Change begins at home

Slower world growth could weigh on India's external finances despite a weaker rupee propping up exports - a case for structural reforms

India's growing vulnerability to global conditions is well known. The rise in oil prices has increased the net oil import bill by 1 per cent of GDP over the last two years. And it's not just oil. The non-oil current account (C/A) deficit has also worsened. Even before the investment cycle has picked up, imports have risen, led by coal, electronics and precious gems. The biggest factor of all is exports. Over the last four years, non-oil exports have fallen by 4 per cent of GDP.

Add to this the dwindling affection of foreign investors towards emerging markets has resulted in a sharp decline in capital inflows into India. And what you get is a sizeable deficit (of over $20 billion this year) in India's balance of payments (BoP) accounts. Historically, a BoP deficit is associated with a weakening rupee. And if a BoP deficit lingers for several quarters, it can begin to erode the country's stock of forex reserves.
 

That doesn’t mean everything is bad. Some believe that the ongoing rupee depreciation will “autocorrect” the C/A deficit. Others believe that if and when oil prices fall, those deficit woes will dissipate.

And they may not be wrong. Our model tells us that assuming all else remains unchanged, 12 per cent rupee depreciation (on a real trade-weighted basis) can stabilise the real (adjusted for inflation) C/A deficit by making exports, especially of services, more competitive and foregoing some imports as their rupee cost rises. 

Illustration by Ajay Mohanty

But can we assume all else will really remain unchanged? Sadly not. We 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 on the back of the global “triple shock” of rising US interest rates, higher oil prices, and ongoing trade friction.

What impact would that have? Two likely scenarios come to mind: One, India’s GDP growth remains unchanged despite world growth falling. This implies that India’s growth differential with the world would rise. That is likely to increase imports faster than exports, leading to a widening in the C/A deficit. True, a rising domestic growth differential with the world would attract more growth-sensitive inflows, such as foreign direct investment (FDI). However, this may not be enough because growth-sensitive inflows are only a part of overall inflows. The other part, the interest-sensitive capital inflows, remains fragile in a world where the US is raising rates and therefore offering higher returns to investors than before. We estimate that a balance of payments (BoP) deficit (of $10-15bn) could linger over the next two years.

Two, India’s GDP growth falls alongside declining world growth, narrowing the growth differential, and India's C/A deficit falls. This would happen if imports rose more slowly than exports. On the funding side, however, a falling growth differential would not attract growth-sensitive inflows as easily. This too, according to our analysis, will leave a similar BoP deficit to that in the first scenario.

Through all of this we have assumed oil will average $80/bbl. If lower world growth pulls down oil prices, it could help to soften India’s C/A deficit and thereby its BoP problem. But given the uncertainty around oil prices, relying completely on them to remain low could leave India vulnerable.
 

Is there a sustainable way out of this BoP deficit? Indeed, we believe there is. Easing domestic bottlenecks on a war-footing is likely to benefit both import substitution and export growth. According to our model, the government will have to more than double its efforts to ease domestic bottlenecks in order to lower the C/A deficit to a level that is fully funded by growth-sensitive capital inflows.

What does easing domestic bottlenecks entail? First, improve domestic infrastructure by increasing overall public infrastructure spending, untangling stalled investment projects and reviving public-private partnership funding models to help “crowd-in” private-sector spending. Streamlining the regulatory burden involved in acquiring land and hiring labour will also help. Second, improve export-related infrastructure and the business environment. For instance, focused spending on irrigation can increase agricultural exports. Better warehousing facilities can help most goods exporters. India’s rankings on the ease of trading across borders is 146 out of 190 countries. Lowering customs formalities and smoother logistics can play a meaningful role.

Steps to attract more FDI could have sizeable results. We found that FDI in both medium-technology sectors (gems, jewellery and oil products) and high-technology sectors (engineering products) can boost exports. Trade negotiations to lower tariffs that India’s exports face abroad can boost textile and engineering goods exports.

Sector-specific factors can also make a big difference. For instance, textile exports can be revived by removing distortions such as greater support to cotton when it is the global demand for man-made fibres that is rising.

Finally, 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, the rupee’s depreciation may not solve all of India’s BoP problems.

The writer is Chief India Economist, HSBC Securities and Capital Markets (India) Private Limited