A V Rajwade: BoP and forex reserves

WORLD MONEY

In the last couple of weeks, data on the 2004-05 balance of payments (BoP) and foreign exchange reserves as on March 31, 2005, have been released by the Reserve Bank of India (RBI).

Turning first to the BoP data, in an earlier article, I had estimated that the merchandise trade deficit for 2004-05 would be more than $35 billion; the actual number is $38 billion, two-and-a-half times the previous year's figure of $15 billion.

While there has been some growth in invisibles, from $26 billion to $32 billion, the sharp increase in the merchandise trade deficit has converted a current account surplus of $11 billion in 2003-04 to a deficit of $6 billion last year, a turnaround of as much as $17 billion, or a little under 3 per cent of GDP.

For a single year, this is a very large change indeed. The principal contributors are oil and oil products (up 45 per cent to $30 billion), gold and silver (up almost 60 per cent to $11 billion) and other imports (up 31 per cent to $ 66 billion).

The import break-up is from the commerce ministry data which excludes defence imports: RBI's BoP data show merchandise imports of $119 billion as against the $107 billion reported by the commerce ministry.

The sharp change in the current account balance is a reflection of the savings investment equation in the economy: one conclusion, therefore, is that investments have gone up, supporting future growth. (Somewhat oddly, machinery imports have gone up only 10 per cent.

The capital goods segment of the index of domestic industrial production, however, shows a rise of 20 per cent.) The assumption of an increase in investments in the domestic economy is also borne out by another number in the BoP statistics: net commercial borrowings were $6 billion as against net repayments of $1.5 billion in each of the three previous years.

Since, broadly speaking, external borrowings can only be used for capital expenditure, this data also supports the investment growth assumption. Paralleling the change in commercial borrowings, the external assistance received during the year has also been a positive $2 billion, compared to a negative $3 billion in the last two years.

Foreign investment inflows amounted to $12 billion, comprising $3 billion of direct investment and $9 billion of portfolio inflows. Overall, what some of the data evidences is a dramatic change in the BoP in 2004-05 as compared to the previous few years.

The prospects for the current account in fiscal 2005-06 could well be even worse. For one thing, oil prices look like they will remain high through the rest of the year. Again, the exchange rate has been adverse for some time, and seems to have started impacting the trade numbers "" the merchandise trade deficit has almost doubled during the first quarter (April to June 2005).

But capital inflows are likely to remain buoyant. For one thing, foreign institutional investor (FII) flows are even stronger than in the previous year ($5.5 billion for January to June 2005).

Given that generally portfolio flows are stronger in the second half, the current year's number could well exceed the calendar year 2004 number of $8.5 billion, more so as an increasing number of Japanese investors are getting attracted to the Indian market.

Issues of foreign currency convertible bonds (FCCBs) by Indian companies are also on the rise "" $1.5 billion in the first half of calendar 2005, compared to $2.3 billion for calendar 2004.

Moreover, the interest of private equity investors in the Indian market is also growing. Private equity investments exceeded $1 billion in calendar 2004, and one has seen estimates for the current year running as high as three times the number "" to be sure, in the first half, the actual flow has been about $750 million.

With the rupee stable to strong against the dollar, the appetite of the corporate sector for external commercial borrowings also remains high.

There is, of course, one cloud on the prospects for investment flows. With the index going up practically every day, investors have started wondering whether the valuations are not too high. Significantly, HSBC, one of the largest India fund managers, has recommended an "underweight" holding of Indian stocks.

But even with this, it looks likely that foreign investment, whether direct or portfolio, will remain by far the single most important element on the capital account "" as it has been for many years.

As the RBI data evidence, of the total accretion of $141.5 billion to our reserves from March 1992 to March 2005 as much as $77 billion came in the form of foreign investment. To be sure, in recent years, Indian direct investment abroad has also grown rapidly but remains well below the foreign capital invested here.

e-mail: avrco@vsnl.com