Current account deficit could worsen in remaining quarters of FY14

The current account deficit (CAD) in the fourth quarter of 2012-13 was 3.6 per cent of gross domestic product (GDP), lower than market expectation which had forecast 4.4 per cent.

For fiscal year 2013, CAD was 4.8 per cent of GDP, or $ 87.8 billion, a record level.

CAD represents the balance sheet of India's commercial transactions with the rest of the world. A deficit indicates that India's imports exceeded its exports and the gap was bridged by foreign investment into India or the Reserve Bank of India (RBI) dipped into its foreign exchange reserves to pay for transactions.

The fourth quarter's CAD as a percentage of GDP, which beat market expectations, is deceptive in suggesting improvement .

A closer look at the data put out by RBI shows that the next few months are going to be challenging and the CAD as a percentage of GDP may worsen in the remaining quarters of 2013-14.

First, the main reason for the improvement in the headline number was that imports in the fourth quarter of 2012-13 contracted by a percentage point as compared to the previous year.

According to RBI, the contraction in imports was on account of a slowdown in economic activity.

With the growth rate in the economy slowing down to 5 per cent in 2013-14, the slowest in a decade, imports of machinery and industrial equipment tapered. The slowdown in imports took some pressure of CAD which showed up in an improvement in the fourth quarter of 2012-13.

This improvement is likely to be short-lived on account of some other trends that have financed India's CAD in the last few years.

A worrisome aspect of India's external sector over the last few years has been the growing proportion of short-term debt that has financed CAD. At end March 2013, India's short-term debt to foreign exchange reserves stood at 33.1 per cent as compared to 26.6 per cent in the corresponding period of the previous year.

An increasing proportion of short-term debt, when the country is simultaneously subjected to negative global influences, increases the riskiness associated with the economy. Short-term debt has to be redeemed in the near future even as an unfavourable global environment can mean that foreign investors are pulling out.

A combination of these factors has resulted in the rupee depreciating against the US dollar from Rs 54.77 at the beginning of 2013 to the current level of about Rs 60.

In India's case, things are set to worsen as the redemption pressure on foreign borrowings will be high this financial year even as foreign portfolio investors have begun to reduce their exposure to India.

According to RBI data, $60 billion of foreign debt on Indian companies' balance sheet and deposits of Non Resident Indians are due to be redeemed this year. A part of the borrowings may be rolled over, but most of it would have to be redeemed.

Given the extent of redemptions around the corner, RBI with foreign currency reserves of  $261 billion (on 14th June) has practically no ammunition left to defend the rupee except sporadically.

In short, India's policymakers have no options left except to brace themselves for tough times as every percentage point depreciation in the rupee from the current level increases pressure on the CAD.