13 October 2016

Economy

Diving into Trending Themes

Does higher external deficit imply lower GDP growth?

Quality of Indian imports has worsened significantly

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It is widely believed that higher external deficit (or lower net exports) implies lower GDP. However, the

relationship is not straightforward. In this note, we argue that until external deficit exceeds its sustainable

level, it is supportive of higher - not lower - GDP growth.

External deficit implies channelization of foreign savings into the domestic economy, which boosts demand.

Further, following the theory of trade liberalization, external trade helps an economy to use its resources

more optimally. The latter usually leads to higher efficiency, and thus, higher GDP growth.

In the present context, the most prolonged episode of declining imports reflects weak domestic demand. A re-

classification of merchandise trade, however, shows that the quality of imports (and thus, deficit) has

deteriorated since productive trade (related to investments) has fallen while inflationary trade (related to

consumption) has increased.

Since domestic investments equal the sum of domestic savings and current account deficit (or foreign

savings), lower CAD in FY17 (expected at 0.8% of GDP v/s 1.1% in FY16) - along with subdued savings - points

to slower-than-expected recovery in investments.

Exhibit 1: Current episode of falling imports the most

prolonged since 1991

85

60

35

10

-15

-40

Merchandise imports

is Motilal Oswal’s new

product, in which we deep-dive into trending

macroeconomic themes. It complements our

existing “Ecoscope” product, which is reserved for

regular updates on macroeconomics.

“EcoKnowLedge”

In this note, we challenge the conventional idea of an

inverse relationship between external trade deficit and

GDP growth. It is widely believed that higher trade deficit

(or higher imports) leads to lower GDP growth. We argue

against this belief. We discuss how higher external deficit

– to a certain extent – is beneficial for the economy.

Higher imports, leading to higher external deficit, help

improve the efficiency in the economy, which boosts

economic growth rather than hindering it. The

movement from an external deficit of 0.5% of GDP

towards 2% is likely to boost sustainable economic

growth, while further widening towards 4%-5% of GDP

makes the economy more susceptible to instability. Thus,

we suggest vigilance, as higher deficit (above 2.5% of

GDP in India’s case) makes it more vulnerable to foreign

capital flows. In simple words, while external deficit

channelizes foreign savings in the domestic economy,

excess reliance on this route must be avoided.

Source: CEIC, MoSL

In the present scenario, with merchandise imports

contracting for the 21

st

consecutive month in August

2016 (and 29

th

time in the past three years) and current

account running at almost balance in the two successive

quarters, the inflow of foreign savings has reduced

considerably, capping economic growth. Considering the

“Theory of Everything”,

with current account deficit

(CAD) expected to narrow further towards 0.8% of GDP

in FY17 (revised from our earlier estimate of 1.4%) from

1.1% in FY16 and lower domestic savings, investment

growth is likely to be more subdued than previously

estimated this year.

Nikhil Gupta

(Nikhil.Gupta@MotilalOswal.com); +91 22 3982 5405

Investors are advised to refer through important disclosures made at the last page of the Research Report.

Motilal Oswal research is available on www.motilaloswal.com/Institutional-Equities, Bloomberg, Thomson Reuters, Factset and S&P Capital.

Where does the idea of “higher deficit, lower GDP” Analyzing relationship between GDP growth and net

come from?

exports

This idea comes from the basic GDP equation, which says

that GDP is the sum of consumption (C), investments (I)

and net exports (or external surplus). It is written as:

GDP = C + I + G + (X – M)

Under the most simplistic (and unrealistic) assumptions,

imports neither add anything to the nation’s GDP nor

subtract from it. However, we believe that higher

imports may actually lead to higher – not lower – GDP

growth. Let’s look at some data.

Since imports (M) are deducted from the equation,

Exhibit 2

compares the movements of GDP growth and

arithmetic tells us that higher imports (or higher external external deficit (net imports of goods & services

deficit) lead to lower GDP. However, it is not so simple.

excluding valuables) of the Indian economy in the past

two decades. The relationship is summarized in

exhibit 3.

Please note we use high imports or high deficit

Between FY94 and FY97, as net exports deteriorated

interchangeably in this note.

