India’s external economy may not be under the same degree of stress as it was in the early 1990s when gold, held as reserves, had to be pledged to ease a tight foreign exchange situation. Yet, even if a comparison with those difficult days is neither correct nor apt, there are strong reasons to suggest that all is not well with a sector that was believed to be in the pink of health until recently.
For more than a decade-and-a-half after the crisis, the external economy was the one bright spot in the macro-economic firmament, showing remarkable resilience even as many countries similarly placed as India buckled under one crisis or another. Aspects of India’s external management, for example, its exchange rate policy, have been considered worthy of emulation by several developing countries. Not only did the rupee stay on course in line with the policy of “managed float” but the exchange rate policy helped in achieving certain other important macro-economic objectives. From a position of near zero reserves, the RBI built up sizable foreign exchange reserves, which, at one stage, was considered to be embarrassingly large.
Politicians, and, very strangely, even normally sober economists put forward outlandish suggestions to use the reserves “more productively”. There have always been a number of flaws in such arguments. Unlike, say, in the case of China whose export earnings have accounted for a very large part of its immense reserves, India’s reserves have come mainly from the dollars brought in by foreign institutional investors and portfolio funds. There have been big question marks over their “stability”.
As more recent developments have demonstrated, the worst fears of the RBI and a few others have come true. FII flows can change directions and move out of India and other emerging economies as quickly as they came in.
Making available even a small portion of the reserves for ‘noble’ causes such as infrastructure financing, as was done, is inherently bad economics. But then there is no accountability for giving bad advice and implementation. Given the tight current account position recently, the RBI has had to dip into reserves, for two quarters in a row.
At a very basic level, the fall in reserves has made the RBI’s task of defending the rupee in the exchange markets even more difficult. The almost free fall of the rupee recently is seen to represent all that has gone wrong with the country’s macro-economic management. There is a delicious irony in one of India’s much touted strengths — in the form of foreign exchange reserves — not being able to come to the help of the central bank when it is needed.
The deterioration in the external economy across several parameters was brought home forcefully with the publication by the RBI of the balance of payments data for the January-March 2012 quarter on June 29. Consider the following:
(1) The current account deficit (CAD) — the sum of the balance of trade and “invisibles”, including earnings from software exports and workers’ remittances — has risen to the highest ever level of 4.5 per cent of GDP (gross domestic product), or $21.7 billion during the fourth quarter of fiscal 2011-12. Last year, during the same period, it was 1.3 per cent of the GDP. In turn, the CAD, for the whole of last year, has risen to $78.2 billion, or 4.2 per cent of the GDP, which is again a record (previous year 2.7 per cent).
(2) Widening merchandise trade deficit ($189.7 billion) has been the main contributor to the high CAD. During last year, external demand was subdued. Import of POL products as well as of gold and silver remained inelastic.
(3) There was a drawdown of reserves to the extent of $12.8 billion during the year as against an accretion of $13.8 billion during the previous year (2010-11).
The BOP data bring into sharp focus the crucial dependence on capital inflows. In an increasingly uncertain world, such dependence can be dangerous.
(4) Recent government policies aim at stimulating the flow of short-term capital flows — through, external commercial borrowings and incentivising non-resident Indian deposits, among others. These can be justified only on grounds of expediency. All the recent measures go against the grain of time-tested external account policies which have sought to promote stability.
(5) The RBI has also pointed out that the country’s external debt reached a new peak last year. Key vulnerability indicators such as debt-GDP ratio and debt-service ratio have worsened.