would appear to be between 1%-1.5% of GDP. That is the most relevant detail and with it, the over-heated economy scenario collapses. It would, therefore, greatly help if the discrepancy between the BOP and DGCI&S imports figures is officially explained.

The writer is economic advisor to Icra