Sharp intra-year volatility in capital flows

Year 2013-14 was remarkable for the external business sector and for the Indian economy because of sharp intra-year fluctuations in forex reserves due to volatile capital flows, even as current account kept improving. Thus, the country’s forex reserves on balance of payment basis plummeted by $10.3 billion during Q2, after a $0.3 billion drawdown in Q1, due to pullout of funds by FIIs in debt market following fears of a likely reversal of QE in USA.

Massive pullout of fickle funds in a short period caused a rapid fall in rupee value which touched around 68 per USD in late August. However, thanks to special swap window opened by RBI reflecting its policy response to stem forex reserves decline and contain pressures on rupee value, FCNR (B) inflow shot up $21 billion in Q3, which helped $19 billion reserve build-up during the quarter. The fourth quarter witnessed another $3.7 billion of NRI deposits inflow and $7.1 billion added to forex reserves. The fiscal ended with an overall rise of $15.5 billion in forex reserves, as compared to $3.8 billion increase in 2012-13 and $12.8 billion drop two years ago.

This relieved policy makers of concerns on rupee value pressures and sustainability of capital flows to finance current account deficit. However, even as the steep decline in forex reserves during H1 was reversed in Q3, the quality of the reserve build-up was lacking because FCNR (B) surge during H2 that helped reserve build-up involved high exchange rate cost.

The country’s current account deficit, somewhat akin to income deficit in its profit & loss account in the external sector, dropped dramatically to $1.2 billion during Q4 – the lowest level since Q4 of 2008-09, from $4.2 billion in Q3, $5.1 billion in Q2 and $21.8 billion in Q1. The improvement has followed reduced trade deficit (in merchandise) from $50.5 billion in Q1 to $30.7 billion in Q4 due cut down in gold import following severe restrictions imposed on gold import. Net service income improved modestly from $16.9 billion to $19.6 billion but secondary income comprising remittances by Indian workers abroad went down slightly from $16.7 billion to $16.3 billion between Q1 and Q4. The outflow in interest, dividend and profit etc. went up from $4.8 billion to $6.4 billion.

In merchandise trade, export on receipt basis, increased from $74 billion in Q1 to $84 billion in Q4; import dropped from $124 billion to $114 billion with gold import falling from $16.5 billion to $5.3 billion between these quarters.

In services, computer services, or software exports, which constituted 90 per cent of total service receipt, increased from about $32 billion in H1 to $34 billion in H2. The improvement in tourism income from around $1.7 billion in H1 to $4.4 billion in H2 reflects also reduction in outgo on account of Indian tourists spending abroad due to curbs on their foreign exchange splurge. The rest of services have practically failed to make much impact on aggregate basis. In a worrisome development, remittances from Indian workers abroad seem to be reaching some plateau, even as repatriations on account of dividends and profits are on the rise due to increasing cost of inward non-debt capital flows. Thus, on a net basis, the support from invisibles to finance merchandise trade deficit is getting contained.

In capital account, longer term non-debt flow like FDI dropped sharply during Q4; following surge in FDI overseas that nearly matched FDI into the country during the quarter. The first half of the year, particularly Q2, witnessed huge outflow in portfolio investment, largely in debt securities; H2 (particularly Q4) saw a rebound in portfolio investment though the year ended with an outflow in debt securities.

Trends in recent years
Sharp contraction in trade deficit, coupled with a moderate rise in net invisibles receipts, resulted in a reduction of the CAD to $32.4 billion, from $87.8 billion in 2012-13 and $78.2 billion in 2011-12. The ratio of CAD to GDPmp dropped to 1.7 per cent in 2013-14 from 4.7 per cent in 2012-13 and 4.2 per cent two years back. CAD broadly reflects import of foreign capital in the form of net absorption of foreign goods and services to finance domestic capital formation; CAD raises concerns when it is financed by capital flows which may not be sustainable and any deficiency leads to pressures on stock of forex reserves. The country has remained net importer of foreign capital in recent years, barring three years 2001-02 to 2003-04.

Net service income has increased to $73 billion from about $64-65 billion in 2011-12 and 2012-13, but software export (computer services), reflecting dynamism of the country’s IT services in the global markets increased relatively modestly by $6 billion to $67 billion. Further, dividend, profit, interest payment has been accelerating; this increased from $16 billion in 2011-12 to $23 billion by 2013-14 and worryingly remittances by Indian workers abroad have stagnated at $63-65 billion between 2011-12 and 2013-14. Thus, in short, support from invisibles to finance merchandise trade deficit is getting cramped.

Excepting 2008-09 and 2011-12, when forex reserves on BoP basis declined, capital flows have managed to bridge CAD in last 14 years. The share of FDI and portfolio investment in capital inflow has gone up over the period. The country’s overseas investment was on the rise till around 2008-09 reaching $19.4 billion (around a half of FDI into the country), but it has tended to decline in subsequent years; amounting to half this level by 2013-14. Portfolio investment has shown high volatility; varying between an inflow of $32 billion in 2009-10 and an outflow of $14 billion in the global meltdown year 2008-09 (the only year of outflow in the new millennium). NRI deposit, largely reflecting sops and interest rate differential, has remained robust in last three years. However, the all-time high inflow of $38.9 billion in 2013-14, nearly three times the raising in the preceding year, mirrored the desperate efforts by the apex bank to shore up forex reserves by offering swap facility to banks for FCNR (B) deposits. Medium- and long term external commercial borrowing has remained at about $10 billion in last four years. Trade credit and advances, receivables etc. saw outflow of $18.5 billion, against an inflow of $18.9 billion in 2012-13.