If Europe gets back into a chaos, we will initially face difficulty in meeting the FX requirement even in the case that the current account deficit eases.

Critical statistics are announced one after another. Yesterday it was balance of payments figures for February. Here are some striking points: First, the current account deficit has decreased, though not at the desired level. Concerning cumulative figures for the preceding twelve months, the current account deficit had a record high $78.6 billion in October 2011. In February 2012, twelve-month cumulative current account deficit had a value of $75.3 billion. The cumulative of January and February demonstrate a $2 billion drop in the current account deficit.

The foreign exchange (FX) requirement caused by the current account deficit is fulfilled via three channels: net capital inflows, the decrease in official reserves and net errors and omissions. The value of the third item did not change considerably year-on-year. On the other hand, official reserves, which showed an increase in the first two months of 2011, decreased in the first two months of 2012. In other words, the amount of FX attained via net capital inflows and unacknowledged inflows via net errors and omissions could not fulfill the FX requirement resulting from the current account deficit. 

Net capital inflows
It is of higher importance to assess the changes in net capital inflows alone ignoring net errors and omissions in order to identify whether the inflows were sufficient to meet the FX requirement caused by the current account deficit. When assessing the balance of payments statistics for January I stressed that capital inflows had been standing below the amount required to finance the current account deficit. Three-month cumulative values used to eliminate the impact of monthly fluctuations had revealed that this was the case since July. This applies also for the cumulative of February and the preceding two months.

Nevertheless, focusing on February’s figures alone, we see that the outlook starts to change positively: We were able to finance the current account deficit via net capital inflows both because of the month-on-month decrease in the FX requirement resulting from the current account deficit and the month-on-month increase in net capital inflows. As a result, the level of official reserves increased in February.

So, will this positive outlook continue in the months ahead? The answer to this question relates to two factors. The first is about international risk appetite. The “blossom” that started across financial markets in February continued in March as well. The concerns over Europe, however, started to aggravate again. Therefore, it is difficult to estimate to which direction net capital inflows will move. The second factor is about the extent to which the FX requirement stemming from the current account deficit will change. This part is a bit clearer: current account deficit has been decreasing, though at a slow pace; therefore the FX requirement of the economy will be easing.

If Europe gets back into a chaos, we will initially face difficulty in meeting the FX requirement even in the case that the current account deficit eases. After this initial phase, however, the growth rate will decrease sharply, lowering the FX requirement. And if things stay on track in Europe, we will most probably not be facing any difficulty in finance.

This commentary was published in Radikal daily on 12.04.2012