Are we headed for an external sector crisis?

India’s external sector is poised to take a ‘U’ turn – from an optimistic and sustainable Current Account Deficit (CAD) financed by normal capital flows to what may well be dire straits of unsustainable levels of CAD and inadequate capital flows, resulting in a deficit in the overall balance of payment (BoP) position. The pressure on rupee depreciation and depletion of foreign exchange reserves will add fuel to the fire. The reasons for such developments are not far to seek. They include: the protracted war in Europe, net capital outflows, particularly, foreign portfolio investment in the event of higher interest rates in the US and strengthening of the US dollar and on top of it an unprecedented increase in crude oil prices.

The pressure on rupee depreciation and depletion of foreign exchange reserves will add fuel to the fire

What do the numbers tell us? Key indicators to enable this assessment are the following: (a) Trade data released by the Ministry of Commerce and Industry on July 04, 2022 and BoP data released last on June 22, 2022; external debt and the International Investment position (on June 30, 2022) disseminated by the RBI; (b) the level and volatility of rupee depreciation and the intervention of the RBI; (c) the position of foreign exchange reserves, and (d) possible policy initiatives by the authorities.

Trade data for April-June 2022 depicted a trade deficit of US $ 70.25 billion with an increase of exports and imports by 22.22 per cent and 47.31 per cent respectively. The crude oil imports accounting for 32.12 per cent showed an increase of 94.34 per cent. The BoP data for 2021-22 recorded CAD at US $ 38.9 billion (or 1.2 per cent of GDP) and with the net capital inflows of US $ 86.3 billion, there was an accretion of US $ 7.5 billion to Indian foreign exchange reserves.

The last such high level of deficit in overall positions of BoP was recorded in 2008-09, that too lower and amounting to US$ 20 billion in the aftermath of the global financial crisis. This tells us the severity of the crisis we have headed into.

Based on the trends witnessed in April- June trade data and trends in services, income (primary and secondary) and net capital flows, BoP arithmetic for 2022-23 shows the following: Exports (15.2 per cent of GDP as against 13.2 per cent in fiscal 2021-22); Imports (22.7 per cent of GDP as against 19.2 per cent in 2021-22), oil imports (6.8 per cent of GDP as against 5 per cent in 2021-22); trade deficit (7.5 per cent of GDP as against 5.9 per cent in 2021-22).   Going by the trend of 2021-22, net services is estimated at 3.2 per cent of GDP and net income at 1.1 per cent of GDP. Given these numbers, the CAD for 2022-23 is estimated at 3.2 per cent of GDP.

In nominal terms, this will be around US $ 110 billion. This estimate assumes net capital flows of US $ 80 billion, a shade lower than that of US $ 86.3 billion in 2021-22 because of higher net outflows in FPI and lower FDI inflows due to uncertainty in the global markets. In the end, this indicates an overall BoP deficit of around US$ 30 billion- which is a record in recent years. The last such high level of deficit in overall positions of BoP was recorded in 2008-09, that too lower and amounting to US$ 20 billion in the aftermath of the global financial crisis. This tells us the severity of the crisis we have headed into.

Let us now turn to the implications.  

First, CAD at 3.2 per cent of GDP is not sustainable. This is corroborated by the empirical work by RBI published in the Report on Currency and Finance, April 2022. According to the report, growth begins to decelerate with a CAD-GDP ratio beyond 2.3 per cent.

The depreciation of exchange rates increases the interest payments on foreign loans although volatility has no significant effect. Thus, the level and volatility of rupee depreciation is important from the point of view of exporting firms

Second, the deficit in the overall BoP position of the order of US$ 30 billion translates to the sale of US dollars by RBI to the tune of 30 billion. Our foreign exchange reserve position as per the data released by RBI stood at US$ 593.3 billion as on June 24, 2022, of which US $ 529.2 billion accounted for foreign currency assets. It may be noted that over March 2022, these assets have declined by US $ 11.5 billion and on Y-o-Y the decline of assets was of the order of around US $ 37 billion. Assuming that there will be a further decline of US $ 30 billion of reserves as explained above at the end March 2023, the foreign currency assets position will be around US $ 500 billion.

Third, the estimated decline in reserves is pertinent from the angle of RBI intervention in forex market to address the depreciation of the rupee.

So far, the rupee has depreciated by 3.93 percent (March- end 2022 over June-end 2022), as compared with higher levels of depreciation in Argentina (10.2 per cent), Brazil (10.9 per cent), China (5.3 per cent), Malaysia (4.4 per cent), Philippines (6.0 per cent), Thailand (5.2 per cent), Turkey (13.3 percent) and South Africa (9.4 per cent). The level of exchange rate is determined by forces of demand and supply and it is important to note that with a deficit in the overall BoP position, the pressure on the rupee increases. The moot question therefore is: should the RBI intervene in the forex market to arrest the decline and/or volatility in the rupee?

The RBI Currency and Finance report of April 2022 has observed that the volatility of the exchange rate impacts exports more whereas the level of exchange rate does not impact. The study has further mentioned that a 10 per cent increase in the average exchange rate volatility decreases export earnings by 1.6 per cent. With regard to profit, the study has observed that a 10 per cent increase in volatility decreases profits by 3 per cent, while a 10 per cent depreciation of INR against the US dollar, decreases profits by 21 per cent.

The estimated decline in reserves is pertinent from the angle of RBI intervention in forex market to address the depreciation of the rupee

According to the RBI, this may be explained by the fact that exchange rates movements may affect the cost of borrowings for firms which have foreign debt. Furthermore, estimation results indicate that the depreciation of exchange rates increases the interest payments on foreign loans although volatility has no significant effect. Thus, the level and volatility of rupee depreciation is important from the point of view of exporting firms.

Two other important aspects are external debt and the international investment position (IIP). India’s external debt revealed that the short term debt on residual maturity (debt obligations that include long term debt by original maturity falling due over the next twelve months and short-term debt by original maturity) constituted 43.1 per cent of total external debt and 44.1 per cent of foreign exchange reserves. This ratio will further increase given the depletion of forex reserves by US $ 30 billion as alluded to earlier. The IIP position showed that our foreign debt liabilities accounted for 49.2 per cent.

The CAD is at a unsustainable level and the RBI’s measures are expected to work merely as short-term fixes

We may conclude that our external sector faces a grim situation. We will need policy action to enhance export competitiveness and further smoothening of the process to encourage FDI inflows. Policy action taken by the RBI on July 06, 2022 to attract a) NRI deposits (exemption from CRR and SLR and relaxation of ceiling on interest rates), b) ECBs (increase of limit to US$1.5 billion from US$ 750 million) and c) FPI investment in debt (relaxation of the limit of 30 per cent) are short term fixes but will only serve to postpone the problem. They will result in fueling external debt and bringing pressure on repayment and eventually on currency movement.

(The writer is a former central banker and a faculty member at SPJIMR. Views are personal)

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