I came across two articles recently discussing concern about India’s current account deficit. (Links are as below).

http://advisorperspectives.com/commentaries/arp_120310.php

http://economictimes.indiatimes.com/news/economy/indicators/Indias-strong-demand-a-problem-too-Goldman-Sachs/articleshow/7039610.cms

At this point in time, problem due to current account deficit is considered as low probability event and, probably, got ignored. However, this got me thinking about how all this will end. It is not practically possible to predict the events but there is no harm to do mental exercise. Hence, here I go!!

Indian consumption has been booming. A lot of this has been financed by bank credit. Earlier to year 2000, it was not usual to get loans from bank for any purpose other than buying house and that too at quite a high interest rates. Situation is changed now. People are happily taking loans from bank for buying house, car, and home furniture and also for a vacation. This has led to predictable multiplier effect on economy, thus resulted in high GDP growth and also improvement in corporate revenue growth and profitability. Stock market and property market has reflected this phenomenon.

So far so good!! However, beyond a point, this growth is not sustainable and could lead to serious problems down the road. What are the signs that it is on unsustainable trajectory? One is rate of change in inflation and bank interest rates. Both have started to move higher which is not good sign. This reflects that there are bottlenecks in economy, most glaring is infrastructure. These bottlenecks need to be removed to improve the growth rate. Otherwise, it results in over heating being reflected in high inflation & interest rates. Second is balance of payment and how it is financed. In this case, our current account deficit is widening and is being financed by FII inflow. The FII inflows are short term in nature and can be quickly reversed unlike FDI flows. That is again not a good sign. When time comes, there could be capital flight out of India.

In summary, a good portion of current growth is not productivity led but led by bank credit growth and indirectly financed by hot FII money. When this trend reverses, it will reverse corporate revenue growth & profitability improvements and result in P/E de-rating for Indian stock market.

So, what is the end game? In the most likely scenario, current trend will continue for quite sometime and, like snowballing effect, becomes glaringly unsustainable.

What will be the signs of end game approaching? High p/e ratio for the market, big time FII inflows & appreciating currency despite high inflation, interest rates and current account deficit.

What will be trigger for trend reversal? Strong but late policy response (like some form of capital controls or trade barriers like high import duties) combined with attractive investment opportunities elsewhere (like developed countries equity market available at generational low P/E) could result in FII money leaving India in wholesale.

What will be implications? P/E de-rating of stock market (long term bear market), big time Rupee depreciation and even banking crisis possible.

What action we, retail investors, can take? Sell domestic consumption theme, move to foreign currency deposits or stock market, buy stocks of companies earning foreign exchange.

Time frame of this happening? No idea….I guess 2016, give or take a year or two.