High forex flows are hiding this rising trend in economy; what you must know about CAD

The Financial Express, September 19, 2017

The $25.4 billion of capital inflows into the country, primarily via foreign direct investment (FDI) and foreign portfolio investments (FPI), in Q1FY18 have ensured a surplus in the balance accounts of $11.4 billion—a two-year high. Given the abundance of liquidity in global markets, flows are expected to remain reasonably good, and there is no real concern they will not be adequate to cover the current account deficit (CAD). Nonetheless, the relative strength of capital flows masks the weakness in exports which is creating bigger merchandise deficits. In Q1FY18, for instance, a fairly large trade deficit, of $41.2 billion, drove up the CAD to $14.3 billion, or 2.4% of GDP—a four-year high. Exports, after growing at close to 18% y-o-y in April, clocked a sedate 6% y-o-y and 4.1% y-o-y in May and June respectively. Coming on the back of very modest increase in the last 18 months and a contraction for more than a year before that, this is disappointing. It underscores the need for some serious steps to help exporters—relaxing labour laws and making the environment less stressful could be considered. Else, they will find it hard to compete even if the rupee isn’t as strong as it is now.
Meanwhile, imports continue to rise. More gold is being brought into the country and, while the pre-GST stocking by jewellers ahead of the July 1 rollout was not surprising, gold imports have risen fairly sharply both in July and August. The trade data for July and August have been encouraging with some of the GST-related disruption in July having been reversed in August. For instance, exports in August rose in double-digits—10.3% y-o-y, sharply higher than the 3.9% y-o-y in July. Nevertheless, the trade deficits, even if they are smaller, remain elevated. There is also the concern that inflows from remittances have risen very marginally in Q1FY18, against the backdrop of not growing meaningfully for some two years now. As such, although invisible surpluses increased nearly 15% y-o-y, in the June quarter, reflecting the better global demand, foreign receipts from travel, construction and other business services, these were not enough to offset the higher trade deficit. Also, a good chunk of the strong portfolio flows in Q1, of $11 billion, was contributed by inflows into the bond markets; with much of the quotas for foreign funds nearly full up, these could taper off. Unless the fund flows into the stock markets compensate for this, the total capital flows could be smaller in subsequent quarters. However, at this point capital flows are less of a concern that the subdued increase in exports. As core imports rise—as they should if the economy picks up steam—exports need to grow to keep the trade deficit in check. For now, the CAD it would appear can be reined in at about $37 billion, or a comfortable1.5% of GDP in FY18.

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