JEDDAH – India is one of the most domestic-oriented economies in Asia. Therefore, in theory, the European crisis should have a less significant impact on the country than on its Asian peers. However, the nation's strong demand for energy from abroad affects the country in its own way. When the rupee weakens and the current account deficit widens, fuel subsidies weigh more on the government's expenses deteriorating the fiscal deficit, creating the so-called twin deficit, KuwaitChina Investment Company (KCIC) said in its research study Sunday. In order to narrow the structural twin deficits, India has undergone reforms in September, which include opening up to foreign direct investment (FDI) in retail and aviation, cutting fuel subsidies and lowering the tax on foreign debt ownership. As a result, increased investor confidence and the highest monthly inflow in the Indian stock market in seven months have driven the rupee higher in September. This should reduce inflation and improve the current account deficit. If India continues to show its commitment toward reforms, the rupee strengthens further and inflation eases, the Reserve Bank of India (RBI) could start loosening their monetary policy. Despite the recent appreciation, the rupee is still relatively undervalued, and with further liberalization measures and public sector disinvestments looming, the Indian currency has a strong potential to appreciate and provide increasingly higher returns for investors. Although gross domestic product (GDP) grew at around 5.5 percent year-on-year in the quarter ending in June, it is much below the potential growth rate of 7-8 percent seen in the mid-2000s. For growth to recover, inflation needs to ease and give the RBI more room to loosen their monetary policy, the study said. India is a net importer, so its current account is systematically in deficit. When global commodity prices rise, the current account deficit widens further as it takes more to pay for the same quantity of goods. This could have two serious negative impacts: higher inflation, as input costs rise, and lower growth, as demand weakens. The current account deficit reached a historical high of 4.5 percent of GDP in the first quarter of 2012. The main reason for this jump was the wider trade deficit on lower exports due to reduced demand from the US and EU, and a rise in imports, driven by high oil prices and the increase in gold imports, which is considered as a safe asset in times of distress. In the second quarter of 2012, the current account deficit improved to 3.9 percent, however on the back of lower demand and lower oil prices: the decline in goods' imports was steeper than the one in exports. The strong depreciation of the rupee also reduced the country's purchasing power, hindering import demand as domestic consumption, in both vehicle and retail sales, and investments fell. While the narrower current account deficit is a result of slowing domestic demand, the trend is a positive one in the sense that inflation should ease in line with the economy's slowdown. The rupee has already appreciated by more than 5 percent in the third quarter of 2012, which should ease external pressures on inflation. The current account is made up of trade in goods and services, income (net earnings on foreign investments) and cash transfers. In India, the current account balance has been traditionally in deficit, averaging at 3.5 percent of GDP in the past two years. The major driver behind the shortfall has been the deficit in goods trade, which averaged at 9.2 percent of GDP. This is mainly attributed to the country's strong reliance on fuel imports – about 80 percent of the fuel consumed is imported. On the other hand, the surplus in the trade of services (averaging at about 3.2 percent of GDP) has been reducing the current account deficit, along with income and transfers (around 2.5 percent of GDP). The current account deficit is exacerbated by high oil prices. Brent crude oil prices have been very volatile this year, ranging between $90 and $125. The rupee also has an important role in containing the current account deficit: by increasing the purchasing power, the appreciation of the rupee alleviates the high costs of oil imports. In Q1, prices peaked leaving the current account deficit at historical highs, while prices hit 2012 lows in Q2. – SG