(means wider deficit) by 1 percentage point (pp) of GDP,

real GDP growth improved by about 2pp. Similarly, as net

Why do we deduct imports from GDP calculation?

exports improved by 1.4pp during the late 1990s and

As per definition, GDP measures the value of all goods & early 2000s, real GDP growth fell by almost 1pp. Similar

services produced in an economy. Therefore, the value positive correlation was witnessed during the mid-2000s,

of all exports (which are produced within the country) is when net exports worsened and GDP growth quickened.

included and the value of all imports (which are In the most recent past (since 2013-14), as the external

produced outside the country) is excluded.

deficit has halved from ~4% of GDP to about 2%, real

GDP growth has also eased. The only period when this

As per expenditure approach – the most common relationship didn’t hold was during FY10-13, primarily

method of calculating GDP in developed economies, GDP because the deficit widened to unsustainable levels.

is equal to the spending of the private sector –

consumers and private firms – and government on all In other words, a look at data for the past 25 years

finished goods & services produced within the country. suggests positive – not inverse – relationship between

However, it is important to note that whatever an sustainable external deficit and GDP growth.

economy imports, is either consumed or invested (or re-

exported). Thus, the estimates of consumption and

investments already include imports. Since GDP

measures the spending on domestically produced goods

& services, imports are deducted.

The estimates of consumption and

investments already include imports.

Since GDP measures the spending on

domestically produced goods & services,

imports are deducted

Under the most simplistic (and

unrealistic) assumptions, imports neither

add anything to the nation’s GDP nor

subtract from it. However, we believe

that higher imports may actually lead to

higher – not lower – GDP growth

13 October 2016

2

Exhibit 2: Positive relationship between GDP growth

and external deficit*

Exhibit 3: The lower the external deficit, the lower

the GDP growth

* (Imports – exports) of goods & services excluding valuables

Source: Reserve Bank of India (RBI), CEIC, MOSL

Not surprisingly, the positive correlation between

external deficit and GDP growth is not unique to the

Indian economy.

Exhibits 4-5

confirm that a similar

relationship holds for the US and Spanish economies.

During the mid-2000s, when GDP growth quickened in

these economies, merchandise deficit was as high as 6%

of GDP in the US and ~9% of GDP in Spain.

Exhibit 4: Positive relationship between GDP growth

and net imports in the US

The positive correlation between

external deficit and GDP growth is not

unique to the Indian economy.

Exhibit 5: Positive relationship between GDP growth

and net imports in Spain

Source: CEIC, MOSL

13 October 2016

3

How can higher GDP growth be linked with higher

merchandise deficit (or imports)?

The entire concept of trade and globalization is to allow

economies to focus on what they do best, as we call in

economics – their comparative advantage. Such goods &

services, where an economy has a comparative

advantage, should be produced domestically and

exported to the rest of the world. On the other hand, the

other products, in which the economy does not enjoy

comparative advantage, should be imported using the

proceeds from exported goods. This process, via better

allocation of resources and improved productivity, raises

economic growth in the economy.

Let’s think of the impact of trade on the global economy.

Ideally, the external account (net exports) should be

balanced for the world economy (the IMF database,

however, shows a surplus of USD378b for 2014). Does

this imply that trade doesn’t add anything to economic

activity? This is not true. As we explained above, external

trade may lead to significant qualitative advantages,

which get converted into indirect quantitative benefits.

Secondly, external deficit reflects underlying trends in an

economy. In a booming economy, domestic resources

are

often

insufficient,

and

thus,

foreign

savings/resources – in the form of imports of goods &

services – are necessary. External deficit (or CAD) also

indicates lower national savings. This is because as an

economy takes a step towards development, the pick-up

in investment demand may outpace domestic savings

(since consumption may not adjust immediately). If the

economy remains closed and does not import, it will

stifle economic growth.

Does this mean higher deficit invariably leads to higher

GDP growth?

Of course, NOT. Our argument of higher deficit helping

economic growth holds only to a certain extent. This is

because an excessively higher deficit (assumed to be

higher than 2.5% of GDP) increases the vulnerability of

an economy, as deficit needs to be financed via foreign

capital flows. The higher the former, the greater the

reliance of an economy on the latter. This is exactly what

seemed to have plagued the Indian economy over 2010-

2013 (and several European economies in 2008-09). As

the economic environment changes (globally or

domestically), capital flows tend to react quickly while

current account reacts with some lag. This may create

funding gap to the external deficit. As we noted above,

India’s merchandise deficit (or CAD) widened by almost

4pp of GDP during the boom period in the mid-2000s.

However, the level of deficit was manageable at ~1.5% of

GDP in FY08 and thus, supported higher GDP growth.

During the following five years, CAD widened by another

3.5pp of GDP, which took it to an unmanageable level of

4.8% of GDP in FY13. With the taper tantrum of the US

Federal Reserve in the mid-2013, while investors

adjusted their capital flows, high CAD increased the

vulnerability of the Indian economy.

