The market impact of the current account

India's current account deficit for 2005-06 printed at $10.6 billion. This is roughly twice the number for 2004-05. This figure was released a couple of weeks back and I have a feeling that the local stock, bond and currency markets are yet to figure out its ramification.

The fact that the deficit would be higher in the last fiscal than in the previous year was largely anticipated. Skyrocketing oil prices were expected to drive a bigger wedge between inflow and outflows related to the current account.

To cut a long story short, the import bill was expected to be much larger than the inflow on the current account, principally goods and services exports, remittances and other forms of inflow like earnings on tourism.

What took the markets by surprise, however, was the fact that the actual deficit figure was roughly half that of the consensus estimate of $19-20 billion.

Even the Prime Minister's economic advisory council had arrived at an estimate of $20 bn for the year, well over 2 per cent of the country's GDP. A number of international investment banks and brokerages, known to wield enormous clout among global investors, had estimates closer to $25 bn. With the data release, a large section of entire fraternity of economists and forecasters seem to have been caught on the wrong foot.

Let me make a case for writing an entire column on what appears to be a somewhat arcane bit of economic data. For one, for the last year or so, the current account deficit (CAD from now on) has been the biggest bogey about the Indian macroeconomic situation.

The apprehension has been that India's imports of goods, particularly oil, have reached alarming proportions, compared to its exports and other inflow like private remittances. If short-term dollar inflow like FII investments were to flag, funding this gap would become increasingly difficult.

The rupee would finally give and large depreciation would erode the value of foreign investments.

This has, quite naturally, had an adverse impact on capital flows, particularly in the last couple of months, when the Indian stock market has taken a bigger beating than most others.

Apart from the somewhat over-inflated valuations of Indian equities, the size of the current deficit has been cited as the other major risk looming over the Indian asset markets and, thus, a reason to exit Indian stocks. I have, in fact, seen research reports clubbing India with the likes of Turkey, South Africa and New Zealand since they all run CADs. These economies incidentally run deficits of about 6 per cent of GDP.

India, going by this recent data release, had a deficit of a relatively puny 1.3 per cent in 2005-06; even in the worst case scenario, the CAD is likely to settle at a little over 2 per cent in the current fiscal year.

I would argue that this seemingly innocuous bit of economic news is quite a big deal. It should give investors and analysts reason to take a fresh look at the Indian markets.

Why did most analysts go so terribly wrong in their estimates? The forecast fiasco, if I may call it that, is a typical example of how certain perceptions get "hard-wired" in the collective psyche of applied researchers.

I must confess that I was not an exception. We had managed to convince ourselves so thoroughly that the CAD problem was so acute that we chose to ignore some critical bits of information that were available to all of us. For instance, many of us chose to ignore the fact the deficit until the third quarter of 2005-06 was roughly $13 bn and historically the fourth quarter typically turns in a surplus.

We (the majority who got the forecast wrong) assumed that this seasonal pattern would be broken this time and the current account deficit would actually deteriorate in the last quarter quite substantially. The data show that history indeed repeats itself - there was small surplus on the current account in the January-March 2006 period.

The implications of this are quite obvious. India's macroeconomic fundamentals are in better shape than many of us had had factored in. Even if oil prices remain high and portfolios slow down, financing the current account gap should not be too difficult.

In fact, both the key reservations that foreign institutional investors had about Indian markets have now been somewhat comprehensively addressed.

After the sharp drop in prices over the last couple of months, valuations of Indian stocks look attractive once again, especially since the profit growth of Indian companies shows no signs of flagging.

The imbalance in external accounts seems much less acute than perceived and instead of a sharp fall in the rupee, it might just be sensible to build in a small gain in the rupee's value over the year.

Finally, a CAD is a net draft on domestic liquidity. Larger the deficit, the larger is the proportion of capital inflows that exit the domestic monetary system to pay for excess imports.

Currently, the domestic liquidity position seems to be healthy. It is likely that this reflects the fact that the balance of imports and exports is actually much less skewed than many of us had thought.

This is good news for interest rates. If inflation comes off a little as prices of vegetables and grains respond to supply side measures and the RBI makes its stance clearer, there is every possibility that bond yields and interest rates will come down over the year.