Recent data on India's growing trade and current account deficit is worrying. The trade deficit for the first quarter has been at 32.267 billion US dollar which suggest an annual run rate of 130 billion dollars. India’s current account deficit in the January to March quarter widened sharply to $13.2 billion from $1.2 billion a year ago. Before we dig deeper into the subject let us understand few terms.
Trade account = Exports of goods - Imports of goods.
(if exports are more than imports trade account is into surplus and vice versa)
Current account
Trade account
+ Export of services
- Import of services
+ Net factor income (interest + dividends)
- Net factor payments (dividend + Interest)
+ Remittance and official transfer.
= Current Account Surplus/Deficit
The Trade account deficit means that we import of goods more than our export of goods. This is offset primarily by export of services (IT and Software around 50 Billion USD) and Inward remittance (approximately 50 Billion USD). This equals to 100 Billion USD of annual inflows. This results into a current account deficit of 30 Billion USD which is approximately equal to 2.2% of GDP.
This current account deficit is financed via Net debt, foreign direct investment and foreign institutional inflows. If we consider that Net debt will be zero in long term. FDI and FII contribute roughly equal amount of 15 -16 Billion USD. The problem with current account deficit countries is that they require attract a constant inflow in capital account which may become difficult in time of slowing global growth and worsening credit environment.
I believe that India's current account deficit may worsen and capital inflows might not be sufficient to cover up for the current account deficit. This will result into a decreasing foreign exchange reserve and depreciating Indian currency which will escalate the problems further.
Before going into it let us understand why the current account deficit will worsen.
- Exports revenue will go down due to slowing global growth specially in US and Europe.
- Import bill will marginally reduce due to falling crude prices but will remain high due investment in infrastructure.
- Trade balance will be over all negative but trade imbalance may reduce.
- Net export of services will be down due to lower demand form US and Europe,
- Net factor income will also reduce which will create current account deficit.
- Remittance and official transfer will be reduce due to lower income of Indian expatriate population.
To summarize the impact of these factors on current account
Trade account - Marginally favorable Impact
+ Net Export of services - Negative Impact
+ Net factor income - Negative Impact
+ Remittance and official transfer - Negative Impact
= Current Account Surplus/Deficit - overall current account deficit will worsen.
To finance this worsening current account position we will need to either borrow more or attract more FDI and FII. I think borrowing in this market will be very difficult as credit risk increases the cost of borrowing will go up and creditors will demand higher interest payment to compensate for the risk they are talking. More over slowing global growth will also reduce Indian GDP growth will reduce FDI and FII inflows. This means that there will be a draw down in foreign exchange reserve and Indian currency will depreciate.
Depreciating Indian currency will have negative effect on Investment. FII who have invested in the market at INR /USD @ 45 will see their investment loosing 10% if INR goes to 50 and 20% if INR goes to 55 per USD. So they will liquidate their investment and create a selling pressure similar to what we witness in 2008.
This supports my view of a imminent crash in Indian equity markets. The crash will be driven by a surge in global credit risk rather than a worsening of India's macro outlook.
I believe that in long term India has the potential to grow at 6.5% in next decade compare to a world which will face stagnant growth rates. This will take Indian equity markets to new highs in next decade but before that we will face an imminent correction due to stagnant global growth, surging global credit risk, worsening current account position and depreciating rupee.
Currently Indian markets are pricing a healthy global economic recovery with Indian GDP growing at 8.5 -9% in the next decade. I think the falling global markets and worsening credit spread has already indicated that global economic recovery will not sustain. Only when the markets have priced in these negatives we will see equity markets surging for new highs in the next decade which will truly belong to India.
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