Further, the quality of deficit (or imports) is more crucial

than the quantity. For the Indian economy, trade deficit

linked with investment-related imports (transport

equipment, engineering goods, etc) is more desirable;

this should ideally be financed by the surplus on

consumption-related items. Nevertheless, in the past

few years, while investment-related deficit has

narrowed, the surplus on consumption-related trade has

Thus, imports may not only help boost economic growth, fallen drastically to the lowest ever in FY16. The former

but are also necessary to help the economy reach the indicates lower productive imports, while the latter

next stage of development.

implies excessive inflationary imports.

External trade may

lead to significant

qualitative

advantages, which

get converted into

indirect quantitative

benefits.

In a booming economy,

domestic resources are often

insufficient, and thus, foreign

savings/resources – in the

form of imports of goods &

services – are necessary

If the economy

remains closed

and does not

import, it will

stifle economic

growth

13 October 2016

4

Our argument of higher deficit helping economic

growth holds only to a certain extent. This is

because an excessively higher deficit (assumed to

be higher than 2.5% of GDP) increases the

vulnerability of an economy, as deficit needs to be

financed via foreign capital flows

For the Indian economy, while

investment-related deficit has

narrowed, the surplus on

consumption-related trade has

fallen drastically to the lowest

ever in FY16.

To understand this, we re-classify Indian merchandise

trade into four buckets – consumption, investments, oil

and valuables.

Exhibit 6

shows the year-on-year (YoY)

change in imports of consumption and investment items

in the past few years. While consumption-related

imports have been broadly stable in the past three years

(at about USD38b in the first five months), investment-

related imports declined 5% over the corresponding

period (down from USD62b in April-August 2014 to

USD56b in April-August 2016).

There are two key takeaways: (1) the surplus on

consumption related trade was the lowest on record in

In

exhibit 7,

we calculate the trade balance based on our

re-classified baskets. Notably, while the trade balance

has improved for investments, oil and valuables baskets,

it has deteriorated for the consumption-related trade.

Notably, the fall in investment-related trade deficit

(generally considered desirable) has been entirely offset

by the fall in consumption-related trade surplus in the

past four years.

Exhibit 8

below gives reclassified

merchandise trade deficit over the past two decades.

FY16, and (2) almost the entire improvement in the CAD

in the past three years has been on account of oil and

valuables in the ratio of 3:2

(from exhibit 7).

Exhibit 6: Investment imports have been more subdued

than consumption imports

Exhibit 7: Various contributors to merchandise trade

deficit (USD b)

Exhibit 8: Detailed long-term history of reclassified merchandise deficit (% of GDP)

Source: RBI, Central Statistics Office (CSO), CEIC, MOSL

13 October 2016

5

What does all this mean for the Indian economy?

There are two key implications for the Indian economy –

one for the short term and one for the medium to long

term. Over the shorter term, it is important to note that

the current episode of declining merchandise imports is

the most prolonged in the post-liberalization Indian

economy

(Exhibit 9).

Merchandise imports declined for

the 21

st

consecutive month in August 2016 (29

th

time in

the past three years) and merchandise trade deficit has

been subdued at around USD7b – marking the lowest in

seven years. Current account deficit stood at 1.1% of

GDP in FY16 and was broadly balanced in the past two

successive quarters. All these factors show weak

domestic demand and thus, the demand for imports has

been subdued.

Over the longer term, the key implication to note is that

while CAD has narrowed to 1% of GDP, a surplus has

remained elusive. Assuming a sustainable CAD of ~2.5%

of GDP, the room to widen CAD is only about 1.5% of

GDP, less than half of 3.6pp of GDP, by which CAD

widened during the boom period of the mid-2000s. It

means while foreign savings (equivalent to CAD) added

almost 1pp to GDP growth (direct quantifiable impact) in

the mid-2000s (assuming incremental capital output

ratio (ICOR) of 3.6), it could add only 40bp (assuming

similar ICOR) to GDP growth in the future. Domestic

savings, thus, will have to bear a greater share of the

burden to boost GDP growth to a higher level.

Finally, by the way, as encircled in

exhibit 10,

the current

level of CAD is close to what it was at the beginning of

the previous slowdown and at the end of the mid-2000s

boom.

Exhibit 9: Current episode of falling imports is the most

prolonged since liberalization (% YoY)

Exhibit 10: Long-term history of India’s current account

balance

Source: CEIC, MOSL

While foreign savings added almost 1pp

to GDP growth in the mid-2000s, it

could add only 40bp to GDP growth in

the future

Domestic savings, thus, will have to

bear a greater share of the burden to

boost GDP growth to a higher level

13 October 2016

6

13 October 2016

7

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