Indias current account deficit widened from less that 1% of gross domestic product in the first half of the 2000s to a recent peak of 5.3% of GDP in the third quarter of last year, Atsi Sheth, vice-president and senior analyst at Moodys Investors Service, said.
The countrys external debt doubled from 2006 to $365 billion at the end of the third quarter 2012, the current account deficit being financed chiefly by debt flows, Sheth said.
While its external debt/GDP ratio of 22% is still relatively modest compared to similarly rated peers, a continued rise in current account deficits and external debt would increase the countrys vulnerability to international financial volatility, with negative implications for the sovereign credit profile, she wrote in a recent commentary on India .
The merchandise trade deficit, which more than doubled to $49 billion at the end of September last year from the end of 2007, is the main factor behind the widening of the current account deficit, due to the global slowdown which has cut demand for Indian exports, robust Indian demand for oil and gold despite rising prices for these commodities and loose fiscal policies that buoyed domestic demand, according to Sheth.
She believes Indias domestic policies are partly to blame for the widening of its current account deficit, which has exceeded that of many similarly-rated peers operating in the same global environment, even those that are similarly reliant on energy imports.
The rating agency will watch 4 more factors in India besides the monthly trade data and the quarterly current account trends to gauge where the countrys external position is going over the medium term.
On the fiscal policy front, more important than the target for the budget deficit will be the assumptions behind that target and the specific policies announced on expenditure and revenue.
Policies that trigger private investment and curb inflationary pressures in the near-term are more likely to help narrow the account deficit, whereas deficit targets based on an assumption of accelerating growth rates are more likely to be missed, leading to higher government borrowing requirements and likely inflationary pressure, both of which have negative implications, Sheth explained.
Inflation and interest rates will also be closely watched. Recent fuel price hikes due to the elimination of some subsidies, a pick-up in growth or rising food prices could cause inflationary pressures to resurface, she said, adding that higher Indian inflation would make exports more expensive, imports cheaper and interest rates higher, widening the current account gap.
Domestic investment is an important factor as, if it does not pick up despite an improving growth outlook and recent policies to revive it, it would suggest diminished competitiveness of the private sector which would also negatively affect the current account, Sheth added.
Finally, foreign investment and external debt will also be closely watched to reveal whether policy changes to boost foreign investment help to shift the composition of financing of the current account gap in favour of foreign direct investment.
If funding for the current account deficit shifted away from external debt and towards foreign direct investment, the sovereign credit profile would benefit, Sheth said.
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