For most of its post-Independence economic history, India has seen a deficit in its current account. The period from 2001-02 to 2003-04, however, witnessed a current account surplus.
The scenario again reversed in 2004-05 and since then the pressure on the current account has been mounting. In the first three quarters of 2005-06, the current account deficit (CAD) touched $13.5 billion.
Rising merchandise deficit has been the key driver of this deficit. The merchandise balance has continued to bloat in the negative zone even as exports have been rising at an average of approximately 23 per cent in the last three years. This is because imports have been rising faster -- at an average of 30 per cent during the period.
The current account comprises net invisibles in addition to the merchandise balance. Balance on the invisible account has been positive and improving due to sterling performance of software exports. But this has not been sufficient to check the rising CAD. Is the rising CAD a cause of concern?
The sustainability of current account is contextual. It depends on its financing pattern and the use it is being put to. The bloating CAD has so far not raised alarm bells for a variety of reasons. First, non-oil imports have been driven primarily by imports of capital goods and mainly export-related items. The rising import trends are, therefore, reflective of enhanced domestic activity and demand from exports. Second, the rising CAD has helped in absorbing the surplus on the capital account, thereby easing the burden on the central bank of managing these. Therefore, the financing of the current account has not posed any challenge as it has been financed through normal capital flows without recourse to foreign exchange reserves. Thus, the rising CAD has been perceived as a healthy development.
The major concern in the external account emerges from the inflating oil import bill. Oil import bill has been rising due to steep rise in international crude prices as well as a pick up in domestic demand for crude. Oil imports have increased threefold between 2003-04 and 2005-06. Thus, in the context of uncertain international crude prices and expected moderation in domestic as well as global growth in 2006-07, concerns about sustainability of the CAD have gained fresh impetus.
In the light of the emerging international and domestic growth scenario, we have attempted to simulate the current account scenario for 2006-07. Given that CAD will be significantly influenced by future movements in oil prices, we have assessed the course of current account under different scenarios of oil prices.
We project the quantum of exports and imports for 2006-07 on the basis of behavioural equations estimated from past data. Within imports, oil and non-oil imports have been treated separately. While the non-oil imports have been linked to domestic activity, oil imports bill has been related to domestic activity as well as international crude prices. Export projections are consistent with expected global economic performance.
For 2006-07, we have used our forecast of 7.3 per cent growth in overall GDP with agriculture, industry and services growing at 3.0, 7.4 and 8.8 per cent respectively. For the global economy, we have relied on the International Monetary Fund (IMF) forecast of 4.7 per cent GDP growth. The momentum in the invisibles balance is assumed to continue and oil prices (WTI Cushing) are assumed at an average of $65 per barrel.
While the export growth is likely to moderate at around 18 per cent, import growth is likely to dip to 19.5 per cent. This will raise the CAD to about $26 billion. Till now, a healthy capital account surplus has prevented any resort to the reserves to finance the deficit. The capital account balance increased from $8.6 billion in 2001-02 to $31 billion in 2004-05.
Given the heightened volatility in foreign exchange flows even a net capital account balance at $30-32 billion for 2006-07 can be termed as optimistic. Under this scenario, the net inflows on the capital account would be just enough to support the rising gap in current account.
But, if the oil prices go beyond the current levels or if capital inflows start drying up, the overall balance would turn negative. Crude prices at $80 and $100 per barrel will spike the current account deficit to 4.8 and 6.7 per cent of GDP, respectively.
Thus, a further rise in oil prices will not only tend to slow down economic activity but would also make financing of CAD unsustainable, and financing of the rising current account gap would require recourse to foreign exchange reserves. Given the healthy foreign exchange reserves a crisis is not in sight but the situation is definitely moving into the zone of discomfort.
The authors are Principal Economist and Economist at CRISIL. The views expressed are personal.