With slowing world growth, the falling ` won’t help. improve domestic infra, ease the regulatory hurdles in acquiring land and hiring labour
Much has been said about the role played by higher oil prices in widening India’s current account (C/A) deficit; however, this is not the only cause. The big question now is whether the sharp fall in the rupee will ‘autocorrect’ the C/A deficit. Three variables (growth, domestic bottlenecks, and the rupee) explain import and export performance rather well. All else being constant, a 12% depreciation in the real effective exchange rate (REER) can indeed stabilise the C/A deficit. But is all else equal? Perhaps not.
Rising oil prices are likely to have raised India’s oil import bill by 1.5% of GDP over two years (FY18 and FY19). Between FY14 and FY18, India’s core C/A deficit had fallen by 3% and it is this weakness that is making India more susceptible to rising oil prices. The blame falls largely on India’s core exports, which fell by 4% of GDP over this period. About 0.5% of this fall can be attributed to demonetisation and the goods and services tax (GST), and could get reversed with remonetisation and improvements in GST refunds. There has been some buoyancy in exports so far this year; however, it won’t be enough to reverse the entire 4% of GDP fall.
Over the last four years, though, India’s export basket has become a tad more sophisticated. The share of high- and medium-technology goods exports has risen from roughly two-thirds (66%) to three-fourths (75%) of the basket, led largely by engineering goods, chemicals and processed raw materials. Alas, the improving composition may have been led more by traditional export items (such as textiles, agricultural products, gems and jewellery) falling, rather than high-end exports rising. On the other hand, over the same period, core imports proved to be more of a tailwind, falling by 2% of GDP. This fall in imports seems to be more a result of India’s falling investment rate, however, and the fall in imports of high-value machinery and capital goods more than offsets the rise in consumer electronics.
The following variables explain imports and exports growth rather well—domestic bottlenecks (proxied by the stalling rate of capex projects), GDP growth (world growth for exports, domestic demand growth for imports), and the rupee (RBI’s 36 currency trade-weighted REER). Moving on to capital inflows, there are two distinct categories: Interest-sensitive inflows (comprising loans, FPI debt, and banking capital excluding NRI deposits), and growth sensitive inflows (comprising FDI and FPI equity flows). In FY18, the former made up 45% of total inflows. However, in the current environment of rising interest rates, they may be harder to come by. Growth-sensitive inflows, which made up 40% of the total in FY18, could continue to flow in if India’s growth differential with the world rises.
Expect world GDP growth to fall over the next two years. The US may be booming, but the rest of the world has started to slow. Assuming that India’s GDP growth remains unchanged despite world growth falling, this would mean that India’s growth differential with the world will rise. This is likely to increase imports faster than exports, leading to a widening in the C/A deficit over the next two years. A rising domestic growth differential with the world will attract more growth-sensitive inflows. However, this may not be enough. Assuming no major response from interest-sensitive capital inflows, a BoP deficit of about 0.5% of GDP (i.e., $10-15 billion) could linger on over the next two years.
Predicting India’s GDP growth to fall alongside falling world growth, in a manner in which the growth differential with the world falls, the C/A deficit narrows. This is led by imports rising slower than exports. On the funding side, however, a falling growth differential will not attract growth-sensitive inflows as easily. Assuming no major change in interest-sensitive capital inflows, a BoP deficit of about 0.5% of GDP (i.e., $10-15 billion) could linger on over the next two years. Historically, a BoP deficit is associated with a weaker rupee. HSBC’s FX team expects USD-INR at 76 by end-2018 and at 79 by end-2019, and oil to average $80/bbl. If lower world growth pulls it down from those levels (assuming none of the supply-side concerns around oil become pressing), it could help to soften India’s C/A deficit, and thereby its BoP problem. But, given the uncertainty around oil prices, relying on them to remain low could leave India more vulnerable.
There is a sustainable way out of this BoP predicament, if India uses the third important driver of imports and exports—the easing of domestic bottlenecks and improving of the ease of doing business. These can be achieved by the following: Firstly, improve domestic infrastructure by increasing overall public infrastructure spend (for instance, in transport and electricity transmission sectors), untangling stalled investment projects, and reviving PPP models to help crowd-in private sector spending. Streamlining the regulatory burden faced in acquiring land and hiring labour will also help. Secondly, improve export-related infrastructure and business environment. For instance, focused infrastructure spending on irrigation can increase agricultural exports. More investment in education can boost software services over time. Better warehousing facilities can help most goods exporters. And more FDI in both medium-technology (gems, jewellery and oil products) and high-technology sectors (engineering products) can boost exports. Thirdly, the limits of the exchange rate as a driver of exports need to be understood. At most, the strengthening rupee explained a quarter of the slowdown in exports over the last few years. Now, too, in a world of slowing growth, the rupee’s depreciation may not solve all of India’s BoP problems.
Pranjul Bhandari is Chief economist, India, HSBC Securities and Capital Markets
Edited excerpts from HSBC’s India’s BoP Burden (Oct 15)
Report is co-authored by Aayushi Chaudhary