>BALANCE OF PAYMENTS OUTLOOK (DBS)

Summary
The eruption of the global financial crisis in Sep08 led to withdrawal of foreign capital in Oct08-Feb09 and a 10% depreciation in the rupee against the dollar. But the crisis did little to alter the longer-term fundamentals of the economy and its attractiveness as an investment destination. Not surprisingly, and given hitherto cheap equity valuations, capital flows returned from March. This has brought the rupee back to pre-Oct08 levels even as foreign exchange reserves have risen by over USD25bn since Mar09.

Looking ahead, we continue to envision a strong balance of payments position but do not expect the current pace of inflows to continue. Our view that the drop in global output in 4Q08 was largely shell-shock has implications not just for the shape of the recovery in output, but also for financial flows and markets [1]. Capital flows, similar to economic growth momentum globally, dropped more than it should in the aftermath of the collapse of Lehman Brothers. Hence, the recovery in capital flows has also been especially sharp and rapid since March. Going forward, just as growth should moderate to a square-root shape from a ‘V’, capital flows should also moderate to more ‘normal’ levels [2].

From a multi-year perspective, we expect capital flows to rise, though the balance of payments surplus is likely to narrow compared to recent years. As a share of GDP, we expect the capital account surplus to improve from the 0.8% in FY08 (ends Mar09) to 4.5% in FY09 and about 5.5% in FY10. This is stronger than the volume of capital flows witnessed in 2003-06 but far from the deluge ( 9% of GDP) seen in 2007. However, the current account balance is expected to deteriorate steadily over the next couple of years, led mainly by wider merchandise trade deficits. Thus, the balance of payments surplus should narrow to 3.3% of GDP in FY09 and FY10 – smaller than in 2006 and 2007.

Capital account to improve
Annual capital inflows more than doubled to over USD 30bn in 2004-06 from the previous three-year period and surged further to USD 110bn in FY07. This was driven by rising external commercial borrowings (ECBs) and strong portfolio flows. Net foreign direct investments (FDI) also improved markedly, but not as much as ECBs or portfolio capital flows, partly because overseas direct investments have also increased in recent years

India should continue to attract strong capital flows in the near-term. Various FDI confidence surveys (UNCTAD 2008, AT Kearney 2007) rank India as the second most favoured destination for direct investment. Likewise, notwithstanding rising domestic imbalances and inequalities, and a less than ideal pace of reform, India is the fastest growing emerging market in the world, save for China. On the back of this growth outlook, we project net FDI to rise to 1.6% of GDP in FY10 from the 0.5% averaged in FY2003-06. Portfolio capital should remain elevated at 1.5% of GDP in FY10, though it should ease from FY09 when we estimate higher flows due to reversal of FY08’s “shell-shock” outflows.

However, ECBs should be more subdued in the next couple of years when compared to FY06 and FY07. While borrowing norms have been liberalised by the central bank (RBI) in the past year, these inflows are highly cyclical (Chart 1). There are two reasons for this. First, the norms on ECB borrowings ensure that ECBs are allowed only for fixed capital investment – the most cyclical expenditure in an economy. Second, the borrowings tend to be inversely related to domestic interest rates – the opportunity cost of borrowing abroad – making it strongest later in the cycle. Additionally, we do not view the loosened ECB norms as permanent [3]. As such, we forecast net loan flows to rise from an estimated 0.4% of GDP in FY09 to 0.8% of GDP in FY09 and 1.7% of GDP in FY10. The FY10 forecast puts it on par with the net loan flows in the strong economic
growth years of 2004-06, but nowhere as high as FY07.

On the whole, these flows imply a capital account surplus of 4.5% of GDP in FY09 and 5.5% in FY10, i.e., about USD 55bn and USD 80bn respectively.

To read the full report: BALANCE OF PAYMENTS