India trade balance adjusts with exchange rate correction

Contrary to popular perception, says DBS, India’s trade balance has already adjusted markedly owing to correction in the rupee exchange rate and international commodity prices.

DBS Group Research noted:

Contrary to popular perception, the trade balance has already adjusted markedly owing to correction in the rupee exchange rate and international commodity prices. This, however, doesn’t imply the days of sharp rupee weakness are over.

The customs trade balance registered a deficit of USD 13.5bn in April and then widened to USD 16.2bn in May, prompting concerns from the central bank about the persistence of the deficit despite the depreciation in the domestic currency.

However, the right way to assess if rupee weakness has led to an adjustment in the trade balance is to consider the deficit after adjustment for seasonal effects. By this measure, the trade deficit narrowed to USD 13.5bn (sa) in May, a big improvement from the USD18.5bn (sa) deficit registered in Jan-Mar.

How much of this improvement is due to falling oil prices? About one-half of the improvement or USD 2.6bn appears to relate to the drop in oil prices, and may not sustain if oil prices climb once more. The remaining improvement owes to the fall-off in non-oil imports in response to a weaker rupee and partly to a general decrease in commodity prices (which too may not sustain).

Non-oil imports in May are down by 12% (seasonally adjusted) from the average in January and February, in addition to being down 16% from the same month last year. To be sure, some of the reduction in the trade deficit also owes to unexplained month-to-month variation.

All considered, about two-thirds of the improvement in the non-oil trade deficit in May could be expected to be preserved ahead, we reckon. This means the annual merchandise trade deficit in FY2012/13 (Apr-Mar) could be smaller by USD 18bn or 1.0% of GDP. Thus, the current account deficit could improve from 4.2% of GDP registered in FY 2011/12 to 3.2% of GDP in FY 2012/13.

The question is: is this improvement enough? The answer depends on the domestic policy environment (apart from global market sentiment). If the domestic policy environment doesn’t improve, it may not be possible to attract capital inflows worth 3.2% of GDP to bridge the deficit in the current uncertain global economic backdrop. This may mean that the days of sharp rupee weakness are not over.

On the other hand, if some quick decisions can be taken to reverse the deterioration in the policy environment this year (liberalizing fuel pricing or large hikes in retail fuel prices, liberalizing FDI in retail, insurance etc), the risk of sharp rupee depreciation is minimized.

Whichever happens, it is worth noting, the rupee has to depreciate on average against trading partner currencies (NEER) each year to maintain its price competitiveness and keep the trade deficit from widening. This is because inflation in India is higher than trading partners’ inflation (with an average 4%-point gap).

Thus, even if the investment environment improves, the outlook cannot be for sharp rupee appreciation against all currencies. If capital inflows ever prove strong, the Reserve Bank of India is likely to step up intervention relative to the past, as the lesson it takes from the sharp 25% increase in the USD/INR exchange rate over the past year will be to limit the current account deficit so as to minimize the risk of wild swings in the currency.