India Insight:Trade deficit narrows sharply;allow for modest depreciation in rupee

Exports to continue to remain a drag (Why are India’s exports falling?):India’s exports have been a drag on overall GDP growth over the past coupleof years. Indeed, goods exports have been falling for the past 14 consecutivemonths by an average of 16%YoY. We believe this sluggish exportperformance is driven by a confluence of factors, including: (a) a sharp fall inglobal commodity prices, (b) weak global demand, (c) low exportdiversification, (d) strengthening of the rupee against trading partnercurrencies, resulting in low export competitiveness, and (e) structuralbottlenecks related to infrastructural constraints, rigid labour laws holdingback large-scale production, procedural bottlenecks and governmentregulations. We believe weak exports and sluggish domestic demand aresome of the key reasons for low capacity utilisation in the manufacturingsector, thus delaying capex-led growth recovery. Going forward, we expectexports to remain weak in FY17 on a subdued global commodity (includingoil) price outlook and weak global growth environment.

Allowing for modest depreciation in rupee (USD/INR) will be positive forgrowth; don’t compare it with 2013 taper episode: As we recentlyhighlighted (Don’t fret the falling rupee (USD/INR), India’s improved macrofundamentals on favourable terms of trade and policy initiatives imply that therisks of a sharp depreciation pressure on the Indian rupee (USD/INR) onglobal headwinds are contained at this point. This is not to say that India isimmune as increased global integration and still-stretched externalvulnerability indicators imply that it will also bear the brunt as global volatilityincreases, but we believe the impact will be limited. Indeed, despite the recentdepreciation seen in the nominal exchange rate since the start of CY16(USD/INR has weakened by ~3%YTD), the rupee seems overvalued on atrade-weighted REER basis (~ 6.7% above the last 10-year mean as of Jan-16) as other currencies have depreciated still faster.

Even as India needs to undertake structural reforms to improve exportcompetitiveness rather than relying on weak currency, we believe thepolicymakers need to allow for modest depreciation in rupee to balancegrowth risks with emerging disinflationary concerns. We expect the RBI toallow for further 2-4% depreciation in Indian rupee (USD/INR) from thecurrent levels over the next 6-months while intervening in the currencymarket to control the near-term volatility for a favourable transition.Accordingly, we expect USD/INR to average 69.8 in FY17 (from 67.8estimated earlier.) It needs to be noted that we have assumed that (a)Chinese authorities have the willingness & ability to maintain control of theRMB, and it will end 2016 versus the US$ at 6.60 and (b) Fed to pause inMarch, but to begin hiking again by 25bp each quarter from June-16, in linewith our global economics team views to arrive at these forecasts (link).

Current account deficit (CAD) to remain manageable: Despite building insluggish exports, we still expect India’s CAD to remain manageable at 0.8% ofGDP in FY16 and 1% in FY17 as imports will also remain contained onsluggish global commodity prices, weak domestic demand and delayedgrowth recovery.