CAD as percentage of GDP: Nowhere near 2012-13 level, yet worrisome

If up to $50 billion is withdrawn from forex reserves to finance CAD, the country would still be able to meet nine month's imports. Any withdrawal beyond this could pose a problem

Much has been said and written about the twin deficit problem the economy is facing in the current financial year. There is a third aspect that makes this problem more worrisome. And that is the capital account. Generally, capital inflows help India finance its current account deficit (CAD), obviating the need to dip into foreign exchange reserves.

Economists believe the CAD could touch three per cent of GDP this fiscal, compared with 1.2 per cent in the previous year. This would be the highest that the CAD would have reached after it had touched 4.8 per cent of GDP in 2011-12 and 4.2 per cent in the year before that. However, the problem of capital outflows did not throw the economy out of gear in 2011-12 when CAD peaked, or even in the third quarter of that year when it had hit an unprecedented 6.7 per cent of GDP. But there were capital outflows in the third and the fourth quarter of the previous year (2010-11) that led to a drawdown from forex reserves. There were fears of capital outflows in 2013-14 too, due to the taper tantrum, but CAD had come down to just 1.7 per cent of GDP by that time.

In the current financial year, both CAD and net capital outflows have started rising, putting the rupee under pressure. This has prompted the Reserve Bank of India (RBI) to take measures to attract NRE (non-residential external) and FCNR-B (foreign currency non-resident-bank) deposits. Despite these measures, experts believe up to $50 billion could be withdrawn from forex reserves.

India's forex reserves are currently a tad below $600 billion, but are much higher than $300 billion in 2011-12 and 2012-13. If $50 billion is withdrawn from the reserves, the remainder would be sufficient to cover imports for about nine months. This is higher than the seven months of import cover in 2011-12 and 2012-13. However, if more than $50 billion is to be withdrawn from the reserves, there could be a problem.  

In fact, the capital outflows that started in the last quarter of FY22 led to withdrawal of $16 billion from forex reserves. There was a capital outflow of just $1.7 billion, adding to CAD of $13.4 billion that led to forex withdrawal. There was net outflow of investments amounting to $15.2 billion, led mainly by foreign portfolio investors (FPIs), who pulled out a staggering $14.3 billion. However, some inflows such as $13.8 billion in net foreign direct investments, helped reduce capital outflows to a trickle.

In the first quarter of the current fiscal too, FPIs pulled out $14.2 billion net. Though the exact data on CAD for the quarter is yet to come, it could touch $30 billion against a surplus of $6.5 billion a year ago, say economists. Trade deficit was much higher at $69.07 billion in the quarter against $29.94 a year ago. More than half the trade deficit is likely to be neutralised by the services surplus and remittances. The services surplus rose YoY 6.39 per cent to $17.39 billion in the first two months of FY23. Data on remittances is yet to come.

Services surplus stood at $25.8 billion and remittance flows stood at $13.2 billion in Q1 of FY22.

India Ratings chief economist Devendra Pant said, "We have estimated CAD to be three per cent of GDP for FY23." He added that high commodity prices and the country's dependence on commodity imports is leading to widening of CAD.

"We being a capital starved economy, our investments are not entirely financed by domestic savings, leading to CAD," he said.

On top of that, the fear of recession in advanced economies and the hiking of benchmark rates by the US Federal Reserve have exacerbated the flight of capital out of India. 

"Whatever measures RBI has taken, there could be some forex inflows. Even then we are going to see depletion of forex reserves to the extent of $45-50 billion during FY23," Pant projected.

Icra chief economist Aditi Nayar said with continued large FPI outflows, particularly from equities, the net balance of payments (BoP) position is expected to have deteriorated further in Q1 FY23.

"India’s forex reserves had declined by around $19 billion in that quarter," she added.

Merchandise trade deficits in excess of $20 billion are set to be the new normal in the remainder of FY23). However, robust services surpluses are set to offer a modest palliative on the back of the remarkable exports seen in the recent months.

"We currently foresee the CAD to more-than-double to an all-time high of $100-105 billion in FY23. This translates to around three per cent of GDP," Nayyar said. It is well below 4.8 per cent seen in 2011-12.

However, concern is warranted on the capital flows, given the aggressive tightening expected from the US Federal Reserve. "We expect a drawdown of reserves in FY23, albeit from the very high levels seen at the beginning of the year," she said.

The scenario in 2011-12 and 2010-11

Though CAD was unprecedented at $88.2 billion in 2011-12, capital inflows of all kinds were a bit higher at $89.3 which resulted in minor accretion to forex reserves.

Of capital flows, net portfolio investments amounted to $26.9 billion. A slightly higher sum of $27.6 billion was put in by foreign institutional investors (FIIs) on a net basis.  

In all the four quarters, net capital flows and within that portfolio investments remained positive. For instance, in the third quarter of 2011-12 when CAD touched the highest 6.7 per cent of GDP, net capital inflows lagged CAD a tad. CAD had stood at $31.8 billion, while net capital inflows were $31.5 billion that time. Within capital inflows, portfolio investments brought in $11.3 billion on net basis. Within that FIIs net bought equities and debt to the tune of $11.5 billion.

In the previous year of 2010-11, when CAD was 4.2 per cent of GDP, the situation was different. In the first two quarters, capital accounts saved the day for the country and there was accretion to forex reserves to the tune of $5.7 billion for the first six months.

However, the situation turned a bit worrisome after capital flows could not match CAD in the last two quarters of the year, leading to $18.4 billion withdrawal from forex reserves in the second half of the year. In aggregate, $12.8 billion was taken away from forex reserves. However, forex reserves were sufficient to finance imports for seven months in 2011-12 and 2012-13.