India’s sticky external account deficit – Oil is not the only culprit!

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With INR breaking above 70 and staying there for last few days, market is now talking of possibility of seeing much higher levels (72 to 77) in coming months. We are not sure of the extent to which INR weakening may be seen. However, the trend is of weakening and many factors are contributing to the trend. Some of these factors are external to India and some are internal like rising trade and current account deficit.

In this research paper we have tried to study changes in India’s external deficit (trade deficit and current account deficit) and impact on INR over long term.

Period of study: FY 2006- FY 2018 (13 years)

Methodology: Key disclosures

1. Out of 13 years (FY 2006 to FY 2018), Indian economy saw crude oil shock and other abnormalities like CNY devaluation in four years (FY 2009, FY 2010, FY 2012, FY 2013). For analysis purpose, these four years have been removed and shown separately in Table 6.
2. To identify factors other than crude oil, we have removed the impact of crude oil on trade deficit and current account deficit (CAD) by analyzing non- oil deficit and non-oil exports.
3. Most of the variables are analyzed as % of GDP rather than standalone number to assess growth in India’s GDP vis-à-vis growth in these variables.

Key findings:

• For last many years, since FY 2006, trade deficit and CAD as % of GDP have stayed in a narrow range and not shows any pattern of secular decline. Ideally, after years of reforms, both should have seen a gradual decline.
• Non-oil deficit as % of GDP is witnessing a rising trend. For FY 2018 it is estimated to be at 13 year high. Similarly non-oil exports as % GDP is declining and for FY 2018 it is estimated to be at 13 year low. Ideally non-oil imports should have been declining and non-oil export should have been increasing. This indicates that non-oil basket which is an area of concern.
• Electronics import is now second biggest import item, ahead of gold, and is growing.
• For FY 2018, Invisibles (IT exports and NRI remittances) as % of GDP is also estimated to be at 13 year low. IT industry is going through churn like automation, visa restrictions. Therefore, we expect IT services exports to remain subdued. On remittance front, large part of remittance comes from Middle East and US and both these markets are seeing wave of hiring locals and therefore this source of USD inflow would also remain in stress.
• In a heartening trend, for last few years, Gold import is flat but is reducing as % of GDP.

Going forward, given declining trend in invisibles, our dependence on capital account inflows (Equity, Bonds and FDI) to finance CAD, would only increase. Since capital account inflows are volatile, we may have periods of capital account outflows resulting in sharp INR weakness (as seen in Apr’18-Jun’18) or periods of huge inflows that would keep INR weakness under check. All in all, INR volatility may increase with time and long term trend of weakening INR may persist.

Detailed study

1. Trade deficit & Current Account deficit not improving: For last 13 years, as a % of GDP, India’s trade deficit and current account deficit have stayed in a narrow range. Trade deficit range has been in range of 6.2% to 7.4% and CAD has been in range of 1.1% to 1.9%. Ideally after years of reforms, deficit as % of GDP should have been on a declining trend. Please refer to Graph 1 below.
2. Crude oil is not only the culprit, it’s a collective concern of non-crude deficit and non-crude exports:
   Crude import is a well-known concern and Government is working on policy initiatives like renewable energy etc. to tame the crude imports. The data in table 1 below shows that non-oil trade deficit as % of GDP is gradually widening. It was 1.6% in FY 2006 and is estimated to hit all-time high of 3.4% in FY 2018. Our sense is that large part of the non-oil deficit is on account of import of consumption items and not because of import of machines etc. Any increase in deficit because of increased import of machines is generally not a worry as it increases productivity and finally increases exports. However widening of deficit because of increase in import of consumption items is a big worry and it puts a big question on our manufacturing capabilities. Hope Make in India becomes successful.2.1 Electronic import is one such big consumption item whose import is steadily increasing year after year. Please refer to Graph 2 below. In FY 2014, electronics import overtook gold imports and has been increasing since then. Electronic imports is linked to lifestyle of people. People want to upgrade to better TV, better mobile phones every few years and thereby keeping electronic import at elevated levels.Controlling electronic import would be a challenge and could take many years of work. Just like automobile manufacturing, which is now an established industry in India with its own ecosystem of vendors, sub-vendors, manufacturing plants and R&D companies, Electronics also needs to follow path of automobile success story.
3. Even non-oil exports as % of GDP is gradually falling. It was 11% in FY 2006 and fell to 10.2% in FY 2018. There was a brief period of FY 2012 to FY 2015 when non-oil exports as % of GDP rose but that could not sustain. Pl refer to table 2 above.
4. Gold import as % of GDP is reducing: One heartening development is that gold import has become almost flat and has been range of USD 27 Bn. to USD 34 Bn per year. Refer to Graph 3 below. Gold import as % of GDP saw a peak of 3.5% in FY11 and since then it is declining and for FY18 it is estimated to be at 1.9%.
5. Invisible receivable are falling which is widening the current account deficit (CAD): India’s exports of IT services and inward remittances from NRIs, the two big earners have been showing an unhealthy trend, falling to 13 year low of 4.3% of GDP in 2017-18 from a high of 6.2% in 2013-14 (Refer Table 2 above). We believe that invisibles would continue to reduce as % of GDP and hence CAD would remain under pressure and would increase in coming future. Key reason to project reducing invisibles is increasing automation in traditional IT services; visa restrictions and increasing budget from global corporates for upcoming technologies like Artificial Intelligence and Digitization. Regarding remittance, Middle East, America and UK are major senders of remittances, accounting for 67% of total remittance of USD 68 bn (Please refer graph 4). Each these places are witnessing wave of hiring locals and not expats and therefore we expect remittances to remain flat.
6. Increasing dependency on capital inflows to finance current account deficit: As CAD is expected to widen, country’s dependence to on capital inflows (equity related, bond related and FDI) would increase. We all know that, other than FDI, Equity and bond related inflows are volatile. These inflows can anytime turn into outflows as seen in April-July months of FY19 when INR weakened by 7% and there was outflow of USD 7.6 Bn.
7. Conclusion – Impact on INR: As a result of above, INR may also continue to see increased volatility. Any periods of INR strength might be short lived while periods of weakness may be long with sharp spikes.

*Note: We have out separated few years from above research as they represent period of economic abnormalities including global economic slowdown of 2008 and devaluation of CNY in 2013. The data related to these years is given below.

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