It is fairly well known that the two prominent vulnerabilities of the Indian economy over the past few years have been persistently high inflation and a large Current Account Deficit, or CAD.
On the CAD front, the issue was two-fold – one, how quickly and sharply it had widened; at $88 billion for FY2013 it was almost 4.7% of GDP and the second largest in the world in absolute terms. What compounded this was India’s reliance on short–term portfolio flows, both debt and equity to finance it. It’s been over a year since we were grimly reminded of this vulnerability and got admitted into the infamous Fragile Five Club.
A review of how these five economies have fared since that episode of weakness last year shows that India clearly stands out in the magnitude of current account improvement which has reflected in superior relative performance of the currency as well.
Indeed, most forecasters peg the FY2015 CAD at about $40 billion or just over 2% of GDP. Importantly, the basic balance (current account balance + net foreign direct investment) has also considerably improved in the past few quarters. Based on trailing 12 months’ numbers, India would be able to fully fund her CAD without any portfolio flows. However, one does not see the same excitement about this improvement, as say, one would see if we got a below 5% reading on the consumer price inflation and the reason offered is that this CAD is not a ‘normalised’ number.
The two major variables that need to normalise to get to a sustainable CAD are gold imports and merchandise imports (excluding gold).
Gold
The argument is that due to increased import duty on gold, its imports are artificially depressed and once these duties are done away with, they will climb back and widen the CAD again.
On merchandise imports, the hypothesis is that a growth pick-up will cause CAD to widen as we would be importing more than we currently do. Arriving at sustainable levels for both these variables is worth attempting.
As per data from World Gold Council, India’s annual gold imports peaked at almost 1,150 tonnes in June 2011. Almost 40% of gold demand for the 12 months ended June 2011 was for investment purposes. It is not surprising that international gold prices peaked at almost $1,900 per ounce in May 2011 and there is no better advertisement for an asset class than trailing returns. Gold prices have since been on a downward trend and currently hovering around $1,300 per ounce.
The other change is that financial savings which were yielding lesser than inflation (or negative real returns) are now yielding slight positive returns making them more attractive as a savings vehicle than gold. We suspect that even if import duties were to be normalised, investment demand is unlikely to return with same gusto. The local gold price premium in India over international prices (adjusted for import duty) has almost gone down to zero showing that demand pressures have eased.
Also, with reducing price premiums the economic incentive for gold smuggling goes down. Five as well as 10 year average for seasonally adjusted consumption (jewellery) demand for gold has been fairly steady at about 140-150 tonnes per quarter and for the last three quarters this number has averaged around 150 tonnes per quarter.
Also, the long–term average for investment demand for gold has been about 25%, despite a much elevated level in the last few years. Investment demand for gold has been less than 20% of overall demand in periods of positive real rates. All this points to a normalised gold demand number of about 750-800 tonnes per annum. What was it for trailing four quarters? 761 tonnes. Is it plausible that gold imports have already normalised?
CAD and growth
On the issue of relationship between CAD and growth, there seems to be little correlation between the two variables. Since FY2004 till FY2013, India’s CAD on a trend basis has only worsened despite periods of accelerating as well as decelerating growth.
When CAD is compared with India’s growth difference with the rest of the world, there seems to be no correlation again. Thus, though theoretically correct, there is not enough evidence that growth acceleration by itself will cause CAD to widen. From a composition standpoint, imports as a share of GDP accelerated from about 21% in FY2008 to over 27% in FY2013 and the chief contributor to this rise, apart from gold and silver, was petroleum imports. Here’s where the recent fall in commodity prices especially crude oil provides a cushion to the CAD.
Indeed for every dollar that international crude price softens, the CAD improves by just over $1 billion. The current price at which India imports crude is lower by almost $10 per barrel than that for FY2014, providing significant buffer even if non-oil imports were to go up. Considering all the above, it seems plausible that normalised CAD may not be too different, if not better, than what the last 12 months suggest.
This article has been contributed by Amay Hattangadi and Swanand Kelkar of Morgan Stanley Investment Management.
