India’s current a/c deficit narrows on record high software exports

India’s current account deficit (CAD) for 3QFY11 narrowed to US$9.7bn or 2.3% of GDP, against US$12.2bn or 3.5% of GDP a year earlier. Three key reasons behind the improvement in the current account deficit: One, the software services exports in 3QFY11 increased 14.6% to US$14.7bn, the highest ever in a quarter, against US$12.9bn a year ago. Two, workers’ remittances rose 5.2% to US$13.4bn in 3QFY11 from US$12.8bn in the year-ago quarter. Three, A US$2 bn delta came from the non-software services exports. Though the balance of non-software services exports in 3QFY11 were a drag (a US$2.6bn deficit), it has markedly improved from the US$4.7bn deficit of the year-earlier quarter.

On the capital account front, thinghs were not too rosy. The capital account surplus rose only marginally to US$14.9bn in 3QFY11, against US$14.6bn a year ago. While inflows under portfolio investment, external commercial borrowing (ECB) and banking capital gained some traction over 3QFY10, inflows under foreign direct investment (FDI) and short-term trade credits were subdued. Notably, the ECB inflows rose to US$3.6bn in 3QFY11, more than doubled from the same quarter a year earlier.

The current account deficit is likely to narrow further in 4QFY11 for two reasons: (a) high exports growth vs. imports resulting in narrowing of the merchandise trade deficit; (b) higher invisible surplus on buoyant software services exports and strong remittances. However, high international crude oil price, if persists, may pause a threat to the improvement in India’s current account balance. Therefore, the rupee is likely to be on the upward trajectory in the next two quarters. I expect rupee to reach around 43 per dollar by the end of June quarter.

Cost of loan likely to increase further as the RBI up the policy rate

Continuing with its calibrated monetary tightening cycle, the RBI today hiked the repo and reverse repo rates by 25bps each. This is a reaction to the high and sticky inflation, which continues to be nearly double the medium-term target of the RBI since Jan ’10. RBI now projects WPI inflation at 8% by end-Mar ’11.

The repo rate – the rate at which banks borrow from the RBI – now stands at 6.75% and the reverse-repo rate – the rate at which banks park money with the RBI – at 5.75%. Today’s rate hike in the policy rates marks the eighth consecutive hike since Feb ’10. Overall, the RBI has hiked repo rate by 200bps, reverse-repo rate by 250bps and CRR by 100bps in the ongoing rate hike cycle. However, the effective rate hike in the operative rate has been 350bps as the operative rate has changed from reverse repo to repo rate due to change in the liquidity situation.

The RBI has increased WPI inflation projection for end-Mar ’11 to 8% from 7% earlier. WPI inflation inched up, to 8.3% in Feb ’11, after softening to 8.2% in Jan ’11. Notably, the RBI has mentioned that non-food manufactured products inflation continues to be Ill above its medium-term trend – it rose sharply, from 4.8% in Jan ’11 to 6.1% in Feb ’11 – indicating that producers are able to pass on higher input prices to consumers.

What next. The food articles inflation has started considerably softening on account of improved supply and the trend is expected to continue on a likely bumper rabi crop, which will hit the market early next month. The main pressure to inflation, going forward, is likely to come from manufactured products. I expect inflation to remain elevated (7% average) in FY12. I expect the RBI to hike policy rates once more by 25bps each in the next monetary policy meeting on 3 May ’11.

Now, the cost of loans is likely to go up further. Clearly, this negative for the Real estate, auto industry and other interest rate sensitive industries. So, guys, be ready to face a high interest rate environment and plan your expenditure accordingly.