Are we heading for a balance of payment deficit this year ?

By the Economist

The country continues to experience the paradox of a surplus of a balance of payment in spite of a massive trade deficit. This was so last year too when the country ran up an unprecedented deficit in the trade balance amounting to 2,516 million US dollars and yet a surplus in the balance of payments of US$ 501 million.

The first half of this year has also shown a surplus of balance of payments despite an even higher trade deficit than in the first half of last year. However the performance in the trade balance and the emerging international and domestic conditions point to a widening trade deficit of a magnitude that may not be offset by the other items in the balance of payments. Are we heading for a serious balance of payments deficit?

The trade deficit for the first half of the year of US$ 1793 implies that even if the import bill does not increase the trade deficit is likely to be over US $ 3500 million this year. In fact the deficit is likely to be higher because of the continued increase in oil prices. The increase in export earnings is not likely to make a sufficient dent in the trade gap.

As a result we may suffer a balance of payments deficit and an erosion of our foreign exchange reserves. A dangerous development is the prospect of reversing such a trend in 2007 may be bleak and unrealistic.

In 2005 the trade deficit widened to an unprecedented US dollars 2,516 million, but other items in the balance of payments reduced the current account deficit to only US dollars 650 million. There was a sharp increase of 22.7 percent in remittances from abroad to reach US dollars 1,918 million in 2005. In addition net inflows to the government too increased by nearly 92 percent. This increase in 2005 was due to the large amount of funds for tsunami relief work. Further relief for the balance of payments was provided by lower debt repayments in view of the debt moratoria. The result was an overall balance of payments surplus of US dollars 501 million.

This raised the official external reserves to US dollars 2,735 million and led to a moderate appreciation of the rupee against major currencies. In the first half of this year the trade deficit reached a huge US$ 1793 million, about 71 percent of the trade deficit for the whole of last year. Yet there was a small balance of payments surplus of US $146 million. Once again remittances were responsible for offsetting a large proportion of the trade deficit. Remittances in the first half of the year increased by a further 24 percent to US $ 1174, around 65 percent of the trade gap.

Is the balance of payments likely to record a surplus this year too? The conditions this year are very different. The country is likely to acquire a much higher trade deficit in the second half of the year owing to a further escalation of oil prices, additional expenditure on defence and perhaps a slowing down of exports.

The current on-going war would indeed be a major factor in these developments.

These items could increase to an extent that they be larger than the incomes from other sources and capital inflows. Although remittances may continue to increase, they may not be as significant in reducing the deficit. Consequently the expected balance of payments surplus may not materialise though there has been a balance of payment surplus in the first half of the year.

As pointed out earlier there were special circumstances that made a balance of payments surplus possible in 2005.

The huge inflow of tsunami relief funds was a significant factor. Additionally, there were moratoria on debt repayments and deferred payments and credit lines on oil imports. Consequently the foreign exchange reserves rose to a higher level than before. Large inflows to the government and increased private remittances bolstered the external finance position, leading to a surplus in the balance of payments and an appreciation of the rupee.

These factors would of course not continue into this year. In fact these favourable factors of last year are likely to exert pressures this year owing to additional payments.

The statistics for the first half of this year indicate that there has been a balance of payments surplus in the first half of this year despite an even larger trade deficit.

The trade deficit in the first half of this year was US$ 306 million higher than that of the first six months of 2005. However since the trade deficit is likely to be in the order of US $ 3500 million or more, the likely prospect is a deficit.

This in turn would fuel inflation that is already running high and increasing the cost of living and burden the poor in particular. The outcome of the balance of payments in the second half of the year could be problematic.