India gets respite on current account deficit

Current account deficit vs fiscal deficit

In the realm of macroeconomics, the two most commonly used deficit terms are the fiscal deficit and the current account deficit (CAD). Fiscal deficit is a much broader term and is also called the budget deficit. When the budget is prepared, the statement puts all expected revenue flows on one side and all expected revenue and capital expenditure on the other side. The shortfall is the fiscal deficit. The fiscal deficit is met through borrowings from the bond market. However, current account deficit is a combination of net surplus or deficit from foreign transactions. Since India is a net importer of oil, it does run a current account deficit, but the key is in controlling the current account deficit as it can weaken the rupee and also weaken the sovereign ratings. For the last quarter ended March 2023, the current account deficit stood at $1.3 billion or just 0.2% if GDP. That is a comfortable scenario.

How current account deficit evolved in 3 years

The table below captures the current account deficit (CAD) over the last 3 years, captured quarter wise. Out of the last 12 quarters, we have seen a current account surplus in 3 quarters (Jun-20, Sep-20, and Jun-21). No prizes for guessing, but this was due to the compression in imports during the pandemic and its aftermath. Other months have seen a current account deficit. 

Data Source: RBI

The last 4 quarters are of special importance. For the September 2022 quarter, the current account deficit had first been reported at a record high of $36.20 billion. However, later that figure was toned down to $30.90 billion. At that point, the apprehension was that the CAD could end up at 3.5% to 4% of GDP. However, the sharp fall in the CAD in the December 2022 quarter and now for the March 2022 quarter ensured that the full-year CAD for FY23 came in at $67 billion or just 2% of GDP. That is still higher than last year (FY22) but much lower than the apprehensions expressed during the second half of 2022.

What narrowed the cad sharply in Q4FY23

As we can see in the table above, the current account deficit for FY23 was eventually much lower than expected; thanks to the sharp fall in CAD in March 2023 quarter. To understand this better, one needs to get into the granular components of the CAD.

Data Source: RBI

The CAD for the fourth quarter (Q4FY23) came in at a mere $1.30 billion (0.2% of GDP) while the full year CAD stood at $67 billion or 2% of GDP. What are the components of CAD that actually pulled it down so sharply?

1. With the sharp fall in the price of oil, greater dependence on Russian crude and an overall tapering of commodity prices; the merchandise (goods) trade deficit improved sharply over last few quarters. From a high of $83.5 billion Q2FY23, the current account deficit (CAD) fell to $72.7 billion in Q3FY23 and further to $52.6 billion in the latest Q4FY23 quarter. As we stated earlier, this was driven by lower commodity prices, but also due to a sharp fall in non-oil imports. That is due to the conscious import substitution policy followed by the government in many of the key sectors.
    
2. The second big differentiating factor was the surplus on the services account. These include the trade in non-merchandise trade and predominantly include IT, BPO, outsourcing, consultancy, research centres etc. For the March 2023 quarter, the surplus in the services account stood at $39.1 billion compared to an average services trade surplus of $34.73 billion in the previous three sequential quarters. While IT sector has faced some pressure from global tech spending; other services like accounting, legal, knowledge services etc are still very robust. That has made up for weak IT growth. 
    
3. The quarter also saw stable primary outflows on account of payments on investments in the form of interest and dividends at $12.6 billion. However, while the primary account is still negative, the secondary account has been strongly positive, which has also helped substantially narrow the current account gap.

To summarise the story, CAD for Q4FY23 has narrowed to just 0.2% of GDP while the FY23 CAD at 2% of GDP is much lower than originally anticipated. That reduces the pressure on the rupee and also any concerns that the agencies may have on the rating outlook for India. 

Subtle link between CAD and interest rates

While the falling CAD is surely welcome, it also poses a very subtle challenge for the RBI. Since February 2023, the RBI has paused on rates. The repo rate has stayed at 6.5%. While the RBI has not called the top, it has ruled out rate cuts for now. Now comes the dilemma. If the RBI holds rates while the Fed, BOE and ECB hike rates, we could see the rupee weaken. That is an invitation for imported inflation and a worsening CAD. However, if the RBI decides to hike rates in response, it impacts cost of debt, solvency, and equity valuations. That is where the middle path gets tough to implement.