The current account deficit narrowed to $4.2bn in October-December 2013 (vs. 5.2bn the previous quarter) led by higher income inflows.
Moreover, the deficit was easily financed, which led to an increase in foreign exchange reserves. Looking ahead, the deficit is likely to remain contained in the near term, although a gradual relaxation of the gold curbs could see it creep up again. If we get an investment-led recovery next fiscal year, that could also gradually widen the deficit as domestic demand for capital goods pick up. However, that would help improve the quality of the deficit and, therefore, the ability to finance it.
The current account deficit for Q3 FY14 (October-December 2013) narrowed to USD 4.2bn (vs. 5.2bn in Q2 FY14 (July-September 2013) as per standard presentation using the Balance of Payment Manual 6. This was better than expected.
The merchandize trade deficit (USD 33.1bn vs. 33.3bn in Q2 FY14) was marginally lower as exports continued to grow faster than imports, which have been curbed due to lower gold imports and soft domestic demand.
Meanwhile, the surplus in the services balance fell slightly to USD 18.1bn (vs.18.4bn in Q2 FY14).
The main contribution to the improvement in the current account deficit came from lower net primary income outflows (USD 5.4bn vs. 6.3bn Q2 FY14) and higher secondary income inflows, which include remittances (USD 16.4bn vs. 16.1bn Q2 FY14).
On the financing side, FDIs recorded lower net inflows (USD 6.1bn vs. 8.1bn Q2 FY14) due to weaker equity and investment fund shares.
Meanwhile, improved investor sentiment led to a turnaround in net portfolio flows (USD +2.4bn vs. -6.6bn Q2 FY14). Equity saw net inflows following net outflows in the previous quarter (USD +6.2bn vs. -0.9bn in Q2 FY14). There were still net outflows for debt securities (USD -3.7bn vs. -5.7bn in Q2 FY14), albeit less so.
Turning to the category of 'other' flows, it was on expected lines. Overall, there was a big swing in 'other flows' from net outflows to net inflows (USD +14.6bn vs. -4.6bn in Q2 FY14). Currency and deposit inflows, which include NRI deposits, increased notably (USD +21.6bn vs. +8.1bn Q2 FY14). However, loans (external assistance, external commercial borrowing, and banking capital) continued to see net outflows (USD -1.6bn vs. -5.6bn in Q2 FY14), but a pick-up in external commercial borrowing (USD +4.5bn vs. +1.3bn Q2 FY14) helped reduce the overall outflow from this category.
With the current account deficit of USD 4.2bn and capital/financial account net inflows of USD 23.7bn, the overall balance was USD +19.1bn (vs. -10.4bn in Q2FY14) and this meant that there was big increase in foreign exchange reserves.
India has come a long way in terms of reducing its external vulnerabilities. A drop in the current account deficit from 6.5% of GDP in October-December 2012 to just 0.9% a year later is quite an achievement and testament to the concerted efforts of the RBI and the government to rein in the deficit. With a cumulative current account deficit of 2.3% of GDP for April-December 2013 we are certainly on track for a more comfortable outcome this fiscal year.
The trade deficit has been contained thanks to a weaker currency, softer domestic demand and, of course, the curbs on gold imports. Moreover, the tightening measures undertaken by the RBI and steps introduced to attract deposit and other inflows also helped restore confidence and bring in the necessary financing, although a more cautious US Fed played a role as well.
Looking ahead, the current account deficit is likely to remain contained in the near term. Nevertheless, a gradual relaxation of the curbs on gold imports, as currently discussed, may add to the deficit in coming quarters. Moreover, a gradual improvement in domestic economic conditions will likely lift imports next year.
On the back of this, we expect that the current account deficit will widen somewhat again in FY2015, although a gradual recovery in external demand will help contain the deficit. But, as long as this widening is measured and driven primarily by a positive turn in the investment cycle, the associated pickup in capital goods import would help improve the quality of the deficit. This would, in turn, make it easier to finance as the growth story improves an increases India's attractiveness as an investment destination.
Nevertheless, this does not mean that policy makers can rest on their laurels. A pre-condition for this relatively favourable outcome to materialize is that monetary policy remains squarely focused on bringing inflation down, fiscal consolidation moves forward and is of higher quality than hitherto, and, finally, that we see stepped up implementation of structural reforms and execution of stalled investment projects to secure the needed revival in the investment cycle.
The latter depends importantly on the outcome of the upcoming general elections. A strong mandate for a newly elected government could help pave the way for economic reform implementation, although it will still take time to lift the structural constraints that are holding back growth. A weak mandate, on the other hand, could make it more difficult to make convincing progress on reforms and this election outcome would make foreign investors a bit more apprehensive.
Bottom line: The current account deficit narrowed further in the October-December quarter as the trade deficit was contained and income inflows improved. Moreover, a pickup in capital inflows helped bolster the foreign exchange reserves. The deficit will likely widen again next fiscal year as a gradual improvement in domestic demand lifts imports, although a recovery in global demand will help contain the deficit. However, policy makers still have to walk the straight-and-narrow when it comes to monetary, fiscal, and structural policies to make sure that the deficit remains contained and of higher quality.